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
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
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
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
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