Interest rate disconnect
October 25, 2004

By now the relationship between the price of gold and the US dollar exchange rate is well established and old hat. Yet it remains very important: the dollar will continue to drive the gold price for the foreseeable future, until rampant speculation takes over and we find ourselves in a rip-roaring, emotionally charged, gold bull market. That will be then. For now we have to concern ourselves with the US dollar and its impact on the gold price.

If the US dollar exchange rate is driving the gold price, what is driving the US dollar? The answer is interest rates.

When interest rates rise, the return on fixed income securities, such as bonds, increases. Higher investment returns attract foreign capital and foreign demand for US investments creates demand for dollars. The increase in foreign demand for dollars (to buy US securities) raises the US dollar-exchange rate. And, of course, a stronger dollar means a lower gold price.

So, we know that the gold price depends on the dollar and the dollar depends on interest rates. Therefore, the gold price is indirectly responding to changes in US interest rates.

The following charts will illustrate these points.

The first chart shows the US dollar gold price versus an index of the US dollar exchange rate against the currencies of the G10 nations. Note that I have inverted the G10 Index so that the dollar is actually getting weaker as the index moves higher. It’s clear that the gold price is rising as the dollar is falling.

Next, let’s look at the same dollar index compared to US interest rates. I have chosen the yield on constant maturity ten-year US Treasury Bonds as a proxy for interest rates and this time the G10 Index is not inverted, so a decline in the G10 Index reflects a decline in the dollar. Obviously the dollar has been falling as interest rates declined.

If we now compare the US dollar gold price to US interest rates (same yield on ten-year constant maturity bonds) then we can clearly see the inverse relationship between the gold price and US interest rates: as interest rates decline, gold prices go up. In the following chart the interest rate curve has been inverted to show the relationship better, so an increase in the red line is actually a decline in interest rates.

Okay, so the gold price is driven by the dollar and the dollar is driven by interest rates making the gold price a function of interest rates. When interest rates decline, the dollar falls and the gold price rises.

So far everything is working as expected: the economy is getting weaker, interest rates are falling, the dollar is falling and the gold price is rising. However, for most of the year I’ve been saying that for the gold price to sustain a meaningful rally we need to see the dollar fall in conjunction with higher interest rates; in other words we need to see the gold price rise with rising interest rates, and that is contrary to what is currently happening.

For the gold price to rise along with rising interest rates it first needs to disconnect from the influence of interest rate changes, and that means the dollar has to disconnect from the interest rate. That is both possible and probable, as I will explain in a minute.

In the meantime the gold price remains vulnerable to an increase in US interest rates.

If interest rates increase prior to the disconnect it will cause the dollar to rally and the gold price to fall. You may recall that the Wall Street Journal reported last week that bond investors are betting on just that: an increase in interest rates, which means the aforementioned risk is not to be ignored.

One possible reason bond investors are betting on higher interest rates is the US budget deficit. The budget deficit has to be financed by issuing US Treasury bonds and an increase in bond issuances should cause bond prices to fall and interest rates to rise, leading to a decline in the gold price.

However, the growing budget deficit is a major problem for the United States. It, and the trade deficit, will ultimately lead to the disconnect between the dollar-exchange rate and interest rates. Because the budget deficit has to be financed by issuing Treasury bonds it will put upward pressure on interest rates. This occurs because issuing bonds, especially in the amount required to finance the budget deficit, will put downward pressure on bond prices and interest rates are nothing more than the yield in debt instruments, such as bonds. So when bond prices decline, as they will because of the budget deficit, interest rates will rise.

Financing the budget deficit is a long-term problem for the US and it cannot be avoided given the government’s current policies, which are unlikely to change much regardless of who wins the election. Because of this I believe that interest rates in the US will increase irrespective of whether the economy can cope with higher rates or not. When interest rates start to rise the dollar could potentially rally driving the gold price down.

However, rising interest rates will wreak havoc on the fragile US economy. As the economy weakens it will become more and more difficult to attract sufficient foreign capital investment to offset the trade deficit. Once that happens the US dollar will fall and, no, I don’t think China, Japan and the United Kingdom are going to support the dollar forever.

It is this combination of rising interest rates, from bond issuances to finance the budget deficit, and a falling dollar resulting from continued weakness in the US economy accompanied by declining foreign investment that will lead to a disconnect between the US dollar and interest rates. And that will set up the next major increase in the gold price.

Under this scenario the dollar will fall in conjunction with rising interest rates; the opposite of what is happening now. Until then, the dollar remains positively correlated to interest rates and hence the gold price remains negatively correlated to interest rates, and that is something that gold investors should bear in mind.

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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