Gold, Derivatives, and the Dollar

With gold futures near two-week lows in early trading today, we thought we’d take a look at long term gold charts in terms of both the Australian and U.S. dollars.

What do the charts show? To the extent that the chart patterns are similar, both charts show the depreciation of paper currencies relative to a precious metal.

They also show the same historic pattern and leave us with a historic question. If gold rose by dramatic amounts in terms of both currencies the last time inflation swept the globe, where does that leave us today? According to the charts, gold in both currencies is near the same highs (in dollar terms, not real terms) that it traded at in the 1970s. And steep as this first phase of gold’s recent bull market has been (beginning in earnest in 2000), is the current leve a high, or just a resting plateau?

We suspect it’s a resting plateau…but for how long. With the dollar index exhibiting signs of strengh, and with our earlier work citing studies which show the demand for dollars is driven by growth in dollar-denominated financial assets (and not, apparently discouraged by high U.S.deficits) this means that gold may spend a good chunk of 2007 relatively flat, consolidating its gains from the past three years and building a base for the next big run.

If inflation runs higher than forecast (something the U.S. Fed is clearly concerned about), it’s possible you’ll see nominal rises in the gold price. In other words, gold will be keeping up with inflation, but not moving clearly ahead of the dollar.

Moving clearly ahead of the dollar,” is another way of saying the break-down of the dollar’s importance to global capital flows. The dollar could be increasingly replaced by the euro. Or, it may simply mean the popping of the asset bubble in derivatives. If it’s correct that the derivatives bubble is driving dollar demand, take away the growth in derivatives and you take away support for the dollar.

Whatever unfolds, gold remains the ultimate hedge against inflation, whether it’s in a currency like the dollar or in financial weapons of mass destruction like derivatives.

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Dan Denning

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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