The real story about the US dollar and gold

I turned bullish on gold in the late '90s, in my former post as a stockbroker.

The collapse of the "strong dollar policy" of that period formed one of the major premises of my case for gold at the time. However, by early 2005, as the currency reached my original target and began bouncing off its long-term lows, I recommended that clients no longer bet against the dollar, because I felt that the dollar would level off. Still, I wrote, gold prices were going to make their biggest move yet. As subsequent events proved, I had that one right.

Now, the gold story is this: The value of money is in danger of dropping precipitously again, and it is increasingly likely that the world monetary system will have another brush with hyperinflation akin to what occurred in the 1970s, except this time, worse.

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The evidence supporting this thesis is devastating, yet this story is scarcely factored into gold values, let alone financial markets. That is, we have seen a rush to gold when the foreign exchange value of the U.S. dollar has crumbled, whenever some geopolitical boiling point has been reached, when other commodities have left the station, because the Chinese and Indian economies were heating up, and so on. But there has yet to be a significant enough deterioration of confidence in central banking institutions, or the quasi-fiat money they produce, to herald the kind of buying in which a person is "anxious to swap his money against real' goods, no matter whether he needs them or not, no matter how much money he has to pay for them," according to Ludwig von Mises.

The evidence suggests we are headed there, but it also suggests that the most spectacular part of the bull market in gold must still lie ahead of us.

But the most interesting part about these "spectacular" moves in gold, where the market's spotlight focuses entirely on the gold story (the greatest story never told), is the behavior of the currency markets.

Stable dollar

The biggest moves in the gold price occur when the foreign exchange value of the U.S. dollar is stable.

Did you get that? It may initially sound counterintuitive, but after reading this article, it shouldn't.

Consider first the fact that the largest moves in gold's free-trading history occurred in four brief periods each lasting two-three years: 1973-1975, 1978-1980, 1985-1987, and 2005-? We know that the first two of these occurred during bull markets in gold, the third one in a bear market rally, and the last one we believe to be a bull market move, which can hardly be considered arguable at this point. As a matter of fact, the two former periods and the last (current) one have something important in common they saw the lowest (inverse) correlations with the currency. That is, they occurred when the U.S. dollar had reached some level of relative stability following a two-three year collapse in its foreign exchange rate.

Since we are still in the midst of the final period, I used the current gold and dollar price for the table, while measuring all the other periods from trough to peak.

But if we take the high in gold prices last year as our peak, the gain in gold was actually 70%, and the U.S. dollar lost just 2% in this period instead of the 51% and 0% originally in the table hence making it more substantial than the bear market rally of 1985-1987, when the U.S. dollar dropped more precipitouslyand nothing yet suggests those trends have ended.

Since its 1971 fix, the price of gold is up some 1,750%, or 18.5-fold.

Everyone will notice the general inverse relationship between the dollar and the gold price that can be seen in the chart, but it is not a well-known fact that the gains in the price of gold that occurred in the top three bull market moves alone (shaded regions in the above data series), where exchange rates were most stable, explain nearly two-thirds of this whole move in gold prices more than $400 of the gain from $35 to $650 while the U.S. dollar's foreign exchange rate fell less than 5% net.

If we apply the 1970s model to the current move that started in 2005, we would suggest that it could end in late 2007 with a run in gold prices to somewhere between $900-1,200, and the dollar might well be only a few points from where it is today when it all blows over. Both of the instances of dollar stability in the '70s saw the most spectacular gains in the gold price, and by all counts, the same factors are at play today. Investors were surely just as surprised by it then as they will be today.

There are a lot of strong arguments for why the dollar should continue to new lows. For instance:

- It is no longer an intrinsically viable reserve currency

- China may buy fewer dollars

- The size of the U.S. trade deficit still suggests that it is cheaper to import goods than produce in U.S.

- The trend in interest rate differentials probably favors the foreign currencies in the medium term.

- But these arguments may already be factored in the medium-term (three-18 months) currency outlook, and attention should perhaps be drawn to the overlooked bullish arguments favoring the U.S. dollar.

For some of these arguments have potency, yet are least considered.

Here are two very important arguments for this time horizon:

- Money supply inflation by international central banks has exceeded the Fed's for four years

- Risk premiums have more upside adjustment in foreign currencies than in the U.S. dollar

Don't worry if you don't understand these things.

The main point of this article is to illustrate the historical precedent behind a potentially bullish gold price explosion, regardless of whether the U.S. dollar makes new lows or not.

The historical fact is that gold's biggest moves occur when the U.S. dollar is relatively stable.

Now you know what few people do.

By Ed Bugos for Whiskey and Gunpowder

Whiskey & Gunpowder is a free, twice-per-week, e-mail service for more from the team, go to https://www.whiskeyandgunpowder.com