Gold and the USD

As we have shown in previous blogs, the relationship between the US Dollar and Gold is complex and not quite as simple as it is often described.

The complexity of the relationship can be seen in the following chart, which shows the monthly % change in the Gold price against the monthly % change in the USD effective exchange rate index ranked by decile from 1980–2014. The 1st decile is the 10% of observations where the USD had the largest monthly decline (and vice versa): so, in the decile of largest monthly USD declines the Gold price rose, on average, 3% and in the decile of the largest monthly USD increases the Gold price fell, on average, 1.9%.


The graph shows, on average, that dollar weakness tends to correspond with gold strength but dollar strength doesn’t really hit gold prices until it becomes serious (i.e. out in the 10th percentile). There is no clear symmetry in the relationship between the USD and Gold prices.

With a number of identifiable, and negative, tail risks, including:

  • BREXIT fallout;
  • Extreme US equity overvaluation;
  • Chinese Yuan devaluation risk;
  • Saudi Riyal devaluation risk;
  • US recession and Global deflation risk;
  • Persistent Yen strength and the increasing frailty of the Japanese banking system and;
  • the perilous state of Italian Banks;

we can see many reasons for US Dollar strength.

Whilst modest monthly USD appreciation has little or no impact on Gold, we can see an environment where that “normal” decline in Gold at extremes of USD strength fails to materializes, where Gold and the USD both rally on rising risk aversion.

A stronger USD and rising Gold price will, no doubt, puzzle many investors used to the “normality” shown in the next chart, which shows the frequency with which the Gold price fell within each USD decile: so, for example, in the 10% of months where the USD had its biggest increases the Gold price fell 72.5% of the time and, on average, by 1.9%.


With large USD declines, the Gold price only fell 22.5% of the time.

The breaking of this relationship will, in our view, signal the loss of confidence in the ability of Central Banks to ride to the rescue of an overleveraged, deflationary biased and horribly unbalanced global economy with a crude assertion that all that ails the economy and markets is a lack of liquidity.

Alongside Gold versus USD, we also need to watch the relationship between European Bank stocks and US Treasury yields. Falling European bank stock prices mean just one thing: lower US Treasury yields.


So, look out for a rising Gold price, a stronger USD, falling European bank stocks and declining US Treasury yields simultaneously. It’s one very large canary!

Gold… it’s not the US Dollar!

July 27, 2015

With Gold hitting its lowest level since late 2009, we are reading more and more commentary attempting to determine the cause of its recent weakness. Many have labelled its decline as a consequence of a stronger US Dollar, which itself is a consequence of expectations of forthcoming US Fed rate hikes. Once again the words of Thomas Huxley spring to mind: “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact

For the sake of argument, for a UK-based investor, the following simple equation describes the relationship between the price of Gold and the US Dollar/Pound Sterling (USD/GBP) exchange rate:

  • USD/Ounce of Gold = USD/GBP   x  GBP/Ounce of Gold

So, the price of Gold goes down when

  1. USD goes up


  1. GBP price of Gold goes down

Clearly, it is, in principle, not the case that the US Dollar going up necessarily implies that the price of Gold goes down.

In fact, if we look at the spot price of Gold (in US Dollars) versus the USD/GBP exchange rate (monthly % changes) we see that there is no relationship at all over the last 20 years (the same is true looking further back).


And using the same chart but showing instead the spot price of Gold (in US Dollars) versus the change in the USD/Euro exchange rate (Gold from the perspective of a Euro investor)… again, no relationship (R2=zero).


Our hypothesis remains the following:

  • Gold has been an effective systemic and catastrophic credit risk hedge – you hold it when you fear for the very survival of the system. To that end, the Gold price has been highly correlated with credit default swap spreads (think of credit default swaps as insurance policies, the price aka “spread” rises/falls as perceived credit risk rises/falls).

The following chart shows a GDP-weighted average of the Credit Default Swap (CDS) spread for Italy and Spain versus the price of Gold during the recent boom and bust period for Gold. You can see the price of Gold surged higher as CDS spreads widened (systemic risk rising) from 2008 – 2011 and then fell from 2011 onwards as CDS spreads narrowed (systemic risk eased). The CDS spread narrowed sharply in the period after 2011 when central banks went “all-in” on QE and effectively “guaranteed” the liquidity (and solvency) of the financial system. The full scale shift to QE by the ECB this year explains the move in Gold, in our opinion, not the US Dollar.

The Gold price is now pretty much where CDS spreads suggest it should be.


What would cause Gold to surge higher again? The (unlikely) abandonment of QE and a decision by central banks to leave the massively debt-laden system to fend for itself.



Gold Miners: The day of reckoning approaches

July 23, 2015

Involvement in less regulated markets comes with its own risks. Markets participants were reminded of that when in the early hours of Monday, the 20th of July, the price of Gold plummeted by just over $45 an ounce (-3.9%) in less than a minute just before the market opened in China. This price action, caused by a massive sell order of $2.7 billion in Gold futures, looks an awful lot like market manipulation since no one in their right mind would try and sell such a large amount so quickly at the lowest liquidity point of the day. If a short-seller with deep pockets wanted to re-price Gold significantly lower, he would follow exactly the same modus operandi.


For Gold miners, this is of course bad news. After a golden decade (2001-2011) – no pun intended – when the market rewarded aggressive growth over cash flow generation and financial discipline, their fortune has changed dramatically. As the market for Gold peaked just below $2000 per ounce, investors came to the realisation that despite the yellow metal being in excess of 6x higher than 10 years before, Gold miners’ cash flow generation in aggregate was flat.

Fast forward 3 years and the situation has deteriorated quite dramatically. The chart below (courtesy of Goldman Sachs) shows the all-in cost of production (including net debt and interest due as well as operational expenses) for the major players of the industry. In effect, this shows that prices per ounce below $1050 would mean that an overwhelming proportion of Gold miners would be making a loss. The top 10 global miners also show leverage ratios (debt: equity) in the region of 100% on average. As the odds of higher interest rates in the US increase, access to financing and interest payment should worsen, adding financial stress to an already challenging operational situation.


Unsurprisingly, investors have started voting with their feet as the price of Gold approaches the $1050 – $1100 territory. Between August 2011 and June 2015, Gold miners showed a Beta of 1.6x to the price of Gold. In practice, this means that when Gold sold off by $1, Gold miners sold off by an average $1.6.

Since the beginning of the month however, this sensitivity has doubled, as Gold miners now sell off by an average $3.1 for each dollar lower in the price of Gold. This makes sense, since each dollar lower in the price of Gold exponentially increases the risk of insolvency, and ultimately bankruptcy, of these companies.


In due course, distressed investors with the nerves to get involved will be able to acquire Gold-related assets at a significant discount to fair value. The day of reckoning approaches, but things will probably get worse before they get better. Especially since the recent price action will in all likelihood spur the deep-pocketed trend-following community to increase their short positions, adding incremental pressure for lower prices to an already very weak market.