Gold
and USDX
Adam Hamilton
Archives
Jul 27, 2007
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
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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