January 12, 2004
The euro has become quite the buzz in
the gold market. No wonder, look at the close correlation between the
dollar-euro exchange rate and the gold price in US dollars, shown on the
Such a close correlation is not a coincidence. The major
driver behind the changes in the US dollar gold price since 1996 is nothing
other than change in the US dollar exchange rate, which explains the correlation
between the dollar gold price and the dollar-euro exchange rate.
The euro, as we all know, had a rough start. But that was
probably more due to the fact that its launch happened to coincide with
a feverish demand for US dollars than to anything else. The dollar was
gaining against almost all currencies, and its momentum was too much for
the new euro to deal with. This caused the euro to decline by 29% against
the dollar from January 1, 1999 to October 25, 2000.
The demand for US dollars was also what caused the gold
price decline from February 1996 to April 2001. You can see the dollar’s
influence on both the euro and the gold price by noting that the rate
of decline for both is the same, except for the spike in the gold price
in September 1999 when the Washington Agreement was announced. If you
remove the effect of the Washington Agreement on the gold price, the euro
and gold mimic each other almost perfectly over a period that spans five
The euro is obviously not a commodity. It is clear from
the chart that gold’ behavior is identical to that of the euro,
the world’s second largest currency by GDP. We have seen before
(see archives) that the price of gold does not respond to changes in net
investment demand for gold, producer hedging, central bank sales, or other
metrics that should have an impact on its price if it were a commodity.
Therefore it is obvious that gold is not behaving as a commodity. It is,
however, behaving like a currency, which is not surprising since gold
is, after all, money.
As mentioned, the euro’s initial decline was mainly
due to the dollar’s momentum. Fundamentally I am not a fan of either
the euro or the dollar, since both are fiat currencies and therefore ultimately
doomed. The euro is actually a worse currency than the dollar because
of the diversity of Europe compared to the United States. But in the short
to medium term, the euro is likely to continue to do well, not only against
the dollar, but against most other currencies for the simple reason that
the euro is replacing a portion of reserve assets currently held in dollars.
It makes sense for countries that trade with both Europe and the United
States to hold euros and dollars in proportion to the relative trade balances
with each economic block. The dollar’s monopoly as the main reserve
currency in which almost all trade, including all oil purchases, is settled,
is slowly being dismantled and this will continue to put pressure on the
dollar and boost the euro, for many years to come.
The expansion of the European Union is a built- in guarantee
that the euro is going to continue to do well in the short term because
any country joining the Union will automatically settle trade with other
Union members with euros.
This does not mean that the euro cannot decline, or that
the dollar won’t rebound in the short term. We have to distinguish
between long-term trends and short-term volatility. In the short term
anything is possible, and the euro will take a knock every now and then,
and the dollar will get a B-12 shot from time to time. However, looking
out five or ten years, I think it’s a safe bet that the dollar will
continue to weaken and the euro will continue to strengthen.
As the chart above shows, the decline in the euro from January
1999 to June 2002, and the relatively stable gold price during the same
time, implies that the price of gold in euros should have increased during
those two and a half years, which it did, by 42%. As a corollary, the
strength in the euro, in perfect step with the increase in the gold price
since 2002, implies that the gold price in euros is no longer increasing.
Since June 2002, the gold price in euros in fact dropped 4%, while the
gold price in dollars increased by 31%.
Let me say it again: the decline in the price of gold from
1996 to 2001 was due to the strength of the US dollar on foreign exchange
markets. The increase in the gold price since 2002 is, similarly, due
to weakness in the dollar. What is currently being perceived as a bull
market in gold is, in reality, only a bear market in the dollar. It is
a dollar phenomenon: the price of gold in euros, as we have seen, has
not increased since June 2002. Neither has the price of gold in South
African rands (down 15% since June 2002) or Australian dollars (down 3.5%
since June 2002), two of the largest gold producing countries in the world.
For all the talk about the cabal losing control, or
the shortfall between mine supply and fabrication demand, or swings in
net investment demand for gold, or concern about the world’s monetary
system collapsing because it’s based on a fiat currency (the dollar),
the evidence suggests that gold is merely maintaining its purchasing power.
That is to say, gold is doing what it has done for centuries: acting as
a store of wealth.
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
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