In last week’s Gold Report we looked at the historical relationship between the gold price in dollars and the value of the dollar, as measured by the Intercontinental Exchange US dollar trade weighted index (USDX) and found a strong inverse relationship between the two – a strong dollar has historically tended to be associated with a weak gold price. Further we showed that this relationship is implicit in the way in which gold’s value is expressed. When an investor buys gold in dollars they are expressing the view that they expect the price of gold to increase in terms of the number of dollars for which it can be exchanged at a future date. An investor that buys gold in US dollars is therefore expressing a directional view on both gold and the dollar – they are expressing the view that as the dollar weakens on currency markets they would expect, all things being equal, to receive more dollars for a given amount of gold. Similarly as the dollar strengthens they would expect to receive fewer dollars for a given amount of gold. In market speak they would be said to be long gold, short USD. And it is this short exposure to the dollar from holding gold in dollar terms that we believe investors should be concerned about in the current macro-economic environment.
Source: Bloomberg LP; Treesdale Partners calculations; past performance is not indicative of future performance.
In the chart above we plot the rolling 3 month correlation of weekly returns between gold and USDX (blue line, right axis) and also the USDX price index (red line, left axis). There are two elements to the current market dynamic that we feel investors that hold gold in dollars should factor into their investment outlook. Firstly, since its trough at the beginning of May, the USDX dollar proxy has strengthened by over 6.5%, representing broad based dollar strength against a trade weighted basket of currencies. And secondly since that time the correlation of the gold price in dollars to USDX has dropped indicating that the strength of the inverse relationship between gold and the dollar has increased materially. Taken together these suggest that further strength in the dollar (for example, driven by the sharp divergence in monetary policy between the Federal Reserve and other central banks) is likely to put significant downward pressure on the price of gold in dollars.
For investors that wish to maintain an allocation to gold to benefit from its defensive qualities despite the current strong dollar environment we would therefore recommend financing gold purchases in currencies other than the dollar. Our preferred gold financing currencies would be from economies whose monetary policy for macroeconomic reasons, is most divergent from monetary policy here in the US such as in the Eurozone or Japan. And for investors that prefer not to express a strong directional view by using a single financing currency we would recommend taking a diversified currency approach.