Gold Soars as Dollar Continues in Record-setting Decline
Changes in the economy are neither simple to understand nor entirely predictable. Virtually every metric that is used to evaluate the economic health of a nation can be influenced by a variation in another metric. For example, consider the price of gold. Typically, when the dollar shows a pattern of a record-setting decline, gold prices tend to soar.
Why Do Gold Prices Typically Soar When the Dollar Declines in Spectacular Fashion?
As Investopedia explains, the value of the dollar and the price of gold usually have an inverse relationship. A weak dollar normally drives up the price of gold, but a strong dollar depresses gold prices. The three primary reasons for this are:
1. A weak dollar is a sign of economic uncertainty, stimulating people to invest in tangible assets such as gold. When the demand for gold rises, prices tend to rise accordingly.
2. A strong dollar is a sign of a stable economy, so people are more likely to buy stocks or make other investments that carry a higher risk as well as the potential for higher profits.
3. When the dollar strengthens, the exchange rate for foreign currencies is often unfavorable for buyers relying on a foreign currency. This means that they cannot buy as much gold from the United States as they could if the exchange rate were more favorable for them. This lowers the demand for gold, so prices fall.
However, the inverse relationship between gold and the value of the dollar does not always hold true, according to MoneyMorning.com. During the 1970s, the Fed hiked interest rates to unprecedented levels. In 1974, the rate hit 13 percent, increasing to 15.5 percent five years later. Despite the interest rates and the corresponding strengthening of the dollar, gold increased by 24 times between the start of the 1970s and the start of the 1980s.
Factors Affecting the Value of the Dollar
There are dozens of factors that can affect the strength of the U.S. dollar. Most of these factors are also tied to other economic changes, so the repercussions can sometimes be far-reaching. Here are some things that can affect the value of the dollar.
• Foreign Trade: Trade deficits — such as the one that the U.S. currently has — tend to make foreign investors nervous, contributing to a weaker dollar. The trade deficit can increase when prices fall on foreign goods, making them more attractive to consumers in the U.S.
• Changing Financial Policies: When investors believe that the financial policies of the U.S. are likely to remain the same, they are more willing to put their money into investments that are denominated in U.S. dollars. If they fear that policies will be changing, they tend to view those investments as less secure.
• Expansion or Contraction of Federal Government: New agencies and initiatives cost money to operate. When the federal government grows, the value of the dollar declines.
• Consumer Taxes: Tax cuts can increase spending, which can lead to improvements in the economy and strengthen the dollar — if the tax cuts do not increase the trade deficit or the budget deficit.
• Foreign Reserves: The U.S. dollar is the world’s reserve currency, and most national banks hold more U.S. dollars than any other type of currency. However, if the bank decides to increase the diversity of their currency investments, the value of the dollar could drop when the banks sell off their dollars or stop adding dollars to their reserves.
• Oil Contracts Denominated in Dollars: Most oil contracts require settlement in U.S. dollars. Since other countries must use dollars, this increases the value of and demand for U.S. dollars.
• Money Supply: When there is more currency in circulation, each dollar has a lower value. Normally, this will result in an increase in the inflation rate, causing the dollar to fall in value.
• Changes in Interest Rates: Generally, when the Federal Reserve increases interest rates, the result will be a stronger dollar. If interest rates are reduced, the dollar will decline in value and gold prices will rise.
• Housing Market: If the housing market is steadily growing, homeowners build equity and their personal net worth. This fuels spending and helps strengthen the dollar. A slow housing market has the opposite effect.
• Inflation: The rate of inflation reflects how much prices are typically rising across the entire economy. When stock prices rise, inflation often rises also. The Federal Reserve tries to manage inflation by adjusting interest rates. In December 2016, the Fed raised the interest rate by 0.25 percent; at the time, both the Standard & Poors 500 and the Dow Jones Industrial Average were near all-time highs. A moderate inflation rate can strengthen the dollar.
• Employment: If the unemployment rate is too high, the dollar will decline in value; consumers have less to spend, but the government also loses tax revenue that could go toward reducing the deficit. When employment is growing, it reflects the health of the economy and attracts investors.
Other Factors Affecting the Price of Gold
In an article appearing on Investopedia.com, author Jean Folger points out that there are other factors that can influence the price of gold.
• Demand for Consumer Goods: Gold is used for a variety of purposes. Medical devices such as stents, precision electronics and jewelry production account for approximately 66 percent of the global demand for gold. If demand for these items declines, the price of gold could fall.
• Production: The United States, China, Australia, Peru and South Africa are important gold-mining countries. The amount of gold produced by all countries contributes to the supply, and if demand exceeds the supply, gold prices increase. However, in most countries, the easily accessible gold has already been taken from the ground, requiring miners to dig deeper and face exposure to additional hazards. The impact to the environment may be affected as well. This means that mining gold costs more to obtain less, which increases the price of gold.
• Investors’ Attitudes: Investors tend to turn to gold when there is economic uncertainty. Gold is typically considered to be a safe haven and a hedge against inflation, currency devaluation, political instability or deflation; most investors believe that gold will always have value, but other investments may turn out to be worthless. When returns on investments such as real estate and bonds fall, more people turn to investing in gold, increasing its price.
Like all economic issues, the correlation between gold prices and the value of the U.S. dollar is complex. Although it is possible to generalize — a weaker dollar usually drives up gold prices and a stronger dollar typically drives them down — there are exceptions to the rule. Furthermore, a wide variety of factors can combine to alter gold prices regardless of how the dollar is performing.
If you would like to explore the connection between the dollar and the price of gold, you can find many articles covering a wide range of economic issues at the Personal Money Store.