The US dollar and the gold price
January 23, 2004
Recall from last week that the PVE Gold Index consists
of the GDP-weighted gold price in thirty-six countries, including
the United States. Since nine of the countries in the index use
the euro, twenty-eight currencies are represented. For convenience,
I copied last week’s chart below; let’s see what we
can glean from it.
The PVE Gold Index gives us an idea of how the average
gold price in the world is changing. When the gold price in any
given currency deviates from the PVE Gold Index it implies a change
in the exchange rate of that currency with respect to the other
currencies in the index.
We can therefore see that the US dollar exchange rate
was relatively stable from January 1990 to the middle of 1992, when
the dollar started to strengthen. We know the dollar strengthened
because the gold price, in dollars, started to drop below the PVE
Gold Index indicating that the dollar’s purchasing power was
increasing. But why did the dollar strengthen?
In 1992 the Brazilian real collapsed and capital in
search of safety made its way, mainly, to the United States. The
real was devalued to practically nothing; it was replaced by the
new real on July 1, 1994. As a result of the Brazilian currency
crisis the demand for US dollars soaked up US currency that would
otherwise have been used for settlement of international trade.
The dollar, therefore, increased not only against the real, but
against many other currencies as well. Between 1992 and 1994 the
dollar increased by about ten percent against the other currencies
in the PVE Gold Index.
This increase in the dollar’s exchange rate
on foreign currency markets is represented in the chart above by
the decline in the US dollar gold price relative to the PVE Gold
Index that started in 1992.
The Brazilian real crisis was hardly behind us when,
in 1995, the Mexican peso dropped more than fifty percent against
the dollar. This was the worst financial crisis in Mexico since
the Mexican Revolution. More capital flowed into the United States,
competing for dollars on foreign exchange markets and keeping the
dollar strong.
Between 1995 and 1996 the Japanese yen lost about
twenty-five percent against the dollar. More demand for dollars
meant that the dollar continued to strengthen on foreign currency
markets, further increasing the gap between the average, worldwide
gold price and the US dollar-gold price. Japan set the stage for
the big one, the Southeast Asian currency crisis.
Between 1996 and 1997, the Indonesian rupiah dropped
seventy-six percent; the South Korean won fell fifty-six percent
and both the Malaysian ringgit and the Philippine peso lost forty
percent of their value against the dollar. This was a financial
catastrophe and its effect was felt across the globe. Since the
US dollar was performing well on foreign currency markets, thanks
to the Brazilian, Mexican and Japanese devaluations earlier in the
decade, a tidal wave of capital made its way to the United States.
Still shaken from the events of 1996 and 1997, Russia
defaulted on its foreign debt in 1998, sending the ruble down seventy
percent in just one year. In conjunction with the Southeast Asian
crisis the mood is grim, and international capital pours into the
US seeking refuge.
The increase in the US dollar following the Southeast
Asian currency crisis crushed the US dollar-gold price and was large
enough to be evident in the PVE Gold Index. The US dollar represents
twenty-eight percent of the Index and contributed to the Index’
decrease of more than twenty percent during 1996 and 1997. As you
can see though, the US dollar-gold price declined much more and
for much longer.
When the euro was launched in January 1999 it collapsed
almost twenty-five percent, on average (PVE Euro Index), and about
thirty-five percent against the dollar. As if this was not enough,
the Argentine peso had trouble in 1998; in 2000 it was the Turkish
lira and in 2002 it was back to Brazil for another round.
As an aside, all the currency devaluations mentioned
are examples of how the dollar’s exchange rate affects the
US dollar-gold price. Even though the world is currently fascinated
by the euro’s exchange rate as a leading indicator for the
US dollar gold price we cannot ignore the impact of other currencies.
Collectively, they could be more important.
The compounding effect of capital flight during all
these currency crises can be seen in the increasing deviation between
the US dollar gold price and the PVE Gold Index. The index is currently
more than sixty percent higher than it was in 1990 while the US
dollar-gold price has only recently recovered to its January 1990
level.
The dollar’s strength stemmed from the weakness
in other currencies. It had very little to do with America’s
productivity, or a “New Era”. Because most major currencies
in the world had already devalued against the dollar it was obvious
that the dollar could not continue to increase indefinitely. A PVE
Dollar Index, using the same GDP-weighted currency data as for the
PVE Gold Index, shows that the US dollar gained 112% from January
1990 to February 2002 (its peak) and has since declined by fourteen
percent.
We have seen that the decline in the US dollar-gold
price, and its under-performance relative to the rest of the world,
is a reflection of the US dollar’s exchange rate. It is my
belief that the US dollar gold price will again catch up with the
PVE Gold Index as a result of continued weakness in the dollar to
correct America’s enormous trade deficit. This correction
of the dollar has only just begun and is likely to increase the
US dollar-gold price by approximately thirty-five to forty percent
more than the concurrent average increase in the gold price in other
currencies.
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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