The U.S. Dollar’s Relationship to Gold

In the current run up in the price of gold, it is time to reassess how gold really relates to the dollar. One has to remember that gold almost never changes in value. It is the dollar that revalues in relationship to gold. For example, in 1920 a good quality men’s suit could be purchased with a typical $20 gold piece. A similar quality suit today can be purchased with about the same amount of gold.

There is endless discussion regarding officially re-linking the dollar to gold in some manner, but in fact, gold is de facto tied to the dollar, and has been since the birth of the nation. Each time that gold is purchased, the price is different, and reflects the current perceived change in the relationship between gold and the dollar.

According to www.kitco.com when the US Dollar gets stronger, it takes fewer dollars to buy any commodity that is priced in $USD. When the US Dollar gets weaker it takes more dollars to purchase the same commodity.

The price of all US Dollar denominated commodities, like gold, will change to reflect the fact that it will take fewer or more dollars to buy that commodity. So it’s quite possible, in fact it’s almost always the case that a portion of the change in the price of gold is really just a reflection of a change in the value of the US Dollar. Sometimes that portion is insignificant. But often the opposite is true where the entire change in the gold price is simply a mathematical recalculation of an ever-changing US Dollar value.

When the dollar gets strong, gold appears to go down, and vice versa. That accounts for part of the fluctuations that we see in the value of gold.

The other part is an actual increase in the supply or demand for gold. If the price is higher when being measured not only in US Dollars, but also in Euros, Pounds Sterling, Japanese Yen, and every other major currency, then we know the gold demand is higher and it has actually increased in value.

Consequently, if gold is higher in US Dollars while at the same time cheaper in every other currency, then we can conclude that the US Dollar has weakened, and that gold has actually lost value in all other currencies. But the price, because it is being quoted in $USD will be higher and give the illusion of gold becoming more valuable. In such a case the devaluation of gold, due to increased supply on the market, is camouflaged by a weakened US Dollar.

In short, the correlation coefficient runs from -1 to 1 with -1 being a perfect inverse and 1 being a perfect correlation.  For instance, the returns of the S&P500 and the Dow Jones Industrial Average are pretty highly correlated, so the correlation coefficient is very close to 1.  Generally, when one index is up, so is the other – as well as the magnitude.  When one is down, so is the other.  There was a slight divergence during the Financial meltdown in March due to the higher proportion of Financials in the S&P compared to Industrials in the DJIA, but for the most part, you can count on a pretty strong correlation outside of crises.

Resources:

www.kitco.com

www.darwinsfinance.com

www.coinsite.com

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