How Gold and the USD Can Depreciate in Tandem

Economics, Premium POM

By JC Collins

The post I wrote the other day on selling gold now while it’s high has created a lot of interest.  While there is a lot of good information out there on gold, there is also a lot of bad information.  It is not my intent to add bad information, so I wanted to take some time to review the POM position and perhaps bring more clarity on why I’ve come to the conclusion which I have.

Many readers find it somewhat contradictory that I would suggest the dollar and gold depreciate in tandem.  The traditional, and accepted correlation between the two, is that one will depreciate while the other appreciates.  This correlation, though somewhat empirical, could also represent a non-empirical set of data points which we have not yet recognized.

There have been many studies completed over the years which prove that this correlation between the USD and gold is not unique to just the two.  That is to say that when the dollar depreciates there is an appreciation in the value of gold priced in the dollar, and that this also holds true for other currencies as well.  This correlation holds true 80% of the time.

Between the years of 1971 and 2009 there were 9 separate breakdowns of this correlation.  The divergence happened twice for the USD, four times for the euro, and 3 times for the pound. Outside of that the correlation holds between gold and the USD, as well as gold and other major currencies.

Others have made a case that the correlation between gold and the dollar doesn’t exist and the two move independently of one another.  Perhaps this is the case and the 9 periods of divergence are providing us a clue to something else.

With that being said, a metric has to be used in order to trend and analyze data.  As such, we will work from the position that the correlation is empirical.  Under such an approach the 9 anomalies between the years of 1971 and 2009 stand out as something more than just skewed data points.

The periods of divergence are the early signs of a larger breakdown in the correlation, whether empirical or non-empirical.  This breakdown is beginning to happen between other pairings as well, such as with the Australian dollar and gold, which has just recently diverted from its traditional correlation.

A similar case can be made with the USD and gold.  The traditional correlation has mainly held with USD appreciation correlating into gold depreciation.  But when we consider the level of dollar appreciation over the last year, we find that gold has not depreciated at the same ratio as one would expect if the correlation between both was still maintained.

In essence, a position can be taken that gold should have depreciated much further than what it already has.  Perhaps even as low as $600.00 to $700.00 per oz.

There exists one of two probabilities.  One, the dollar has diverged and will depreciate back to a range where the correlation resumes.  Two, gold depreciates further, faster, so that the correlation resumes.

There is the possibility that the divergence could be corrected by sudden adjustments in both, but I don’t see this being likely in an environment where the dollar will strengthen more under increasing interest rates.

In recent posts I’ve made the case that the dollar will see initial appreciation when the Fed finally begins the process of increasing interest rates, but will begin to weaken in the months after the first increase.  There are many reasons for that, and I would recommend readers revisit the post The Case for Increasing Interest Rates and Depreciating the Dollar.

But what happens to the gold/dollar correlation when the dollar begins to depreciate?

We would normally expect that gold would begin to rise in such a situation.  What isn’t considered is that international demand for gold usually goes up when the dollar goes down because foreign buyers can purchase it cheaper with dollars.  This increase in demand pushes the price higher.

Now consider that the internationalization of the Chinese renminbi will provide an alternative opportunity for investors to make returns as the dollar weakens against the RMB.  The liquidity market for the Chinese currency has slowly been built over the last few years, and is waiting for the massive capital flows which will begin once the RMB achieves reserve currency status alongside the dollar.

Under such a scenario we could see the correlation between the dollar and gold diverge even further.  The lower demand for gold combined with a more defined period of rare divergence, like the 9 periods between 1971 and 2009, could double hammer gold down into the $300 to $400 per oz range.

How long it will stay at those prices will depend on many factors.  One of which will be the new exchange rate arrangements that will be structured over the next few years.  Another will be the stability of the renminbi as its liquidity market increases.

Contrary to some opinions I am pro precious metals.  Unfortunately my analysis, which is built around the monetary transition to a multilateral framework, is telling me that gold will bottom further before it turns.  The intent of the article was to suggest an opportunity to sell gold now while it is still at higher values, and transfer that wealth into commodities and mining based equities while such are low.

The coming commodities boom will see massive returns over the next 2 to 3 years.  At that time those equities can be sold at high values and the wealth reinvested back into gold at lower prices, potentially even the $300 to $400 range.

Gold will increase in value again as the new monetary framework begins to settle and the correlations between gold and currency return.  The upside here for precious metals investors is huge.  Especially if they bought in at the lower levels.

A return to the upward values of $2000 per oz may not be seen for a few decades.

The much lauded collapse of the dollar will likely not happen as many expect.  Sure, there is a debt issue, but keep in mind it is more about how effective a country can manage their debt, as opposed to how large the debt is.  As an example, after WW2 the US has a debt-to-GDP ratio of over 140%.  Today the debt-to-GDP ratio is around 101%.

When the dollar depreciates American exports will increase, which will in turn be reflected in the GDP numbers, lowering the ratio and making the debt more manageable.

I simply do not see the big crash that so many have been calling for.  There very well could be some volatility and a financial crisis where many companies and banks will fail, but I would suspect the storm will pass before long and a new balance will be found in the international monetary system.

At least for a few years.  – JC