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The Bullion Report

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September 15, 2010 in 'The Bullion Report'

Gold & the U.S. DollarGold & the U.S. Dollar

Throughout history, gold has served as a means of trade and commerce. It has been both currency and the definition of exchange. The dawn of paper money and other coinage brought changes to the world of gold. Money from different countries was marked as redeemable for gold and/or silver bullion. Exchange rates were set by this metals backing. This standard was abandoned by most nations through the twentieth century. New methods of currency exchange were adopted, many of them leading to a US dollar peg. Despite the changes in currency exchange methods and monetary policies over the centuries, the link between the money and metal is just as strong today.

The US Dollar

Gold prices that are familiar to most traders are quoted in US dollars. This link to the US dollar is quite different from a century ago. When paper dollars first made an appearance, they were backed by gold and silver. The exact amounts specified in the Coinage Act of 1837 were 24.75 grains of gold and 371.25 grains of silver. It takes 480 grains to make a troy ounce.  This bimetallic standard, as it was known, was dropped in 1900 when the Gold Standard Act set the dollar as 23.22 grains of gold or $20.67 for a troy ounce.

The quantity of grains per dollar was lowered on more than that single occasion. In the 1930s, it was 13.71 grains which put the price per troy ounce of gold at $35. By the early 1970s, a troy ounce of gold was over $40 and President Nixon had ended the redemption of currency for gold. The currency was allowed to float. When the Federal Reserve began to increase the money supply the value of the US dollar fell. This kind of currency depreciation, not just in the United States but also in other countries, is often cited as a reason for the increased value of gold.

 


 
Past performance is not indicative of future results.
***chart courtesy Gecko Software’s Track n’ Trade Pro

The recent fallout from the housing and credit issues have contributed to another round of currency depreciation and some historic gains in the US dollar. The lack of imminent economic recovery could fuel several issues to move the US dollar and gold by extension.

The first factor to consider is the effort to stimulate confidence and economic growth. The Federal Reserve has pledged to keep historically low interest rates and various forms of stimulus money and programs have been set into motion by the US government. This has led to an influx of money and an even wider deficit. Sure, other nations across the globe have the same issues which can sometimes bolster dollar investment. But generally speaking, these efforts have pared back the value of the dollar, contributing to the gain in gold prices. These efforts have not borne fruit yet, and that kind of flop can affect general investor and consumer confidence. That leads to the second factor to be aware of, the investor’s perception of the US economy.

The average investor needs to have confidence that the economic condition in the United States is improving; otherwise, there will be hesitation when it comes to moving investment direction. For most people, the fear of the collapse in the stock market and other markets brought a general exodus from those assets and a plunge into precious metals. Every bad or benign economic report will continue to weigh on those investors. A true signal of recovery and sign of how long the good times will last will be needed to inspire more investors to profit taking and an exit from gold positions.

Finally, the fact that gold is priced in US dollars means that the exchange against other currencies which traditionally spell weakness in the dollar could mean gains for gold. The US dollar value comes from a basket of other currencies, most heavily geared in the direction of the Euro. Normally this means that strength in the Euro spells a downturn in the US dollar. This kind of strength can come from positive economic outlooks for any of the Eurozone member nations. The link between the two markets doesn’t run point for point, but it is definitely a factor that can impact pricing.

Summary

In the past decade, the link between an increase in money supply and gold price has been explored extensively. The simple fact is that the purchasing power of gold remains pretty healthy even when the currency it is valued in declines. In the case of the US dollar, the drop in value has stemmed from a lack of confidence in the economic health of the nation. The fear that grips the marketplace led directly to other assets being liquidated and a migration to gold investment. Purchasing gold is treated as the equivalent of saving for a rainy day. Why buy dollars to stuff into the mattress when the future of the US economy is so uncertain? The bottom line is looking for an investment that will maintain some store of value, no matter how the world currency markets fluctuate. Gold, and silver to a certain degree, can function as that investment since they are likely to always be an easily recognized and tradable commodity.

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense... that gold and economic freedom are inseparable.
- Alan Greenspan
 


Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.