Gold is a usually a popular hedge against currency weakness. A weak US currency also makes dollar-priced gold cheaper for holders of other currencies and vice versa. This link sometimes breaks down in times of widespread financial market stress, however, as both gold and the dollar Index benefit from risk aversion. Their ratio was -90% negatively correlated in late 2008 and early 2009 after the Lehman Brothers crisis and fall into recession.
Four months ago, when Europe's debt crisis had markets panicking about sovereign risk, it seemed that all roads led to the dollar. The greenback started rising against the other big global currencies, the yen, pound and euro. Its role as the world's reserve currency seemed an inestimable advantage when investors were unsure where they could safely park their cash. Within the rich world, America's economy looked the best of a bad bunch. The stage seemed set for a dollar rally. Gold was also considered as safe heaven and it rose in tandem with dollar index with correlation reaching close to + 90%.
On June 10, Comex gold and the dollar index made a interim top and started falling as the safe haven appeal lost its status when quantitative easing measures were announced by European Central Bank. The ECB broadened its efforts to ease market tensions and minimize damage from the debt crisis by offering short-term loans to banks on top of existing efforts to boost government debt and keep interest rates at record lows. The ECB said it would keep the key rate at a record low of 1%, while its chief, Jean-Claude Trichet, said the bank would offer unlimited amounts of three-month loans to banks to increase liquidity in the financial sector.
How quickly things have changed. On Aug. 11 the dollar fell to a 15-year low against the yen of yen84.7. It perked up against the euro to $1.32, though that was still much weaker than the $1.19 it reached in early June when euro-revulsion was at its worst. On Aug. 10 the Federal Reserve conceded that the recovery would probably be slower than it had hoped. The Fed kept its main interest rate in a target range of 0-0.25% and stuck to its creed that rates would need to stay low for "an extended period." In addition, the central bank said that it would reinvest the proceeds from the maturing mortgage bonds it owns into government bonds to prevent its balance-sheet (and thus the stock of ready cash) from gradually shrinking.
Gold currently has 80% positive correlation with the dollar index and this is again expected to reverse as the dollar loses its shine if the US heads for a double-dip recession. Gold is expected to trade inversely of the dollar index going ahead. Leading indicators suggest the the probability of a US double-dip recession in the next six to nine months is around 50-50%.
Economic data are pointing to a gloomy picture for the US ahead. The US trade deficit widened in June, job creation is stagnant, initial weekly claims for unemployment are at the highest level since February, construction and home sales are sluggish and consumer spending remains weak. Every slim piece of economic data will be put under the microscope by financial markets from now onwards in the wake of the Federal Reserve's new caution about the outlook. The data will be sliced and diced and spun in a centrifuge for signs of whether the economy is sinking into an actual double-dip downturn or whether it only has hit a soft patch. Therefore, gold is expected to cross its record high of $1,260 soon and trade above $1300 in next one to two months.
Renisha Chainani is a deputy manager for research at Anagram Capital Ltd. in Ahmedabad, Gujarat, India, and blogs at marketsandyou.blogspot.com.
