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28 March 2024

Crisis could end link between gold and dollar

Gold ingots at the Argor-Heraeus plant in Switzerland. Prices of the yellow metal are still responding negatively to Greek sovereign risk issues. (AFP)

Published
By Sunil Kumar Singh

Gold's traditional position as a safe-haven asset and a store of high value has a lot to do with its negative correlation with the US dollar for a long time. A very liquid asset like gold has traditionally been seen as a hedge against dollar depreciation against other major currencies.

Gold's appeal to both investors and central banks has hinged on its role as an alternative monetary asset – effectively a currency that cannot be debased by printing presses, as the World Gold Council (WGC) notes in its recent report.

However, tell-tale signs of this correlation matrix getting decoupled have been recently becoming more apparent, say analysts. "A sovereign debt crisis like the one we have seen in Greece over the past month, kept gold stable as the safe haven buying was offset by a stronger dollar. An escalation of that theme could result in a net rise of gold despite potential dollar strength," says Ole Hansen, Senior Manager for CFD and Listed products, Saxo Bank.

Gold has stayed range bound during the dollar rally over the past few months which is obviously a sign of strength and also shows that some of this dollar strength has been due to sovereign debt worries that have been supportive for gold, he says.

Gold prices are still responding negatively to Greek sovereign risk issues and an element of momentum selling. However, despite the generally firmer US dollar, gold continues to trade in a range between $1,060 (Dh3,893) and $1150 per ounce, a range which has been in place since mid-December 2009.

Sentiment among investors remains bullish for 2010 with some asset managers suggesting gold could gain as much as 30 per cent this year, according to Rothschild Private Banking and Trust's latest observation in its investment weekly.

So, what are the factors working behind the price of gold apart from the dollar?

The last decade has shown that while gold is, in many ways, a simple asset (it has no default risk or counterparty risk and no complicated structures underpinning it) the drivers behind demand and the gold price are not that simple.

Gold has shown that it can perform strongly when economic growth is buoyant, as it did during the 2003-2007 period, but it can also outperform when the global economy is in recession, the WGC report says.

Gold can outperform when inflation is benign (as it did through much of the past decade), it can outperform in a deflationary environment (as it did in 2008 and early 2009), and it can outperform during an environment of above trend inflation or expected inflation (as it has done more recently).

While this doesn't imply that gold is immune to cycles, it does show resilience across the economic cycle, WGC says. Going by the historical correlation between US currency and gold, a stronger dollar has most often been bearish for gold. This is because when the US dollar rises, it makes dollar-based metals more expensive for holders of other currencies.

There are, of course, leads and lags and there is no reason to expect that percentage changes in one will be accompanied by equal-and-opposite percentage changes in the other, but when charts of the dollar and gold are compared, it quickly becomes apparent that the two have been inversely correlated since 1970 at least, said Pradeep Unni, Senior Research Analyst and Trader at Dubai-based Richcomm Global Services.

Now, more than ever the arguments of the US dollar and gold decoupling itself from its inverse correlations are emerging and this is because investors are hedging recent euro zone and UK crisis equally in gold and in the US dollar, he explained.

However, he added that gold never actually decouples from the US currency on a longer time duration because the investment demand for gold is the only thing that really matters as far as gold's intermediate and long-term price trends are concerned and is inexorably linked to what is happening to the official currencies.

Predominantly, gold gains on dollar weakness. But analysts say there are other factors that affect the price of gold as well. In addition to dollar weakness, fears of future inflation and ongoing financial uncertainty also support the metal well, said Unni.

Many investors and hedge funds are reported to be flocking into gold on fears that deteriorating public finances and ballooning national debt of major economies can undervalue the current monetary setup, he added.

In the case of the Dubai Gold & Commodities Exchange (DGCX), increased trading in gold futures is being driven by price volatility in gold as well as the requirement to hedge risk in a secure and regulated environment, according to Eric Hasham, Chief Executive Officer, DGCX. Last month saw a whopping 175 per cent year-on-year increase in gold futures volume on DGCX.

"Dubai is a key international hub for gold trade and as such, many participants in the physical market also leverage DGCX futures contracts to manage risk arising from fluctuations in gold prices, he said.

RISKS BEHIND THE LURE

As with any other investments, timing is of much importance when it comes to buying gold, say analysts.

Buying at the highs hearing the general voice of markets could result in losses, which could have been averted by entering at the right levels. In gold it is always ideal to wait and trade rather than to trade and wait, said Pradeep Unni, Senior Research Analyst, Richcomm Global Services.

Gold is not immune to the general panic in other markets and hence will gyrate in line with the general market sentiment. Supports are not strong enough to drag fresh buying and volatility is keeping many investors at bay, he added.

In the immediate term, uncertainty with respect to the Greece bail-out and its impact on the peripheral euro-zone, which is carrying similar debt problems, is exaggerating fears. Amidst this conundrum, the dollar has been adding gains as concerns mount that the US economic crisis is nearing its end and other economies are sinking deeper into economic chaos.

Investing in the metal after reading the macro news isn't enough as the gold market is more of a 'tangled web' with too many factors playing at the same juncture and no factor that can be discounted to the other. It's prudent to take expert help before an entry into the market as it's difficult to discern all factors into the prices at one go and decide on the investment, he added.

Another factor an investor must know before investing in gold is liquidity, say analysts. "The investor should know before entering a position what kind of loss he is willing to accept i.e. where stop loss should be placed. When corrections hit the market, liquidity tends to dry up and the market fall is extended beyond expectations."