Up until now we have always questioned to what extent the price of gold was due to the U.S. dollar's weakness or to gold's secular strength but with the introduction of the Kitco Gold Index now we know - precisely - because it measures the price of gold, not in terms of U.S. dollars (USDs), but rather in terms of the same weighted basket of currencies that determine the US Dollar Index. How ingenious!
By way of explanation below are further edited excerpts from the original article* on the subject:
The Relationship Between the USD's Strength/Weakness and the Price of Gold
When the USD gets stronger, it takes fewer dollars to buy any commodity that is priced in $USD. When the USD gets weaker it takes more dollars to purchase the same commodity.
The price of all USD denominated commodities, like gold, will change to reflect the fact that it will take fewer or more dollars to buy that commodity. As such, it's almost always the case that a portion of the change in the price of gold is really just a reflection of a change in the value of the USD. Sometimes that portion is insignificant but often the opposite is true where the entire change in the gold price is simply a mathematical recalculation of an ever-changing USD value.
When the dollar gets strong, gold appears to go down, and vice versa. That accounts for part of the fluctuations that we see in the value of gold. The other part is an actual increase in the supply or demand for gold. If the price is higher when being measured not only in USDs, but also in Euros, Pounds Sterling, Japanese Yen, and every other major currency, then we know the gold demand is higher and it has actually increased in value.
When gold is higher in USDs while at the same time cheaper in every other currency we conclude that the USD has weakened and that gold has actually lost value in all other currencies. The price, however, because it is being quoted in $USD, will be higher and give the illusion of gold becoming more valuable. In such a case the devaluation of gold, due to increased supply on the market, is camouflaged by a weakened USD.
The Kitco Gold Index (KGX) approach to evaluating gold breaks the change in the price of gold into 2 components.
1. One part shows you how much of that change can be attributed to USD strength, or lack of it.
2. The other portion is indicative of how much the price changed as a result of normal trading.
Interestingly whatever changes happen to the price of gold as a result of USD strength/weakness also occurs to every other USD denominated commodity by the exact same proportion.
What is the Kitco Gold Index and Why it is Relevant
The purpose of the KGX is to determine whether the value of gold is actual, a reflection of changes in the USD value, or a combination of both. The U.S. Dollar Index(R) represents the value of the USD in terms of a basket of six major foreign currencies: Euro (57.6%), Japanese Yen (13.6%), UK Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%). It is an exchange traded (FINEX) index and has become a standard used worldwide. The KGX is the price of gold measured not in terms of USDs, but rather in terms of the same weighted basket of currencies that determine the US Dollar Index(R) and, as such, needs to be compared to the actual USD price to give it some perspective.
Here are a few possible situations that you may see and what the meaning could be:
a) The Kitco Gold Index is up and the USD price of gold is up even more:
This would definitely mean that gold has increased in value. It also means that the USD has weakened and so the degree of the gold value increase will be exaggerated when examined strictly in terms of the USD. This is the exact scenario that we've witnessed over the span of the early years of the 21st century.
b) The Kitco Gold Index is down and the USD price of gold is down even more:
This would definitely mean that gold value has declined in value - but not by as much as it may appear in USD terms.
c) The Kitco Gold Index is up and the USD price of gold is down:
This would indicate that the USD has strengthened relative to the other major currencies, but that gold has gained in value.
d) The Kitco Gold Index is down and the USD price of gold is up:
This would indicate that the USD has weakened relative to the other major currencies, and that gold is really not up as it may appear.
While there has definitely been a bull market in gold over the past 6 years or so it has been aided and abetted to a large degree by the weakness in the US dollar and, as such, when seen through the lenses of other currencies via the KGX, the gold bull has been much less robust than otherwise portrayed.
Lorimer Wilson is editor of www.FinancialArticleSummariesToday.com, "a site for sore eyes and inquisitive minds", which provides visitors with abridged edited excerpts of some of the most informative articles to be found on the web to ensure a F.A.S.T. and easy read. He can be reached at editor@munKNEE.com