Gold remains sounds investment despite dollar issues (page 1 of 2)

By Kathleen Brooks, Research Director

Forex.com


To answer this, it is necessary to analyse the different factors that drive the gold price and try and assess how sustainable they are. Gold is considered an inflation hedge so the prospect of rising prices can drive the yellow metal higher. Since gold is priced in dollars, movements in the greenback also affect its price. Lastly, gold is considered the ultimate safe haven, so it tends to rally in periods of financial or economic stress.

Let's take inflation first. Price pressures have been building across the world because of a rise in commodity prices, which has caused central banks from China, Australia and the European Central Bank all to raise interest rates in recent months. While these headline inflation pressures have been building, it's actually the fear of more entrenched price pressures, like wages and rising prices of non- commodity goods, that cause real problems for economies.

The massive fiscal stimulus employed by the Bank of England and the Federal Reserve in the US, where central banks pumped billions into their economies to ward off deflation, threatens to create the kind of growth-destroying price pressures mentioned above. This latent fear is weighing on the gold price, and it is no coincidence that gold has a positive correlation with the size of the Fed's balance sheet: as it has expanded to an unprecedented size so too has the price of gold surged to fresh record highs.

Gold manages to hold its value for long periods of time

Gold is considered an inflation hedge because unlike other assets it manages to hold its value for long periods of time. A recent paper by Oxford Economics called "The impact of inflation and deflation on the case for gold", has found that the momentum in the gold price is higher than other assets. Thus, it can maintain an uptrend even in periods of high inflation.

But what about the dollar? The same research has found that in the short-term, the value of the dollar has the strongest bearing on the gold price. The value of the greenback affects gold in two ways: firstly gold is priced in dollars, so when the US currency is weak you need more greenbacks to buy an ounce of gold. Secondly, the dollar has been falling in value for most of the past decade bar some respites during the financial crisis in 2008 and again in 2010. The US has been accused of debasing the value of its currency by flooding the market with dollars as part of its quantitative easing programme. This has boosted the attractiveness of gold as a store of value and alternative to a weak dollar in recent years.

While foreign exchange markets are extremely volatile and can reverse course very quickly, there are some important reasons to think it may be difficult for the dollar to stage a rebound any time soon, which may support the gold price in the medium-term. The US has more than $14 trillion of debt and the next decade will be consumed with austerity measures to try and reign in public spending. Typically high debt levels and a strong currency don't mix, and as the spotlight shines on the US's enormous debt pile this isn't boosting sentiment towards the greenback.

Gold typically performs well in times of financial stress

Gold also tends to perform well in times of financial stress. It rose more than 20 per cent in the month after the failure of Lehman Brothers in September 2008.