Gold and the Euro? I thought it was Gold and the Dollar?!

Gold and the Euro? I thought it was Gold and the Dollar?!

Let me preface this post, by noting that I try to avoid writing about gold, since there are some many other excellent analysts out there writing about the subject. But when there is a such a strong overlap between gold and forex markets, well, I just can’t resist!
Recently, gold prices have collapsed at virtually the same rate as the Euro, with the result being a near-record high short-term correlation between EUR/USD and gold prices. This has caused no shortage of confusion among gold-watchers, which are accustomed to seeing the strongest (inverse) correlation with the US Dollar. This change is causing everyone to rethink some classically held assumptions about gold prices.
The foremost of which is that gold is chiefly a hedge against the Dollar, which is a symbol for inflation and erosion of value. [In fact, analysts argue that gold has little real purpose (besides a handful of trivial practical uses, such as jewelry), especially since holders of gold don't receive interest, there is little reason to own it other than as a store of value].  Thus, as the Dollar has declined over the last five years, gold has soared. Investors who are nervous about perennial budget deficits in the US and the skyrocketing national debt, have turned to Gold because of the belief  it will continue to hold its value even (or especially) if the US government is forced to devalue its debt by devaluing the Dollar. While this tenet underlies the gold/Dollar inverse relationship, the long and short of it is that investors typically buy gold when the Dollar falls, and vice versa. Thus, when the credit crisis struck and the Dollar rallied, gold prices fell, despite the fact that the US was now more likely to default on its debt.
In the last month, however, the Euro has taken center stage in dictating the price of gold. This is most likely because of the sovereign debt problems of certain EU countries. A not insignificant number of which well exceed the budget (not to exceed 3% of GDP per year) and debt (not to exceed 60% of GDP) limitations imposed on them by their membership in the EU. Recent credit rating downgrades have underscored an increasing likelihood of default, which has been duly noted both by the forex and gold markets. As the Euro has dropped (quite dramatically in fact), so has gold.
According to the current paradigm, this is not wholly unsurprising, since the Euro’s fall has naturally been mirrored by a rise in the Dollar. Thus, if you continue to look at gold prices in terms of the Dollar, it seems naturally that a rising Dollar is being accompanied by falling gold. On the other hand, the fact that the Dollar is suddenly rising has little to do with a change in US fundamentals, and instead reflects the fact that in forex, it’s impossible to short all currencies simultaneously, even if sometimes fundamentals would justify such an approach.
In other words, that certain EU member states are more likely to default on their respective debt obligations has limited bearing on whether the US will also default. [If anything, it increases the likelihood, since a default in the EU would likely send sovereign borrowing costs higher around the world, straining the ability of the US to continue borrowing]. By extension, the current drop in the price of gold is fundamentally irrational, especially when viewed relative to currency markets.  To borrow a hackneyed expression, perhaps it’s time for a paradigm shift.

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Gold Rises as “Alternative Currency”

Gold Rises as “Alternative Currency”

Everything in forex is relative, right? Actually, it turns out this adage is wrong, as there is now a way you can short the entire forex market! I’m not talking about some innovative new financial product that you’ve never heard of, but rather something that everyone already knows about: Gold.
Before you accuse me of sounding like an infomercial, consider that while gold has been an investable commodity for quite some time, its trading pattern has changed recently, especially in the context of forex. Before, the link between gold and forexwas inverse and clear: “When the greenback strengthens…this tends to pressure gold since it reduces the need to buy as a hedge against a soft dollar. Also, a strengthening dollar makes commodities generally more expensive in other currencies.” In other words, a rising Dollar is usually accompanied by falling gold prices, and vice versa.
Over the course of 2010, this relationship has steadily grown weaker and weaker, and in the last month, it has almost completely broken down. To understand the rationale for such a change, one needs not to look any further than the sovereign debt crisis currently facing Greece and indirectly, the Eurozone. This crisis has affected the way that investors think about gold; while previously it was primarily viewed as an inflation hedge, now it is seen as a hedge against fiscal/financial crisis. In this regard, it has assumed the characteristics of a “safe haven” currency, much like the US Dollar.
“Gold is going to move higher regardless of what happens in the currency market, as long as there are fears of problems in Europe. People are starting to have more skepticism to a lot of these sovereign entities,” explained one analyst. At the moment, that means that the inverse correlation between the Dollar and Gold (Dollar Up = Gold Down) appears to have reversed itself, such that a rising Dollar is also accompanied by rising gold. In this case, there may be correlation (since investors are buying both gold AND the Dollar as safe haven vehicles) but there is no causationbetween the two as there was before.
At the moment, the correct interpretation is that anything is preferable to the Euro (whose sovereign debt problems are the most pressing). Thus, gold prices are rising at basically the same rate as the Euro as falling, and gold prices in local currency (EUR, CHF, GBP) terms are already at record levels.As for the future, however, many are betting that gold will distance itself from the Dollar as well, if/when the fiscal “problems” of the US escalate to the level of a Greek-style crisis. At this point, Gold will start to trade as an alternative to the entire forex market! In fact, gold contracts denominated in US Dollars have also been rising, which means that investors already perceive it as more than just an alternative to the Euro. (If this was the case, one would expect gold to appreciate in terms of Euros, but to remain constant or even fall when priced in Dollars. This clearly hasn’t happened).
Admittedly, gold is outside of my expertise, so I’ll refrain from personally making any predictions. According to Deutsche Bank, “If the correlation re-establishes itself before July, either the dollar must continue to decline or investment into bullion-backed funds must pick up in order to avoid erosion in gold prices.”
Regardless of what happens, my intention here is simply to point out the emergence of this trend, for its own sake. While it doesn’t have any serious implications about the internal dynamics of forex markets, it most certainly is important insofar as it reflects what investors (forex and otherwise) are generally thinking about. In this case, it signals that concern over the ongoing sovereign debt crisis isn’t going to abate anytime soon.

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Currency War Devalues all Currencies…Except for Gold

Currency War Devalues all Currencies…Except for Gold

Have you ever heard currency cheerleaders rave about how unique forex is because there is never a bear market? Since all currencies trade relative to each other (when one falls, another must necessarily rise), it couldn’t be possible for the entire market to drop at once, as happens with other financial markets. The ongoing currency warmight be turning this logic on its head, as currencies embark on a collective downward spiral. Profiting in this kind of market might involve exiting it altogether, and turning to Gold.

For those of you who haven’t been following this story, a handful of the world’s largest Central Banks are now battling with each to see who can devalue their currency the fastest. [Of course, this war is being couched in euphemistic terms, but make no mistake: it is indeed a form of battle]. The principal participants are emerging market economies, which worry about the impact of rising currencies on their export sectors. However, industrialized countries have also intervened directly (namely Japan) and indirectly (US, UK).
Among the major currencies, there are only a few that continue to sit on the side-lines, including the Euro (to a certain extent), Canadian Dollar, and Australian Dollar. For as long as the currency war continues, these currencies and the handful of emerging market currencies that have forsworn intervention will be the winners (at least from the point of view of speculators that deliberately bet on them).
Then there are those that believe all currencies will suffer, and that even the currencies that are still rising are actually depreciating in real terms (due to inflation). Those who harbor such beliefs will often try to short the entire currency market, usually by betting on commodities or heavy metals, of which Gold is probably the most prominent.
The price of Gold has risen more than 20% this year (in USD terms). Its backers claim that it is the ultimate store of value (where this derives from is unclear), and defend its lack of utility and inability to accrue interest by arguing that its appreciation is more than enough of a reason to own it. When you look at the performance of gold over the last five years, you begin to wonder if maybe they have a point.
Interest in Gold as an investment has surged in the last couple years (and especially the last few months), as the currency wars have heated up and the Federal Reserve Bank contemplates an expansion of its Quantitative Easing program (dubbed” QE2″). On the one hand, the notion that the only way to defend against real currency devaluation is to own “alternative” currencies is well-founded. On the other hand, regardless of the fact that the Fed has already minted $2 Trillion in cash and that the US national debt is expanding by $1 Trillion per year, inflation in the US is low. In fact, it’s at a 50-year low, and at an annualized .9%, it’s practically non-existent. You would think that with Gold’s unending appreciation, we would be in the midst of hyperinflation, but that’s simply not the case.
In the short-term, then, there’s really not a strong fundamental basis for investing in gold. That’s not to say that it won’t continue to appreciate and that investors will continue to buy into it merely to benefit from what has become self-fulfilling appreciation. From where I’m sitting, though, there’s really no foundation for this appreciation. Consider, for example, that gold investors still have to convert their gold back into paper currency in order for it to to be “used;” otherwise, it offers no benefit to the owner except that it looks pretty (though most investors wouldn’t know, since they buy gold indirectly). Not to mention that if/when the Dollar stops depreciating, there really isn’t really a justification to buy gold as a short-term store of value.
Over the long-term, the picture is certainly more nuanced. I’m not going to explore the viability of fiat currencies here, but suffice it to say that, “Positioning for significantly higher gold prices over the long run demands a very bold strategic bet: that the global monetary system as we know it will completely break down and be replaced with a gold standard.” Regardless of the merits of this point of view, those that invest in Gold should at least understand that this is really the only justifiable reason to hold it. Those who are buying it because of the ongoing currency war will be disappointed.

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