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.