In this article we will be looking at the relationship between the US dollar (USD) and the price of gold. We will be exploring some of the factors that cause changes in the USD. Throughout most of late 2007 and early 2008 the weakness in the USD has meant that the gold price has been increasing. We will be looking at the factors affecting the USD, and conversely why the price of gold had risen.
What are some of the factors affecting the USD?
Domestic Economy; The domestic economy effects the exchange rate of a country. The perceived location of the US economy on the economic cycle (ie boom, bust, expansionary or contractionary) is one consideration. Things like economic growth, economic outlook and inflation will give an indication on the economic health of the country. Depending on where in the economic cycle an economy is will influence the the level of interest rates. For example, in the boom phase in the economic cycle, central banks will increase interest rates to slow demand and reduce the possibility of inflation occurring. This has been noticed in Australia in early 2008 with the Reserve Bank of Australia (RBA) increasing interest rates to reduce inflationary pressures.
Monetary policy in the US is similar to Australia in the sense that interest rates will rise to curb inflationary pressures and/or demand. However an increase or decrease in interest rates in the US causes the the demand/supply of the currency to increase/decrease.
One of the major problems with the US economy is it's debt levels. The USA owes net around $3 trillion to overseas nations. This has the effect on putting downward pressure on the USD. Furthermore, the USA pays more interest on their debt to overseas nation than they interest they receive.
Interest Rate Differential; Differences in interest rates from one country to another effect the demand of foreign currencies. Put simply, international investors would rather put their money in a country that pays higher interest on their investments. For example, as at May 2008. the interest rates in Australia are higher than in the US, therefore an investor from Europe or Asia would rather put their money in a bank account in Australia and earn more income. The net effect is that there is upward pressure on the Australian dollar (AUD) and downward pressure on the USD. Conversely, investors in the US might want to move their cash holdings to Australian banks for that same reason, similarily causing upward pressure on the AUD and downward pressure on the USD.
Foreign Currency Reserves; Countries like China, Russia, Japan hold vast amounts of reserves in foreign currencies and the USD is just one of the many they hold. It is estimated that countries (excluding the US) hold around $13 trillion in US currency. The major problem here is that if the US economy continues to show weakness and the USD continues to fall, then many nations who hold USD as foreign currency reserves might sell it and replace it with another nations currency, or even gold.
What affects the price of Gold?
The price of gold is primarily affected by two things. Geopolitical tensions and as an inflation hedge. When tensions in the Middle East are perceived to be at a very dangerous level, that is, they could boil over and cause a war in some countries or the supply of oil will be affected, then people will invest in gold. It is seen as a safe asset to hold in times of difficulty. Inflationary expectations also influence the price of gold. This was evident in the 1970s when inflation was very high and the price of gold increased as well. As mentioned above, central banks hold gold in their reserves, just in case there is geopolitical tensions or world inflationary pressures.
What's the Link Between the USD and Gold?
The USD used to be considered the safe haven, this is not the case any more. Many investors/central banks continue to hold gold as their safe haven asset to protect themselves from worldwide economic shocks or tensions. The USD diversification is set to continue with the US having such a large foreign debt and weakening economic conditions. Due to the inverse relationship between gold and the USD, many people are medium to long term bullish on the gold price.