Flight to Gold

As we have covered in a lesson on the relationship between gold and the US dollar, there is a stong inverse relationship between the gold price and the US dollar.

• As the US dollar drops, so the gold price rises. The chart below from March 1995 to March 2005 clearly shows this 'inverse" relationship. The US dollar is the single line
  

 

The Crisis

US Subprime lending fiasco: In late July 2007 US Federal Reserve Chairman Ben Bernanke fuelled the subprime mortgage market concerns by saying that there were clearly going to be substantial financial losses due to problems with subprime lending. He estimated losses tied to the subprime market had the potential to reach $100 billion. What we normally see with a financial crisis is a flight to Gold which is historically viewed as a safe haven.

The current line of thought suggest that any continued weakness in the US economy may cause the US Fed to drop interest rates. This in turn would soften the $US further. Based on the theory of inverse relationship between the US dollar and the price of gold, the gold market could experience a continued strengthening of the gold price.

Of interest, gold producing companies such as Lihir Gold and Newmont have had a concerted effort to buy back the hedging that they had placed on the future price of gold. The removal of the 'hedging' effectively places the share price of the respective companies more directly aligned with the underlying spot gold price. This removal of heding suggests that these companies have the belief that the gold price will be stronger for longer.

Emerging Counter Argument

However contrary to the popular accepted view, some commentators are suggesting that Gold is not the assured safe haven it was previously. Their viewpoint details that the rise in the gold price has raised the prospect of central banks reducing the volume of gold in their currency reserves. In short, cash in while the price is high. For example, Switzerland is on course to reduce its gold reserves by over 250 tonnes (~US$5bn) due to the value of gold held rising by 30%. The argument is that a subprime market fuelled crash could send the price of gold down due to a flight to cash (which is the preferable asset to hold in a crisis).

Market's Perception

If the market is to be believed (and it normally is) the rise in the price of gold-producing companies such as Lihir Gold and Newcrest Mining suggests that if the US dollar weakens further and the inverse relationship theory holds, gold price and the value of gold mining companies will enjoy further strengthening. Just be aware of the fact that as the above chart shows, the US dollar and the gold price can bounce around, so any growth in the value of gold mining companies will similarly reflect this movement.

For a more generic look at Gold and Gold stocks click here