The Correlation Between Gold and US Dollar

Gold is a precious metal that has historically been in high demand both by individuals and governments of various countries. It is the world’s oldest medium of exchange and store of value that is still in use. This precious metal has a long relationship with the US dollar. In fact, this is what gives the US dollar the position of the king of currencies in the forex market. 

Understanding the Interoperability Between Gold and the US Dollar

Gold forms an important part of the reserves held by central banks around the world. This is because of the metal’s perceived safety, liquidity and returns. Central banks hold as reserves around 20% of all the gold mined throughout history.

Before the 1900s, the world’s monetary system was based on the Gold Standard, where every country “fixed” the value of its fiat currency to gold. Britain was the first to adopt this and the first to abandon it. Faced with economic challenges and war debts in 1929, several countries tried to protect their gold reserves. This was done by a series of interest rate hikes to encourage investors to keep their fiat money deposits and not convert them into gold. Soaring interest rates had a hugely negative impact on the global economy. These challenges resulted in several countries suspending the Gold Standard, which left the US as the only major economy with large gold reserves. At the end of World War II, the US had around 75% of the world’s gold reserves.

Although governments no longer require all their fiat money to be backed by gold, the US holds bullion reserves of more than 8,100 tonnes, which is the world’s largest by a wide margin. So, in a manner of speaking, the greenback is now the only currency that is still backed by the yellow metal. 

This is the reason for the dominance of the US dollar in international trade and the forex market. Almost 50% of all cross-border loans and debt securities are denominated in the US dollar, while the greenback accounts for almost 90% of all foreign exchange transactions.

Gold and US Dollar: How Are They Related?

Gold is quoted in the US dollar in the global markets. This is why these two important assets tend to share an inverse relationship. When the US dollar weakens, it does so versus other currencies. This makes gold cheaper for holders of other currencies. Let’s understand this better with an example.

Let’s assume:

• The price of gold is $2,000 per ounce.
• The GBP/USD is 1.20, which means £1 can be exchanged for $1.20.
• This means a trader would need to pay £1,666.66 for an ounce of gold.

Let’s say:

• The price of gold is still $2,000 per ounce.
• But the GBP/USD rises (because of a weakening US dollar) to 1.30, which means £1 can be exchanged for $1.20.
• This means a trader would need to pay £1,538.46 for an ounce of gold.

Although the price of gold has remained the same, weakness in the US dollar has made the yellow metal cheaper for holders of the British pound. When gold becomes cheaper for holders of other currencies, its demand rises, lending support to the precious metal’s price. This is why when the US dollar declines, gold prices tend to rise.

Similarly, when the US dollar strengthens, gold becomes more expensive for holders of other currencies. Its demand falls and exerts pressure on its price. 

Rival Safe-Haven Assets

Another explanation for the inverse relationship between gold and the US dollar is that both are considered safe havens. Gold’s limited supply, history as a store of value, and position in central bank reserves ensure that the yellow metal retains its value against other assets, especially compared to fiat money. This gives gold its safe-haven status. The US government’s reserves of gold and the greenback’s dominance in international trading give the US dollar its safe-haven status.

Experienced investors and traders hedge portfolio risk by maintaining a proportion of safe havens in their mix of assets. Since investors and traders choose between the US dollar and gold, the rising demand for one means lower demand for the other. 

During periods of uncertainty, like a global economic slowdown or geopolitical tension, the inverse relationship between gold and the US dollar tends to become more pronounced, as such events hurt the risk appetite of investors and traders, who then increase their purchases of safe-haven assets. 

Do They Always Share an Inverse Relationship?

No. During periods of heightened global uncertainties, when market sentiment becomes very low, the demand for both gold and the US dollar may rise. Similarly, when markets are extremely bullish and risk sentiment is high, the demand for both assets may fall. So, while gold and the US dollar do share an inverse relationship, there are instances where both have weakened and strengthened together.

What to Watch When Trading Gold?

When trading gold, traders need to watch all the factors that impact the US dollar. Experienced gold traders watch the most important US economic data releases, like NFP (nonfarm payrolls) report, GDP growth, balance of trade, and inflation rate. They also look out for the Federal Reserve’s monetary policy meetings and statements from policymakers.

Apart from a change in the value of the US dollar, gold prices may fluctuate on other factors, like:

• The supply of the yellow metal.
• Seasonal increases in demand for gold. 
• Movements in other major currencies, such as the euro, British pound, Australian dollar, and Japanese yen.
• Global economic growth. 
• Expansion or contraction of major economies, like China and the EU.
• Geopolitical tensions.

A rise in prices in the oil and commodities markets may also impact gold prices. This is because governments may release their gold reserves to purchase oil or other commodities, resulting in an increase in supply of the yellow metal.

To Sum Up

• Gold has high demand from individuals and governments.
• Gold is held by central banks around the world. 
• Gold is quoted in the US dollar in the global markets and, therefore, shares an inverse relationship with the greenback. 
• Since both Gold and the US dollar are considered safe havens, they compete for space in investment and trading portfolios.
• There are times when gold and the US dollar move in the same direction.
• Gold traders need to understand what moves the yellow metal as well as what impacts the US dollar.

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