Gold and USDX
Over the past couple weeks the financial markets have burst free from their usual summer doldrums to provide some welcome excitement. Prices that have long seemed locked in stasis with trivial daily moves are now witnessing dramatically increased volatility. It is great to see the markets getting interesting again!
While mainstream attention remains focused on the rising amplitude and frequency of down days in the general stock markets, the volatility in the currencies has also accelerated considerably. As a dollar-denominated American investor and speculator riding the secular gold bull, I've found the behavior of gold and the US Dollar Index particularly intriguing lately.
Gold, of course, has been the ultimate form of money all throughout history. Its immutable intrinsic value has transcended every era, government, and currency the world has ever seen. Gold is the perfect form of money because it is universally prized and is rare in the natural world. This scarcity of gold ensures that world supplies only grow around 1% a year on average over centuries, so it is immune from inflation.
Since gold demands ironclad spending discipline by governments, they have generally tried to avoid using it as a currency. Instead they inevitably create paper currencies ex nihilo and render them legal tender by regulatory fiat. Since they can print as much paper as they want, there is no natural limit to inflation. This is why all paper currencies in history ultimately inflate themselves into oblivion. Their supplies are quite literally unlimited.
So all throughout history gold has been locked in an epic struggle with the countless fiat-paper currencies that have challenged it. This perpetual war between enduring money and ephemeral money persists today, with the US dollar continuing to cling to its world-reserve-currency status. In light of this history, watching the interplay between gold and the dollar over the last six years of this secular gold bull has been fascinating.
But like every market relationship, perspective is absolutely necessary to truly understand how gold and the US dollar interact. Over the last few weeks and indeed for most of 2007, gold and the dollar have moved in opposing lockstep. On any particular day that one is weak the other tends to be strong. This relationship is real and valid. And it makes logical sense due to gold ultimately competing against the dollar for global monetary hegemony.
Analyzing this recent interaction between gold and the dollar is the reason I penned this essay, as it has major near-future implications for investors and speculators in a broad array of markets. But in order to really understand the present, we must first ground ourselves in the strategic perspectives offered by the past. Hence this initial long-term chart to properly frame the big picture behind today's events.
Over the last six years, gold and the dollar have been moving in opposing secular trends. Gold's secular bull began powering higher in early April 2001 while the dollar's secular bear began bleeding lower in early July 2001. So the history of interaction between these two currencies goes way back beyond the last week, month, or year. Here the dollar is represented by the trade-weighted US Dollar Index in these charts. This USDX has become the most universal and popular way to track the dollar's progress.
From this broad perspective, the mirror-image symmetry between the secular gold bull and secular dollar bear is quite obvious. Gold has generally thrived on the dollar weakness and the dollar has generally withered in the face of gold's strength. Upon seeing a chart like this, most traders make the assumption that this symbiotic relationship must be the cornerstone of the gold bull. This is incorrect though.
While dollar weakness is certainly a major factor in gold's strength, it is certainly not the only one. Gold and the dollar each have their own independent supply and demand profiles which govern their individual price performance. Gold's fundamentals reveal a structural deficit while the dollar's fundamentals show a structural surplus. The underlying drivers for each currency are largely independent.
In gold's case, global investment demand is rising but mined supply and central-bank sales cannot keep pace. Finding gold and bringing it to market is a very difficult process that can take a decade or more after the initial discovery. So gold miners cannot ramp up supply in response to high prices for many years. This supply-limited nature of gold coupled with accelerating global investment demand is its primary driver.
In the dollar's case, its supply is unlimited. The US Fed can and does create as many dollars out of thin air as its political masters in Washington demand. Want big government? Want welfare? Want wars? Want to buy votes? All this stuff is extraordinarily expensive. So the Fed wishes new dollars into existence to "pay for" anything the politicians can dream up. Naturally the result is accelerating monetary inflation and rapidly ramping dollar supplies.
But the problem is the world is already swimming in dollars. Foreigners hold vast amounts of Washington's paper and are heavily overexposed to the dollar. Even if the dollar was strong, it would still be prudent to diversify which would decrease dollar demand. On top of diversification there are big reasons to sell dollars worldwide, including its six-year-old bear, frustrations with Washington's imperialist foreign policies, and superior returns available in other major countries' currencies and bonds.
It is this waning demand in the face of perpetually growing supplies that is driving this dollar bear. And while the gold bull and dollar bear affect each other psychologically, such as a weak dollar increasing investor awareness of gold, they are not each other's primary driver. Gold is being driven higher by a structural deficit in it alone and the dollar is being driven lower by a structural surplus in it alone.
If you are an investor or speculator, this is a very important distinction to understand. Almost everywhere I look today, from CNBC to analysts on the Internet, there is a ubiquitous assumption that the gold bull only exists due to the dollar bear. The logical extension of this flawed idea is that if the dollar does not fall, then gold will not rise. In other words, gold's fortunes are held hostage to those of the dollar.
Thankfully a careful examination of this chart immediately dispels this false notion. From their respective beginnings in 2001 to their parallel interim extremes of late 2004, gold rose 77% while the dollar fell 33%. Now if the dollar bear was the sole driver of the gold bull, there should have been rough parity between gold's gains and the dollar's losses. Instead we saw gold outpace the dollar by about 2.3 to 1.
And although gold's overall performance from 2001 to 2004 far outpaced the dollar's weakness, these two competing currencies did exhibit a powerful negative correlation on a daily basis. Over these four initial years, gold and the USDX had a correlation r-square of a staggering 92%! In other words, 92% of the price action of gold on a daily basis was statistically explainable by the inverse of the USDX's daily moves and vice versa. This is an incredibly high correlation over such a long period of time, quite remarkable really.
And there certainly was a reason for this lockstep opposition. Gold bulls have three stages. The first stage is driven by a currency devaluation. The dominant currency, in this case the dollar, grows weaker which gets early contrarian investors interested in gold again following a long gold bear. During Stage One, most of the time dollar weakness indeed was the primary driver of gold just as people wrongly assume it still is today.
Eventually Stage One matures and investors start to pursue gold for its own fundamental merits. This ushers in Stage Two when gold starts rising on its own global investment demand independent of whatever the dollar happens to be doing. The transition zone from Stage One to Stage Two is marked above on this chart. It happened in mid-2005 when gold held stable despite a powerful USDX rally.
Since mid-2005, we have definitely been in Stage Two of this gold bull. There are several empirical ways to verify this fact on this strategic chart. First, from 2005 to today, the r-square between gold and the USDX plummeted to 18%. Thus only 18% of the daily moves in gold were statistically explainable by opposing moves in the USDX since early 2005. 18% is not much, virtually uncorrelated, and is a radical departure from the 92% witnessed from 2001 to 2004. These are obviously entirely different environments.
Second, the last time the USDX approached its long-term support at 80 in late 2004, gold was trading near $450. Today with the USDX once again approaching 80, gold is trading nearly 45% higher near $650. If the dollar remained gold's primary driver, then gold would probably be back at late-2004 levels today. Clearly something else is driving gold demand besides dollar weakness.
Finally, gold has powered 181% higher in its bull to date while the dollar has "only" fallen 34% in its bear to date. Gold's strength is outperforming the dollar's weakness on the order of 5.3 to 1. The dollar bear alone is nowhere near devastating enough to account for the impressive early-Stage-Two strength in gold.
This strategic background is crucial if you want to understand the gold and dollar interaction today. There was indeed a time when gold's primary driver was the USDX bear, but it ended in 2005. Since then gold's behavior has really diverged from that of the dollar. Although it can seem like the dollar must still be in gold's driver's seat if you are mired deep in day-to-day action, strategically this is no longer the case.
As a student of the markets I am really blessed to be able to watch them all day everyday. So I will be the first to admit that we have seen a lot of days in 2007 when gold seemed to be doing nothing but reacting to the dollar's flows and ebbs. This week was a key case in point, when the dollar sunk to its critical long-term support near 80 and then rocketed back higher. Gold sold off on the dollar's renewed strength.
Now if I did a survey today, I am convinced that virtually all gold watchers would tell me that gold's inverse correlation with the dollar is stronger than ever. I would probably say it too, as I find myself watching the USDX more and more closely and crediting its impact on gold as the reason behind gold's daily price movements. Yet statistically, as this next chart shows, the gold/USDX negative correlation during this latest gold upleg and dollar downleg is nowhere close to being as strong as it was in Stage One.
Gold's latest interim low, and the dollar's latest interim high, both happened in October. The latest gold upleg and latest dollar downleg started that month, so it is a good place from which to consider the gold/dollar interaction of late. Provocatively, the daily correlation r-square between gold and the USDX since October was only 63%. 63% is definitely considerable and meaningful, but it is a far cry from the 92% we saw prior to 2005 back in Stage One.
Despite this, there is undeniably a certainly symmetry in this chart. Gold has had four major rallies within this upleg and three of the four coincide with dollar slides. The vast majority of the second gold rally, running from early January to late February, happened when the dollar was pretty flat. Otherwise though, the mirror-image behavior of gold and the dollar has largely returned. Gold has been in a persistent upleg since October while the dollar has been in a persistent downleg. Is the dollar back in control here?
No. The key thing to remember about Stage Two is that it can contain episodes of Stage-One-like behavior. While Stage One is currency-devaluation driven so gold tends to move in inverse lockstep to the dominant currency, in Stage Two gold gradually becomes uncorrelated. But even though it has been mostly uncorrelated with the dollar overall since 2005, there can still be episodes of inverse correlation from time to time.
An uncorrelated pair of prices ought to move in concert, in opposition, and independently roughly a third of the time each on sheer randomness alone. So a rising inverse correlation for a season does not mean that we are regressing to the days of dollar-dominated gold. Stage-One-like apparently-currency-dependent gold behavior makes an appearance periodically even when global investment demand is gold's primary driver.
Another indication we remain in Stage Two is the magnitude of the gold gains compared to the dollar losses since October. As of the lows this week, the dollar was down 8% since October. Meanwhile gold rose 23% at best in mid-April. Gold's upleg gains are outpacing the dollar's downleg losses by about 2.9 to 1 which again shows that dollar weakness cannot be gold's primary driver even over the short term. Back in the early Stage One days, gold only tended to gain as much as the dollar lost.
We can further consider today's lack of parity between gold's gains and the dollar's losses by looking at where these two currencies have traded relative to their 200-day moving averages. When a price is divided by its 200dma, it creates a relative price. This shows the price as a constant multiple of its 200dma which creates a horizontal trading range when charted. Based on my Relativity trading model, this helps investors and speculators understand when a price is cheap or dear.
Looking at both gold and the USDX as constant multiples of their own 200dmas really illustrates the lack of parity between gold's gains and the dollar's losses. Gold's rallies have been of much larger amplitude, diverging farther away from its own 200dma, than the dollar's slides. Once again, something beyond mere dollar weakness is driving gold. There is no other way to account for gold's superior performance.
Another subtle indication of gold strength emerges from rGold's support line. It is rising, with gold making higher bottoms relative to its 200dma in early January than in early October and again higher in late June than in January. When a price continues getting stronger relative to its 200dma at subsequent interim lows, it tends to be setting up for a major move higher. Meanwhile the dollar is getting weaker relative to its own 200dma, its interim highs diverging farther away.
All these charts considered together ought to shatter the popular myth today that gold is once again slave to the dollar. The dollar's behavior is certainly influencing gold more than it has since 2005, but it is not gold's primary driver. Gold is following the dollar's general pattern, inverted of course, but it is far more responsive to the upside than the dollar is to the downside. So don't fall into the trap of believing that gold is once again being held hostage by the dollar.
Back in Stage One when gold had a 92% r-square with the USDX, the inverse relationship between these two currencies was pretty mechanical. Gold could only move if the dollar led the way in the opposing direction. But today in Stage Two where gold has only had an 18% r-square with the USDX, I believe the dollar's impact on gold is far more psychological than anything else. Psychology is certainly very important in the markets, but its impact is less precise and concrete.
Greed and fear have always been the most powerful short-term motivators in the financial markets. When one or the other dominates sentiment, prices can rise or fall rapidly totally independently of underlying fundamental drivers. The dollar seems to be evolving into more of a sentimental driver of gold than a fundamental one. This would explain the dollar's weakening, yet still apparent, impact on gold.
When the dollar sells off, futures traders still steeped in the Stage One paradigm rush to buy gold. Similarly when the dollar rallies, the futures markets sell gold. This is probably what creates the day-to-day correlation and drives the perception that the dollar remains gold's primary driver. And these daily gold moves opposing the dollar reinforce the sentiment that drives this futures trading. It becomes a kind of self-fulfilling prophecy on a daily basis.
Although the belief that the dollar still dominates gold is no longer correct, we can use it in our favor. Today the USDX is approaching critical multi-decade support at 80. Once it falls decisively below 80, it will hit new all-time lows and enter uncharted territory. As I discussed in May, such brutal lows will probably create an international crisis of confidence in the US dollar. Dollar holders, big and small, will get scared and feel tremendous pressure to sell dollars to lighten their positions. This will exacerbate the dollar slide.
Now the futures world, still looking to the dollar as gold's primary driver despite all the evidence to the contrary, will buy gold as this dollar selloff intensifies. This gold buying will coincide with a seasonally strong time for gold which should lead to a serious rally. Thus the sentimental impact of the dollar on gold, particularly when the USDX slides under 80, could lead to a huge surge of investor interest in gold worldwide.
We've been preparing for this potential major upleg in gold and silver all year at Zeal. We've been researching countless stocks and recommending elite precious-metals miners and explorers at technically opportune times to buy. If you want to join us in our trades as we lay in positions, please subscribe today to our acclaimed monthly newsletter. If this thesis proves correct, our realized gains should be outstanding.
And if this week's general-stock corrections and sympathetic precious-metals weakness spooked you, I encourage you to read a couple of essays I wrote earlier this year. HUI and Stock Selloffs analyzes the HUI's performance during the massive stock downlegs of 2000 to 2002. The HUI did great despite heavy stock selling. And Gold, Silver, and Stock Bears looked at gold and silver during the brutal 1973 and 1974 stock bear similar to the potential one we may be entering today. Gold and silver soared. Precious metals are classic alternative investments that draw the most interest when general stocks are the weakest.
The bottom line is the dollar's impact on gold is now only a shadow of what it once was on a purely technical and fundamental basis. We have moved on into Stage Two where international investors bid up gold on its own fundamental merits independent of the dollar bear. Despite this, the dollar's fortunes still have a big sentimental impact on gold futures traders and hence the tactical gold price.
So while dollar weakness is no longer necessary for gold to power higher, its lingering psychological impact could make a sub-80 slide look like gasoline thrown on a fire. As gold approaches its seasonally strong time of the year and the dollar threatens to plunge to new all-time lows, it should generate a lot of positive sentiment for gold. This can only help gold, silver, and the PM stocks in their coming upleg.
Adam Hamilton, CPA
Jul 27, 2007