"Everything you need to know about gold"
When it comes to analysis of gold, the U.S. Dollar Index finds nearly universal acceptance. Or rather, when most analysts refer to comparison/correlation of the U.S. dollar to gold, they usually illustrate their point with a chart of the U.S. dollar index.
While they won’t say it straight out, most of them see the U.S. Dollar Index as a proxy for the U.S. dollar. But, is it?
The first gold coins appeared around 560 B.C. Over time it became a practice to store larger amounts of gold in warehouses. Paper receipts were issued certifying that the gold was on deposit. These receipts were negotiable instruments of trade and commerce which could be signed over to others. They were not actual currency but are a presumed forerunner to our modern checking system.
Gold is original money. It was money before paper receipts were issued. The paper receipts were not money. They were substitutes for real money. Today, all paper currencies are substitutes for real money.
GOLD AND US DOLLAR
“Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire…” — Warren Buffett Feb2012
During that same period (1965 – 2012) the price of gold increased from $35.00 per ounce to more than $1800.00 per ounce – a whopping 5000%.
GOLD AND USD/CNY
My last article, Gold And The Elusive Chase For Profits/The Case For Gold Is Not About Price, generated the following anonymous comment:
“Gold is now pegged to CNY not USD.”
I responded as follows…
GOLD, US DOLLAR, AND INFLATION
Gold bulls have a short memory. Last year at this time, gold was similarly priced and they were quite bullish then, too. But their expectations didn’t ‘pan out’ as expected. In fact, gold prices turned and went in the opposite direction, hitting lows in late summer well below $1200.00 per ounce.
The downturn was unexpected. But it was unexpected because most analysts and investors were looking in the wrong place for the wrong clues.
Gold’s price changes over time in response to changes in the value of the U.S. dollar. But some additional explanation is necessary.
Some say that a weaker U.S. dollar ’causes’ a higher gold price. That is like saying that lower interest rates cause higher bond prices. That’s not the way it works.
Gold and the US dollar move inversely. So do bonds and interest rates.
If you own bonds, then you know that if interest rates are rising, the value of your bonds is declining. And, conversely, if interest rates are declining, the value of your bonds is rising. One does not ’cause’ the other. Either result is the actual inverse of the other.
When you were a kid you probably rode on a see-saw or teeter-totter at some time. When you are on the ground, someone on the other end of the see-saw is up in the air. And, vice-versa, when you are up in the air, the other person is on the ground. Again, one does not ’cause’ the other. Either position is the inverse of the other.
Most of those who comment on gold consider the dollar to be one of several factors contributing to a higher gold price. But, in truth, gold’s price reflects only one specific thing: changes in value of the U.S. dollar.
There are six major turning points (1920, 1934, 1971, 1980, 2001, 2011) on the chart below. All of them coincided with – and reflect – inversely correlated turning points in the value of the U.S. dollar.
Since gold is priced in US dollars and since the US dollar is in a state of perpetual decline, the US dollar price of gold will continue to rise over time. There are ongoing subjective, changing valuations of the US dollar from time-to-time and these changing valuations show up in the constantly fluctuating value of gold in US dollars.
There is also more talk about inflation recently. So here is an axiom to remember: inflation is the debasement of money by the government.
When you hear someone referring to things such as ‘cost-push’ or ‘demand-pull’ inflation, accelerated wage growth pressure, or an ‘over-heated economy’, listen politely. But know that there is only one cause of inflation – government. And government in this case includes central banks, especially the United States Federal Reserve Bank.
Government creates inflation by expanding the supply of money and credit. They do this intentionally and continually under the pretense of managing the economic cycles.
Since inflation, as practiced by government, is ongoing, the risks are cumulative. As that cumulative risk builds, events triggered by the effects of inflation become more volatile; and they are unpredictable.
When the Federal Reserve responded to the financial crisis of 2007-08 by increasing hugely their monetary expansion efforts, many thought that it would lead to runaway inflation and collapse of the U.S. dollar. It didn’t. But it did drive the prices of assets like stocks, bonds, and real estate, much higher.
Originally, of course, the price of gold surged in response to the Fed’s efforts. Since gold’s price is an inverse reflection of the U.S. dollar, it should come as no surprise that the dollar continued its long decline in value; and significantly so.
But the drop in the value of the dollar and gold’s higher prices from that point forward were mostly in anticipation of damaging effects from the Fed’s inflation in the form of significantly higher prices for all goods and services. In essence, a repeat of the seventies, only much worse, was expected. And the looming threat of U.S. dollar repudiation fanned the flames.
But there was no significant increase in the “general level of prices for goods and services”. And U.S. dollar weakness (possibly overdone) eventually reversed and the price of gold began to decline (2011 – see chart above).
Between 2011 and 2016, the U.S. dollar continued to strengthen and gold’s price continued to decline. At that point the two reversed direction again and that brings us to where we are currently.
Some are convinced that recent dollar weakness will continue unabated and that the price of gold will soar soon. Some are still banking on severely damaging effects from the Fed’s past money creation efforts. And still others are short-term traders who are looking at their charts and want to be “on the right side of the trade”.
Most of them will likely be disappointed – again. There are two reasons:
1)The fundamentals and logic involved are inconsistent and flawed.
2)The effects of inflation are volatile and unpredictable.
Applying investment logic to gold leads to erroneous conclusions. Gold does not react or correlate with anything else – not interest rates, not jewelry demand, not world events.
Changes in gold’s price are the direct result of changes in the value of the US dollar. Nothing else matters.
Since paper currencies and credit can be manipulated by government, expectations and reactions become more volatile and increasingly unpredictable.
That should be relatively clear; especially after what we have experienced in the past ten years. But some are still predicting a gold ‘moonshot’. And they want it now.
Something like that may occur. In fact, it is quite possible. But when? It will only happen if it is accompanied by a complete collapse and repudiation of the U.S. dollar.
The chart above is current. Does it look like we are in the midst of something similar to 1970-80 or 2001-11? Or something worse?
Yes, forewarned is forearmed. But most of those who are the most vociferous in their calls for huge increases in the price of gold are those who were doing so all during gold’s price decline from August 2011 through January 2016. What’s changed?
Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED!
What’s next for gold? Seems like a fairly simple question. Unfortunately, it is nearly impossible today to get a simple answer. That’s the problem.
GOLD IS STILL ABOUT US DOLLAR PART II
In my original article I made the following statements:
“It means that holders of any non-USD currency who want to exchange it for gold, must first exchange it for US dollars and then exchange the US dollars for gold.
When anyone is selling gold, the proceeds are always paid in US dollars. The dollars can be held as such, or they can be exchanged for other currency.”
Another professional labeled the above statements as “fiction”.
I do not agree. But I do see the possibility for others to infer something other than what was intended. Therefore, I apologize. And I have replaced the statements in question with the following:
GOLD IS STILL ABOUT THE US DOLLAR
The US dollar is the world’s reserve currency. And that isn’t likely to change in any radical way, anytime soon. Unless there is some kind of calamitous implosion of the dollar. I am talking about outright rejection and repudiation. And that could happen. The problem is that there isn’t another currency that could likely take its place. By the time that possibility becomes a reality, any possible candidates would likely be in worse shape. This includes the Euro and Chinese Yuan.
All currencies are substitutes for real money, i.e. gold. And because all governments inflate and destroy their own currencies, the possibility of gold reasserting itself as the international medium of exchange increases considerably under the aforementioned conditions.
But, a lot of bad stuff has to happen before we get to that point. And governments around the world have too much at stake to capitulate when it comes to ceasing to issue ‘funny money’.
So, for the time being, lets focus on things as they are. Which leads us back to the title of this article.
Gold is priced in US dollars and trades in gold are settled in US dollars because of the hegemony of the dollar and its role as the world’s reserve currency. But what does that mean to others around the world? For example, those who live and work in Germany (euro), Japan (yen), China (Yuan)?
When someone in Switzerland, for example, exchanges Swiss Francs for gold, they are quoted a price in Swiss Francs. That seems pretty straight-forward. But how is the price for gold in Swiss Francs calculated when the international market for gold is priced in US dollars?
The amount that someone pays in Swiss Francs (or any other non-USD currency) is determined by calculating the exchange rate between the US dollar and the specific non-USD currency involved. Based on that calculation, it is then known how many Swiss Francs are needed to equal the transaction amount in US dollars.
What is particularly important here isn’t necessarily obvious. But it is a critical factor when assessing a transaction of this nature. And here is why.
On December 31, 2013, gold traded at $1210 per ounce. And on that day one euro could be exchanged for 1.3776 USD. Hence, 842 euros ($1210 USD divided by 1.3776 = 842) could be exchanged for $1210 USD which could then subsequently be exchanged for one ounce of gold.
Nine months later, on September 30, 2014, gold again traded at $1210 per ounce. But the exchange rate for one euro was 1.2629 USD. Even though the gold price in US dollars was unchanged, the cost for an ounce of gold in euros had increased nine percent to 958 ($1210 divided by 1.2629 = 958). To be technically correct, the cost of US dollars had increased for holders of euros.
On May 31, 2016, twenty months later, gold was again trading at $1210 per ounce. The euro had weakened further relative to the US dollar and the exchange rate for one euro was 1.1131 USD. Using the same math as before, the cost for $1210 US dollars had again increased, this time by an additional thirteen percent to 1087 euros.
Over the entire two and one-half year period (twenty-nine months in all) the cost to acquire gold for holders of euros had increased by twenty-four percent. And yet, gold itself, priced in US dollars was the same.
There are several things we can learn from this.
For one thing, there is always a demand for US dollars since they are needed for use in international trade (oil transactions are priced in US dollars, too).
For another, the potential for changes in exchange rates of any other currencies relative to the US dollar must be considered for these transactions.
The possible combinations are numerous and always different. An increase in the value of the euro relative to the US dollar in the examples above would have given us results opposite to those which actually occurred. And, of course, every currency other than the US dollar would show different results based on their changes in value relative to the US dollar.
Currency exchange rates are continuously changing and so is the US dollar price of gold. It is possible to have an increasing US dollar price for gold and, simultaneously, a stronger US dollar relative to another currency. This results in a ‘double whammy’ to the holder of a non-USD currency – unless you already own the gold.
In our examples earlier, the US dollar price of gold could actually have declined for the periods indicated and still resulted in a higher cost for holders of euros.
The US dollar price of gold does not tell us “what gold is doing”. It tells us what the US dollar is doing. Or rather, what people think is happening to the US dollar.
But what people think is happening changes all the time. Also, the information we are ‘fed’ by the Fed is suspect and inaccurate. Hence, changes in the US dollar relative to gold are ongoing and can be quite volatile. Over time, however, the gold price in US dollars is a reasonably accurate reflection of the value of the US dollar.
The US dollar price of gold does not tell us anything about other countries and their currencies. To know that we must look at exchange rates of those currencies relative to the US dollar.
Let’s be clear about something. The ‘value’ of gold does not change. It is original money and its value is constant and stable. And has been for several millenniums.
The value of the US dollar, however, changes all the time. This is precisely because the supply of dollars is manipulated by the Federal Reserve via the ongoing expansion and contraction of the supply of money and credit. Mostly expansion.
For an historical, real-life example of value and purchasing power as they relate to gold and the US dollar, see my article A Loaf Of Bread, A Gallon Of Gas, An Ounce Of Gold.
Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED!