In our previous commentary “Gold and the US dollar – a love hate relationship” we used a normalized time series of the price of gold expressed in US dollars and an index representative of the value of the US dollar on currency markets to show the inherent relationship between the price of gold and the financing currency. As the financing currency strengthens on currency markets, one would expect the price of gold expressed in that currency to fall. We used the gold price in dollar terms as an example.

As would be expected when the dollar falls, the price of gold in dollar terms would tend to rise. This result should not be surprising- when a currency is weak, an asset priced in that currency should increase in value, relative to that currency.

In this week’s commentary, we explore this relationship further focusing on historical events where there was a flight to quality, evidenced by a surge in demand for high quality US dollar assets (typically US government treasury bills). These will serve to highlight one of the potential risks of owning gold priced in dollars as a defensive asset.

While gold priced in dollars does indeed show characteristics as a safe haven asset, financing gold purchases using only US dollars can, under certain market conditions, detract from gold’s performance during these stress periods. The reason is self-evident and related to our initial discussion about the relationship between gold and the financing currency used.

During periods of stress, the dollar has historically strengthened in value on currency markets as investors sold non-dollar assets for dollar-assets to hold as a defensive move against market declines. In fact in recent history, absent a viable alternative, the US dollar has been the defensive currency of choice and typically strengthened in value versus other currencies including gold as investors bid up its value in their search for financial safety.

This arguably remains the case today for a number of reasons in particular i) the strong regulatory regime in the US, (ii) high liquidity and (iii) the size and diversity of US financial markets unrivalled anywhere else in the world. And following the logic of our initial discussion as the dollar strengthens, the price of assets financed in dollars, including gold, will tend to fall in value relative to the dollar.

An investor that buys gold financed in US dollars is expressing a strong directional view on both gold and the dollar – in market speak they are long gold, short USD. And it is this explicit short position on the dollar that creates the potential vulnerability for gold during periods of high market stress, as the dollar strengthens.

As we have discussed in previous commentaries a viable strategy for investors to reduce dollar exposure is to diversify the financing currency used to make gold purchases across two or more currencies i.e. follow a “diversified gold” strategy. In effect this would reduce exposure to the dollar and thereby reduce the risks to holding gold from a surge in the value of the dollar.

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