The Gold/Dollar Relationship
The relationship between gold and the U.S. dollar is an important one. Understanding this relationship can be advantageous when it comes to making investment decisions.
The relationship between gold and the dollar began a long time ago. This relationship began as gold was used to set the value of currency. Under the gold standard monetary system, the value of a country’s currency was directly tied to the value of a specific amount of gold. The United States went on the gold standard in the early 1900s, and remained on this monetary system until 1971.
Following the end of the gold standard in the United States, the U.S. dollar and gold were free to fluctuate on open markets. At this time, the U.S. dollar became a true fiat currency that was traded on open markets with no risk to the country’s gold reserves.
The price of gold was also now free for trade, as it was no longer tied to monetary policy and financial policies that were designed to keep currencies in order.
Over time, the price of gold has seen more relative stability than currencies. This is one of the reasons that gold is considered by many to be a “safe-haven” asset. Another way of looking at this relationship is that the price of gold is indicative of overall confidence in the dollar. After all, when the dollar goes up, gold often goes down. When the dollar falls, gold often goes up.
The U.S. dollar is the reserve currency of the world, and as such its value is very important to the global economy and financial engine. This reinforces the idea that as the dollar weakens, reserves may be shifted to currency, and as currency weakens, reserves may be shifted to gold.
Because gold is a dollar denominated asset, there are other factors involved as well. When the dollar weakens, gold becomes relatively less expensive for foreign investors. On the other hand, when the dollar is rising, gold becomes relatively more expensive for foreign investors. This fluctuation between relative cheapness and expensiveness can drive the price of gold as supply and demand forces take hold.
Does the dollar/gold inverse correlation always hold true? No, it does not. For example, if there is an economic crisis in another country, that country’s currency may fall against gold while the dollar may rise with gold. In other words, there are times when both assets may be seen as safety instruments and draw buying interest.
Understanding the gold/dollar relationship may help one make better investment decisions. It is important to understand how a weaker dollar eats into purchasing power, and how owning gold may potentially offset this loss of purchasing power.
While the dollar remains the reserve currency of the world, there could be challenges to its status in the not too distant future. Should the dollar begin to lose its status as the reserve currency of choice, not only could the price of gold potentially move significantly higher, but many other new financial dynamics would be set in motion.