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Gold and the Dollar
October 30, 2008
The collapse of Lehman Brothers in September led to a stampede to gold by investors who feared that the world’s financial system was on the verge of a meltdown. The U.S. Mint ran out of coins and the vaults of Swiss banks were filled to overflowing with gold bars as investors sought a safe haven. Gold prices jumped from $746.80 just before Lehman fell to $911.50, a gain of 22% in one month. Five weeks later, gold had fallen to below $700.00 an ounce, the weakest level in more than a year and 34% below the record of $1,030.80 reached in mid-March 2008. What happened?
Since September, the dollar has strengthened 8% against a trade-weighted basket of 26 currencies. Gold is bought and sold in U.S. dollars, so any increase in the value of the dollar causes the price of gold to fall. Therefore, the recent strength of the dollar has served to pull down the price of gold, despite the tremendous amount of new retail demand created by the implosion of global markets.
In recent months, the dollar has been the beneficiary of the global flight from risk as well as the unwinding of debt made with borrowed dollars. That has come as a surprise to many who expected that increased government spending and a collapsing U.S. economy would cripple the dollar. Instead, there has been a steep decline in most currencies against the dollar, as investors continue to seek safe haven investments (defensive assets) and as other countries appear to be in even worse shape than the U.S. The dollar has risen to a two-year high against the euro, a six-year high against the British pound, and a six-year high against the So. African rand. Emerging market currencies are crashing as well. For example, the Brazilian real and the Mexican peso have suffered declines of more than 40% against the dollar in a matter of weeks.
As the dollar has risen, the price of gold has fallen sharply in dollar terms, overshadowing the fact that gold prices have stayed strong in the local currencies of large consumers, such as India and Turkey. Even in euro and sterling terms, gold is still trading significantly higher than it was a year ago.
Retail demand for physical gold remains strong on a global basis. However, holdings in the world’s largest gold exchange traded funds have fallen, and analysts point to gold liquidations by institutional investors who need to meet margin calls in distressed assets.
Although the biggest factor driving gold down has been the tremendous strength of the U.S. dollar, a contributing factor, along with the liquidations by institutional investors to meet margin calls, has been the collapse in the prices of many raw materials, as investors have been aggressively liquidating their commodity portfolios.
The oddest thing about the recent decline in gold is that, according to the Financial Times, retail investors do not appear to have been deterred by the drop in gold’s dollar value, with abnormally high premiums still being paid for gold bullion. Part of the reason is that there is a huge amount of money looking for a safe home, with stock mutual funds headed for their largest annual investor withdrawals in history.
In the longer term, analysts believe that inflationary pressures from the Bailout will produce a powerful downward adjustment in the dollar. The highly regarded Bank Credit Analyst stated that a further drop in the dollar is inevitable over the next few years, given the large U.S. trade imbalance. In fact, it insisted that there is no precedent for a country with such a large external deficit to avoid a major currency depreciation. What will that dollar depreciation do to the price of gold? Merrill Lynch expects gold prices to move up to $1500 per ounce. “The unintended consequences of the ongoing financial bailout will be a return of inflationary pressures to the commodity markets. Ultimately, as lending returns to normal and money supply goes back to previous levels, we should see a renovated demand for real assets such as gold.”
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