The dollar and gold

As we all know, gold is priced in dollars. Production at SA gold mines might be paid for in terms of the rand price of gold, which influences their price on the JSE, but where it really matters – deep in the investment subconscious – the dollar price is what matters.

It so happens that the dollar has been in a bear trend for the past year. Since February 2002 the dollar has lost 27 % against the Euro, almost 14 % against sterling and even 13 % against the Yen – and this despite the fact that the Bank of Japan is trying desperately to weaken the Japanese currency so that they can remain competitive with China.

Over the same period, the gold price has increased by 25 %, keeping pace with the Euro; in this instance despite all kinds of measures and stratagems that are being used to keep a lid on the price of gold, including the sudden 50% increase in the margin on Comex gold futures that brought the price down by $ 40 from its recent high at $386. At its high early in February, gold showed a 32 % increase over the past year, well ahead of the Euro.

Forecasting the price of gold therefore has two components; firstly one has to forecast the fortunes of the US dollar and secondly one will consider the supply-demand relationship. Of course, it is a given that the efforts by parties short of gold trying to keep the gold price under control will intrude in these equations. However, since the quantity of gold available for this purpose appears to be declining, these countervailing efforts are likely to be intermittent and intense when they occur, indicative of desperation. Over the longer term it can be expected that the intervention will become less effective and more rare.

At the macro-economic level, the health of a currency is supposed to be determined by the balance between in- and outflows of funds over the longer term. In the case of the US dollar, it occupies a unique position as the recognised reserve currency of the world. Yet, even so, it is generally accepted that the large and growing trade deficit of the US simply has to be off-set by an equal flow of investment funds into the US. Part of this inflow is the result of the trade deficit – exporters to the US do not repatriate all the income they earn there, but invest a certain fraction in US assets.

Additional funds flow in from investors in foreign countries who can earn a higher return in the US than in their own backyards. While the dollar was appreciating against the rest of the currencies – between 1995 and 2002 – the strong dollar also brought exchange rate profits, which made the foreign investors doubly grateful. However, now that the dollar has peaked and started to lose ground, these investors have to decide between remaining invested – in assets that now deliver a lower return than before, or are losing money – and repatriating their funds before the weakening dollar erode too much value.

The degree of divestment taking place is not known, but the inflow of new funds has declined substantially over the past two years – and this is presumably one of the primary reasons why the dollar has come under pressure. It can be reasoned that a belief in an US economic recovery is still keeping foreigners invested, on grounds of having to choose between the chances of improvement there against near certainty of weakness at home. The prospect of war in Iraq also is likely to restrain foreigners from early action; perhaps people are correct in saying the US economy will rebound once war fears have receded in the wake of brief and victorious hostilities – and a supply of cheap oil! Then it is better to remain invested.

However, if the war should prove inconclusive and expensive, or if the war is over and, after a brief euphoria, the bear markets on Wall Street and the dollar continue, a decision to repatriate might well be forced on them. In which case the dollar will tank and gold will prosper.

While war fears can be expected to trigger improved demand for gold, demand has been greater than supply for some two years now, as evidenced by the gold bull market. Once the war is out of the way, in whatever manner, there is sufficient uncertainty in the world at large and in the US economy in particular to prompt prudent investors to look to gold as the safe haven of last resort.

The shortfall between annual mine and scrap supply – i.e. without excess supply coming from the now near-depleted vaults of the central banks – is estimated at about 1500 tons, about 50 % more than the 3000 tons annual supply. Surely that will be sufficient to keep gold in a bull trend for quite some time before equilibrium between supply and demand is reached. In this respect it should be kept in mind that while demand for gold as jewelry will suffer from a rising price, investors are actually drawn to any market that promises profits through rising prices. Just think back on the Nasdaq madness.

A sustained rise in the price of gold, coupled to sinking prices in almost all other markets, sooner or later will catch the fancy of the average investor and that is when the real bull market will begin. In fact, in view of the very limited supply of bullion and gold equities compared to the amount of funds sloshing around the global investment market place, it will not surprise should the gold market develop a ‘feeding frenzy’ that exceeds anything Nasdaq had experienced.

And a steep bear market in the US dollar will be one of the factors stoking such a frenzy once it takes off.