The association between gold and the US dollar has existed since 1900.
The association between gold and the US dollar has existed since 1900. During the gold standard from 1900 to 1971, value of a unit of currency was tied to the specific amount of gold. It moved to floating exchange rates after 1971. The US dollar and gold were freed from their association.
Now the US dollar is a fiat currency, which means it gets its value from government regulation. The US dollar is used as a reserve currency. According to the International Monetary Fund (IMF), around 40–50% of the moves in the gold prices since 2002 were dollar-related. A one percent change in the effective external value of the US dollar led to more than a one percent change in gold prices.
So, why is there is an inverse co-relation between gold and the US dollar? Gold is traded mainly in the US currency, so a weaker dollar makes gold less expensive for other nations. A falling dollar increases the value of other countries’ currencies. When the US dollar starts to lose its value, investors look for alternative investment sources to store value. And that alternative is gold.
Now the next question is from where is gold price derived? Isn’t the price derived by looking at demand and supply? The answer is unfortunately a big no; or else, gold prices would have been up as the physical demand for gold was strong in 2016 with inflows into Exchange Traded Fund (ETF) reaching second highest on the record.
The gold and silver futures markets are not a place where people buy and sell gold and silver. This is the market where speculators and hedge funds use gold futures to hedge against other bets. The gold prices are determined in this speculative market and not in physical market where people buy and sell gold.
This is the reason why large speculators or bullion banks can drive the price of gold down even if the demand for the physical metal is rising. There is physical tightness in the global gold market.
The ratio of 542:1 gives such an indication. This ratio is that of COMEX (Chicago Mercantile Exchange): 542 paper ounce of gold is traded for every one ounce of registered gold, which means that if gold buyers after buying future contracts ask for delivery, COMEX would default as there isn’t physical gold to fulfil the buy contracts (1 ounce available out of 542 ounces traded).
Of course, hardly any buyer in COMEX will ask for delivery as they are all speculators. So, this proves that a weakness in the US dollar does not necessarily make gold prices go up as it is more appealing and less expensive as physical buying will hardly prop up the gold prices. In fact in COMEX, there are very few physical buyers.
The writer is director, Tradebulls Securities