The Two Sides To Gold

By Relmor Demitrius

Gold made front page news in 2009 when it soared past the $1000 barrier and reached new all time highs.  People rushed into gold tracking stocks like NYSE:GLD , NYSE:IAU,  and NYSE:GDX.  Many economists offered explanations for why this happened or found a causal relationship in the economy to justify this event.  Whatever the reason, understanding how currency and gold values are affected can reveal the answer and maybe even how, where or even when to invest in the future.  Can gold go higher?  If so how high?  To say gold is high due to inflation is immature and shows a lack of knowledge about the subject.  Sorry main stream media gold fly by night journalists, your two bit answers don’t explain even a portion of the story, nor why that statement isn’t accurate right now.  To understand this move in gold we must first understand currency and its relationships with hard assets.

Like anything, the value of the dollar is based on supply and demand.  First let us focus on the demand side.

If demand of the U.S. dollar increases, and the current supply of dollars remains the same, the value of the dollar will increase.  This means that the dollar index, a basket of currencies used to track the value of the dollar, ironically against things measured against simply other currencies themselves, and why they call it a floating currency, will go up.  As the dollar index goes up, it signifies that fewer dollars are necessary to purchase the same amount of goods.  It also means the price of gold will drop in dollars.

If demand of the dollar decreases , and there is the same amount of supply available, the value of the dollar will drop, and the price of gold will go up in dollars.  So as the dollar index goes down, the price of gold should rise, all other factors, of course being neutral. 

Think of the U.S. dollar as a stock in a company.  In the FOREX exchange, currencies are traded and valued against other currencies on a daily basis, similar to how stocks are valued.  Our dollar is no different.  Demand of the dollar goes up and down, just like equities or bonds, or even oil.  It’s traded on the open global market.  What a dollar is really worth is decided day in and day out, completely outside the thoughts and minds of every day Americans.  We go and spend it, and use it to buy groceries, but there are international traders deciding on a computer screen what the actual global value of that dollar really is.  In the new global economy, that is the price you pay.  Now that we understand the demand side, lets see what happens when we throw deflation/inflation into the mix.

Deflation is fewer dollars chasing the same amount of goods.  Deflation has zero to do with price.  Price movement is simply a symptom of deflation or inflation, whichever the case may be.  This is a common misconception.  Right now the American Economy is experiencing one of its harshest and quickest bouts of deflation since the 1970s, and quite possible since the Great Depression.  Since so much money disappeared in the M3 category of our money supply, basically derivatives, wall street bets and bank leverage, money that was never really there to begin with, it almost crippled our economy.  Companies went bankrupt,  people stopped spending money, lost their jobs or had to take pay cuts, housing prices tanked.  All these things are deflationary in nature.  A huge amount of wealth evaporated in a short period of time.  This causes the value of cash, basically the ability to purchase assets, to skyrocket.  As everyone attempted to convert to cash, the value of cash increased.  Demand for cash went up and the demand for hard assets like real estate, stocks, and other investment vehicles grinded to a halt.  This caused a huge spike in the dollar index. There was massive deflation and a run on cash.  As money flows from stocks to cash, stock values drop, and the value of cash increased.  So if cash is becoming more valuable in this situation how can gold go up with it?  I see the gold chart and the stock chart.  I see massive deflation, and the largest price in gold’s history in the same year.  Why?  How can gold go up in a period of massive deflation and in the same period cash is in such high demand?

Well that’s the funny thing about gold.  It goes up when the dollar is strong, or extremely weak.  If confidence in the system is failing, people turn to gold causing a supply problem.  But what is also affecting the price of gold is the value of the dollar, which is increasing, which should be causing the price of gold to drop accordingly.  Interesting anomaly.  The very reason the dollar was strengthening was the very reason gold was increasing as well. Loss of confidence in the fiat money system brings investors to the 6000 year old medium of storing of wealth, in gold.

Gold has unique properties that make it the perfect historical vehicle to store wealth.  It can be easily transported.  It can be broken down.  It does not rust or corrode.  It is universally recognized.  One must acquire work to obtain it, and there is a limited supply.  All these factors made gold the perfect representation of what real wealth has always been, hard assets.  Sheep and pigs and farmland in the day.  Now it is land, food products, oil, wood, and  iron.  Same concept, just different names.  If you own and control these things, you still had wealth.  Was the commodity boom of 2003 to 2008 a bubble?  Of course not. It was a simple reflection of a rush to true wealth. as paper instruments failed.  Gold benefited the most, as people after 2007 went to gold for safety, the entire time it was reflecting the drop in the dollar’s purchasing power.  A double bonus.  Really not hard to see why this metal achieved new highs in this economic environment.  Something fiat couldn’t compete with.  Safety.  If you want to put your cash in something, and stocks weren’t working, hence the explosion in commodities.  An extreme example of this in 2007 to 2010 was the oil market.  The dollar index was dropping and oil was steadily rising.  Investors and traders poured into oil in 2008, as the case of the ridiculous $150 a barrel ending price on that wave of insanity.  Had those prices continued something would have had to break or give.  It was unsustainable.  Why certain banks pumped oil in the media in mid 2008 and began shorting it at this time.  Why?  Because they knew this to be true of oil.  The common investor usually doesn’t understand basic economic principals, let alone subtle nuisances in unsustainability within global market conditions.

Another aspect that is important to these relationships is the rates from the Federal Reserve, and how they play into market conditions.  A good place to start with the FED is to learn how money is created in the first place.

The FED creates money by paying the cost to print the money from the Treasury to the Treasury, then using the money it receives to buy government bonds, or it gives it to the banking system to be lent out to companies and private individuals.  Using fractional banking this can be very inflationary.  $100 lent out can turn into over $800 of lending power by the time it is done.

For example:

$100 is lent by the Federal Reserve to Bank A and in turn Bank A lends to Bank B, but only $80 this time.  This process can continue on and on.  With leverage of each bank possible on this partial asset of the original loan, one can see how money and wealth is created, and how it can easily be destroyed when just one person who owes the initial $100 fails to pay it back.  In 2008, Americans experienced what it is like if thousands if not millions of people couldn’t repay their loans to banks.  Since these banks are dangerously leveraged, some failed, and more would have if not for government involvement.

The FED moves around the interest rate to control inflation or increase inflation.  The system really doesn’t work with long periods of deflation.  By raising the rates, the FED is worried now about inflation, and will attempt to discourage maximum rates of lending.  By lowering the FED rate they are encouraging lending to the best of their abilities with this weapon.  Usually the FED raising rates is a good signal to the market that the worst is behind us.  If you notice on the charts below, the FED rate generally increases with the market, and goes down with the market.

Knowing these factors can help us understand the delicate balance between the markets, the federal reserve rates, inflation/deflation, and the price of gold.  There will always be market conditions where one or all of these classes move in illogical or irrational directions, either with or against each other, whichever the case may be.  However, overall certain factors and simple laws of the fiat system and the economy can predict certain general patterns in movements and price associations.

For instance, as the dollar index moves up, the price of gold goes down.  This is simple.  The more spending power the dollar has versus other fiat currencies, the less money in dollars gold will cost, compared to other currencies.  It will basically take fewer dollars to buy one ounce of gold.  The reverse is also true.  As the dollar index moves down, the price of gold usually rises.

As the stock market increases, this is a sign that the economy is improving and inflation is heading back into the system.  Additional money is being created and asset classes that are leverageable are once again a functionality of this money creation system.  As the FED increases the money supply, stocks tend to rise.  This can be confusing however, as the time it takes the money the FED creates, can take years to hit the economy.  By that time the FED might already be raising interest rates to keep the inflationary winds of the money creation from causing massive price increases and a huge drop in the dollar index.  It is generally beneficial in the global economy to have a relatively weak currency, but huge drops or long sustained constant devaluing of ones currency is not healthy.  The negatives outweigh the positives especially when you are in a trade deficit situation.  So not only are you losing money out of the system every year, your money is worth less too.  This is not good.

As the stock market increases, the dollar index is usually going down.  As you need more cash to buy 1 share of a stable company, news neutral, as its spending power has decreased, the value of the stock appears to be worth more.  If you bought the stock with cash from 5 years ago, and its still the same price today, you basically lost money.  Your purchasing power decreased, as the dollar has been slowly doing since 1913, the creation of the Federal Reserve, and yet you have no more cash to show for it.  Holding cash would be the same in this situation.  What one hopes for is that as the dollar index decreases, your stock value increases.  This is usually the case, unless of course the company is struggling.  Can the market go up with the dollar index?  Of course, just look at the two charts from 2009 to now.  Generally we have a stronger dollar, and a stronger market.  Which one is correct?  Well if stocks were sold under market value, a rebound can ensue regardless of the dollar index.  This is a best case scenario for an investor.  Not only is your dollar worth more now than yesterday, but your stock value went up as well.  Enjoy these runs while they last.  They usually come after or during large bouts of deflation.  Massive drop in money supply causes a more massive drop in prices, and as money begins to come back, or if you already had cash waiting, one can make out quite well in this situation.  So you ask that’s great and all, but how does gold fit into this?

Well gold is simply a reflection of the strength of the underlying currency its trading it,  in addition to, the availability of the metal itself.  Basically, regardless if gold is scarce, if the dollar gets unproportianally weak overriding any increase in demand in gold, which are unrelated but can be related depending on economic conditions, meaning demand for gold can and will affect its price, but gold will always also represent the value and purchasing power of the underlying currency as well.

So as gold goes up, the dollar index should be going down.  As the dollar is less and less valuable, it will require more and more dollars to purchase the same one ounce of gold.  If the market is strong, that usually means the dollar index is weak, Fed rates are high, and demand for gold as a safety net diminishes.  Yet gold might still go up if supply is low that year, or the dollar is weakening.

After going through all this you can see the value of gold.  Only massive deflation and huge increases in its supply could cause this asset class to burst and break hard south.

Another thing to consider is that when the market is going down, people are selling stock, and going into cash, which can lead to a shortage of cash, as seen in March 2009.  This kind of rush into cash simply due to the market crashing, can actually cause the demand for the dollar to go up.  If more people need cash because they are cashing out of other asset classes, then demand for the dollar rises, even if the underlying “confidence” of the currency is weak.  For instance, even though we are fiscally irresponsible as a government and culture, our dollar might appreciate as demand cash increases.  Here supply is overriding sentiment.  Although the dollar has massive debt attached to it and a huge government deficit, demand for cash can still make the dollar appreciate, as we have seen recently.

All these factors and relationships are fascinating and keeping a careful eye on all these metrics can be tedious, but a good investor will always know what’s going on in these relationships and will seek to take advantage of them on any trade they do.  Whether its to execute a carry trade, where you first go into another currency before going into a hard asset, or buying stocks simply because the dollar index is so strong at a certain point in time, and you feel the dollar going down will actually give your stocks added value.

Knowing these relationships and how gold moves, one can see the opportunities for gold to have continued growth and success in years to come.  Is gold overplayed?  No, because gold held strong through deflation and a rising dollar index.  These are excellent signs that when inflation comes back, gold prices might just be getting warmed up.  If supply is already weak as well on gold, a new yearly record price in gold might be the norm, at least for now.

Examples and discussions of how best to use these relationships in your trading strategy, visit www.kingofalltrades.com for up to date stock information, fundamental, and technical analysis of any trade in any market.