One of the strong headwinds in the gold market has been the strong dollar. As shown in the chart below, the US currency has been appreciating since mid-2021. The broad US dollar index has fallen from 110.5 in June 2021 to 124 currently, or more than 12%.
Wait, wait a second. The dollar strengthened during a bullish period inflation (see table below) in which money loses purchasing power. How could currency gain and lose value at the same time? It doesn’t seem to make sense.
Nevertheless, it is. Because of inflation, the dollar loses its internal purchasing power, that is, how many real goods and services can we buy with these green papers? However, the exchange rate is about external purchasing power, that is, the number of sheets of paper with different symbols and signatures issued by foreign central banks that we can buy. The answer is: more! As shown in the graph below, the the dollar is now close to its highest levels in decades against the British pound, euro and Japanese yen (Please note that, for consistency, the chart presents exchange rates as the value of the dollar in foreign currencies).
However, this does not necessarily reflect the strength of the dollar, but the fact that other currencies have been even worse. As investors say, the dollar is “the least ugly cup of a beauty contest.” You see, the fed lagged terribly in its fight against inflation, but compared to other major central banks, such as the ECB and the Bank of Japan, he is a super hawk who quickly rose to fight. Remember that exchange rates are relative values. For example, inflation in the euro zone exceeded 5% in December 2021 and it has now risen to around 9%, but the central bank has not lifted its interest rate until July 2022.
The Fed’s quicker and more decisive response has increased the monetary policy divergence and interest rates (see graph below) between the dollar and the euro, which reinforced the value of the old. The mechanism was simple: higher rates in the United States attracted money from around the world, and as investors bought dollar-denominated assets, the value of the greenback rose.
So far, so good. Now the question is, what does a strong dollar mean for the global economy? Problems! Why? Well, maybe because about 30% of all S&P 500 company revenue is earned overseas, a stronger dollar reduces the dollar value of those sales. Or maybe because many governments and companies have international debt denominated in dollars?
Thus, the stronger the dollar, the greater the debt to be repaid. According at the IMF, 60% of low-income countries are over-indebted or exposed to a high risk of public over-indebtedness. Tighter financial conditions in the United States and a stronger dollar could only increase the pressure on indebted countries abroad. The dollar is America’s currency, but the problems of emerging markets. Egypt, Pakistan and Sri Lanka have already asked the IMF for help – and others may follow suit.
Please also note that about half of international trade is invoiced in dollarswhich means that importers face higher costs not only due to inflation and supply chain disruptions, but also due to the appreciation of the dollar.
What does a strong dollar mean for the gold market? It goes without saying that the recent appreciation of the greenback has weighed on the price of gold. Without the strong dollar, gold would have fared much better. Indeed, this year the yellow metal has lost around 6% of its value when measured in US dollars, but it has gained 6.2% in euros and 9.3% in sterling. So maybe gold’s performance wasn’t disappointing, just the greenback was shining, and maybe gold is a hedge against inflationafter all (but in currencies other than the US dollar)!
It suggests that when the dollar weakens (for example, due to the onset of the recession and the Fed pivot, or due to the end of the war in Ukraine), gold will start rallying ultimately. It looks like most of the greenback’s bullish move is already behind us.
The strong dollar could also trigger economic turmoil, which could benefit the yellow metal. However, I wouldn’t bet that financial crises in emerging markets will induce a seek refuge for gold. Precious metals investors don’t care too much about countries other than the United States or Western Europe.
There is a real silver lining for golden bulls: one of the reasons for the appreciation of the dollar. The The Fed Tightening Cycle is only one driver, but another is the influx into shelters. Investors turn to the US dollar not because it is so strong, but because of economic turmoil and the risk of recession. If so, gold could at some point (perhaps when the Fed pivots and adopts a accommodative policy Again) start moving in tandem with the greenback.
(By Arkadiusz Sieron)