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Gold is not the main act
March 04, 2005

The correlation between the US dollar exchange rate and the US dollar gold price is getting a lot of press, but it seems that the assumption is that when the dollar falls gold becomes less expensive to non-US dollar-buyers, and that in turn stimulates the purchases of gold and causes the gold price to rise. That's not how it works.

Let's simplify the market: you and I are trading gold in US dollars, and John is trading gold in euros. So every day John trades his euros with us in exchange for dollars with which he then trades gold. Now let's say that one day we decide (for whatever reason) that the euro is less attractive and offer John less dollars for his euros. Since he cannot get dollars anywhere else, and since he still wants to trade gold with us, he reluctantly accepts the lower exchange rate and continues his gold trading. What just happened?

The euro fell against the dollar and as a result John had less dollars with which to trade gold. So the gold price in euros increased. But the gold price in dollars didn't change at all. What you have to pay really close attention to is the fact that the amount of gold traded has not changed due to gold's new price in euros.

Now let's come back to reality. If the US dollar falls against foreign currencies the gold price in US dollars rises only because of the exchange rate change. A change in the US dollar gold price does not imply that gold is more, or less attractive to foreign traders and it does not imply that gold will be preferentially bought or sold by foreigners. It doesn't mean anything other than that the US dollar lost some value and as a result everything bought in foreign US dollars markets is more expensive.

Many people still wrongly assume the US dollar gold price is "the" gold price and that a decline in the US dollar makes gold more attractive to foreign buyers, which in turn stimulates buying, and causes the gold price to rise. Then they go on the fret about the close correlation between the US dollar exchange rate and the US dollar gold price, wondering when that will break down.

If there were only one currency to trade gold in, then the gold price in that currency would be solely a function of the differential inflation rates of gold and the currency. If gold mining (as a percentage of all above ground gold) exceeded the inflation rate of the currency, then the gold price would fall, and vice versa.

In the real world, where we have numerous currencies, the price of gold is still determined by the inflation rates of the currencies relative to gold. In most cases the currencies inflate more rapidly than gold is mined, which is why the gold price continues to rise over time.

When we consider the gold price in any one particular currency, it is still a function of the relative inflation rates over the long term (decades), but in the short term (months and years) volatility in the currency's exchange rate will over-print the long-term trend. This overprint, due to exchange rate volatility, does not imply a fundamental change in gold's value, or a change in the gold market itself. It is merely a reflection of the currency's exchange rate.

The other thing that occurs in the real world is that investors oscillate between being manic and depressive, which causes emotional bull and bear markets. When they're manic with respect to gold, they buy gold with no regard to fundamentals and the gold price can exceed its underlying value. We saw that happen in the late 1970s. Then, when investors become depressive, they sell without any regard for value and the gold price falls below its intrinsic value. Such bull and bear cycles can be identified on time scales varying from days to decades.

The gold price that we observe is a combination of all three factors: differential inflation rates determine the long-term gold price, or trend line if you will, while exchange rate volatility and emotional bull-and-bear cycles cause the short-term volatility in the gold price.

But it's important to realize that in today's financial markets gold is not the main event. Fiat currencies are the main event. It may be that this system of fiat currencies will blow up one day, and that gold's role in our monetary system will become more pronounced than what it is today. But I have not seen any indication that that is imminent.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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