Gold against Dollar risk: a value proposition

The US dollar dominates world finance. It is the most important currency for transactions, financing and investment. The US dollar-denominated stock market is deep and very liquid in international comparison. The 'greenback' is very attractive, especially to non-US investors, providing borrowers and lenders with access to a large pool of opportunities.

However, from the end of March 2020 to mid-December 2020, the external value of the US dollar has declined by about 11%. It can be assumed that increased uncertainty about the economic outlook for the US economy and world trade, as well as the Federal Reserve's expansionary monetary policy, have contributed to a decline in investor demand for US dollars.

Quite a few investors hold the view that the price of gold benefits (suffers) if the external value of the US dollar declines (rises). In a long-term perspective, the available data supports this notion quite well. Because, since 1973, the trend in the external value of the US dollar has indeed been downward, while the price of gold has been upward. However, there is more. Various charts show the monthly changes in the external value of the US dollar (represented by a trade-weighted index of the US dollar) and the monthly changes in the price of gold. Three findings are highlighted, according to these.

First, the price of gold in US dollar terms has increased by an average of 9% per annum over the period under review, irrespective of changes in the external value of the US dollar. 

Second, the price of gold fell when the external value of the dollar increased and vice versa. Over the period under review, a 10% appreciation in the external value of the US dollar was accompanied by a 12% fall in the average gold price.

Third, the explanatory power of the linear trend line is relatively low. It represents only 12% of the change in the dependent variable (changes in the gold price) that is predictable from the independent variable (changes in the external value of the US dollar).

This suggests that there are - not surprisingly - other factors that also influence gold price changes. With regard to the relationship between changes in the external value of the US dollar and changes in the price of gold over the period from January 2000 to December 2020, the relationship between the two series has become much closer. A linear regression explains almost 31% of the change in gold price changes. However, the reaction of the gold price to a change in the external value of the US dollar has not changed. At the same time, an increase in the gold price that is independent of changes in the US dollar grew by more than 10% per year on average.

What lessons should be learned? Gold - as long as it is seen as a form of money - was an effective hedge against the vagaries of the external value of the dollar, especially in the long term. For international investors in particular, holding gold proved more attractive than reliance on (non-interest-bearing) US dollars. Of course, this experience of the past cannot simply be extrapolated to the future.

However, there is every reason to assume that holding gold in the period ahead will also be profitable for the investor, as monetary policy worldwide is about to degrade the purchasing power of the official currencies, be it the US dollar, the euro, the Japanese yen and others. All the more so because a "tacit consent" has emerged among people that running the electronic printing press is considered the policy of the lesser evil.

In an environment of significant monetary expansion, artificially suppressed interest rates and uncontrolled public deficits, the possession of gold (and also silver, by the way) is a possibility to escape the debasement of the purchasing power of money. Bought at today's prices, gold has a good chance of reducing risk and increasing returns for the long-term oriented investor in the years to come.