Gold has been one of the hottest topics in the investing world in recent months, and with good reason. In 2009, investors received a 25 percent return on gold—the biggest absolute annual gain in three decades. Arguably, gold’s nine-year streak of positive returns is even more impressive.
If you’re considering whether to invest in gold, it’s important to understand the close relationship between the value of gold and the value of the dollar.
A Brief History of Gold and the Dollar
To understand how and why gold has had such a historical run-up, a little history lesson on the relationship between gold and the dollar is helpful.
The relationship between the dollar and gold is tied to the concept of tangible assets vs. financial assets. To put it simply, gold has real value, while the dollar is a representation of real value.
In 1944, the Bretton Woods Agreement launched the first system of convertible currencies and fixed exchange rates, requiring participating countries to maintain the value of their currency within a narrow margin against the U.S. dollar, which was fixed at a rate of $35 per gold ounce.
However, in the 1950s and 1960s, the increasing supply of U.S. dollars along with capital outflows aimed at Europe’s postwar recovery put downward pressure on the dollar.
Eventually, a series of dollar devaluations in the early 1970s ended the Bretton Woods system, allowing the dollar to be freely traded and freely sold, beginning the long drawn-out period of the falling dollar.
An Inverse Relationship
Perhaps one of the most well-known relationships in currency markets is the inverse relationship between the U.S. dollar and the value of gold. This relation occurs because gold is typically used as a hedge against inflation through its intrinsic metal value. As the dollar’s exchange value decreases, it takes more dollars to buy gold, increasing the value of gold.
While the dollar’s value is at risk of fluctuation through shifts in monetary policy, gold’s value is largely determined by supply and demand, without interference from shifts in monetary and corporate policies.
Between January 1999 and May 2008, the correlation between the two has been a staggering (-0.84), indicating a very close negative correlation.
As with any close relationship between two assets, the gold-dollar inverse relationship has not been without periods of temporary decoupling. The most significant exception to this rule occurred between April and December 2005 when the correlation between gold and the dollar was as high as 0.66. During this period, the U.S. raised interest rates while China revalued its currency, giving them an opportunity to snatch up gold and other commodities.
Monetary Policy Effects on Gold
The dollar’s value is largely determined by monetary policy enacted by the Federal Reserve Bank. Over the last few decades, the Fed has used the federal funds rate as a tool to control inflation and stimulate the economy and in doing so, has also impacted the price of gold.
In plain English, when the central bank lowers the federal funds rate, banks can lend to other banks at lower interest rates which, in turn, makes lower interest rates available to borrowers. And when rates are lower, borrowers have a greater incentive to take out loans (to start businesses, for example). This type of policy increases the supply of money in the system.
Conversely, if the central bank becomes concerned that there is too much money flowing around, it will raise interest rates to pump money back out of the system, curbing the risk of inflation.
As you can imagine, as the central bank lower interest rates, more money is printed. This lowers the value of the dollar and, consequently, raises the value of gold. Likewise, a rate increase strengthens the dollar and devalues gold.
Gold’s Current Rally
Gold is in the midst of a great bull market because interest rates have been at historic lows for such a long period of time.
Towards the end of 2008, small businesses sputtered and the economy stumbled. In response, the Federal Reserve cut rates to stimulate borrowing and spending—an attempt to cushion the blow of a souring economy. These low rates have been virtually unchanged since November 2008. In response, gold has enjoyed a run throughout 2009 as investors worried about inflation.
Should You Invest in Gold Now?
This is a tough call. Although inflation concerns are legitimate, gold has been making new highs during the last couple months leading many to wonder if it might be running out of steam. My gut feeling tells me that all the media attention gold has been getting as a safe haven for inflation has put gold into “bubble” territory.
Although inflation is still a concern, Americans are spending a lot less and a stable economic recovery is a much bigger concern at this point than rising inflation. Once the economy shows any signs of surviving on its own without government aid, the central bank will most likely raise rates quickly, to subdue any risk of inflation.
I would advise against investing in gold for now, but if you are interested in gold, the best and easiest way to gain exposure is through ETFs. Make sure you do your research before making an investment!
- Read More: How to Invest in Gold
What about you? Are you bullish on gold? Would you consider buying gold despite its recent run up?