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
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
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
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
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