Political Metals

By Vedran Vuk | Casey Research

You’ve probably heard that a strong dollar means weaker gold prices.

Yet anyone who has been watching the markets closely knows that “strong dollar = weak gold” isn’t exactly true.

Sometimes, when the dollar strengthens, gold will fall. Other times it will stay flat or can even rise.

So where does that uncertainty leave gold investors?

The Dollar-Gold Relationship Has Some Surprises

We really need to understand the gold-dollar relationship in precise terms, not general ones.

One thing that you can do is look at a chart of gold and the USD/EUR over the past six months, starting from the February 1 price of $1,749.50:

It clearly shows that gold has been going down as the dollar has been gaining against its primary competitor, the euro.

In fact, the percentage gain for the dollar is nearly the same as the decline in gold, just under 10%. Seems like an almost perfect inverse correlation, right?

No, not exactly. Look closer.

There are a lot bumps and anomalies along the way. Sometimes gold has a mind of its own, separate from the dollar, meaning that other factors must be driving it.

To find out more, we also calculated the correlation of returns on gold and the USD/EUR currency pair.

For a quick refresher on definitions:

• A correlation of +1 means two variables are moving perfectly together.
• 0 means no correlation between the variables.
• -1 means a perfectly inverse correlation - when one variable goes up, the other goes down.

So what’s gold’s correlation with the USD/EUR currency pair over the past six months? It is -0.471.

To make sure this wasn’t a euro-only phenomenon, we also checked the correlation of gold to the US dollar Major Currency Index, which reflects the strength of the dollar relative to the currencies of the Eurozone, Canada, Japan, the United Kingdom, Switzerland, Sweden, and Australia.

Once again, the correlation was far weaker than one might expect, at -0.531.

So what does this mean to you and your gold investments?

If you’re expecting more flights to safety boosting the dollar, then these correlations are definitely something to think about. At the same time, the correlations are not that strong.

Many gold investors falsely believe that a stronger dollar will simply run gold into the ground. Yes, a strong dollar would present challenges, but we need to also remember that we’re not talking about a correlation of -1.

Bottom line… the dollar influences gold prices, but it is not the sole determinant of its value.

Another factor for gold investors to consider is that the relationship between these variables can change over time. -0.471 is not set in stone - the correlation can get stronger or weaker from there.

In fact, over the past five years, the correlation has typically been weaker.

It’s hard to believe, but in the six-month period preceding September 21, 2010, gold hit a peak positivecorrelation to USD/EUR of +0.149. On the other end of the spectrum, gold had its most negative correlation of -0.741 in the six-month period prior to September 12, 2008. From these two points, gold has been everywhere in between.

So a strong dollar doesn’t mean the end of the world for gold.

If we enter a period of an even stronger dollar, gold investors might be concerned, but nonetheless, as the data show, gold and the UD dollar are not the perfect inverse of each other.

Even if the correlation were to become as negative as -0.741 again, a rising dollar wouldn’t necessarily crush the gold price.

Furthermore, there’s also the possibility of gold becoming less negatively correlated to the dollar. Even without the statistics, this is apparent. After all, the dollar has already strengthened, and gold is still holding up well. Has it been roaring to new heights as it did in years past? Not lately; but it hasn’t been beaten into the ground either - and there’s a lot more of the gold story yet to play out.

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Vedran Vuk is a senior analyst at Casey Research, publishers of 10 research services read by over 175,000 independent-minded investors around the world. The August issue of BIG GOLD, due out Tuesday afternoon, outlines a new trend in gold that most analysts haven’t picked up on yet - and more importantly, an actionable solution. Now is the time to buy gold and gold stocks while prices are down.