The All-New Gold/Dollar Correlation

05/27/2011 6:00 am EST

Focus: FOREX

Andy Waldock

Founder, Commodity & Derivative Advisors

The European debt crisis has altered the traditional correlation between gold and the US dollar, and traders must understand the new dynamic, which has the potential to last through the summer months.

Trading the markets is sometimes like being a relationship counselor. There are times when it’s easy to see how one thing said or done affects the other’s actions. We use a fancy term for it: “Correlational analysis.”

When the correlation is positive, both things move in the same direction, and when it’s negative, they move in opposite directions. Pretty straightforward stuff—like when the dollar falls, gold rises. That’s a negative correlation based on inflation.

Similarly, the stock market rises as interest rates decline because businesses find cheaper money for expansion and capital equipment acquisition. Unfortunately, every good therapist knows that relationships change over time, and these markets in particular are not performing true to pattern.

Fortunately, in the financial world, we have tools that let us quantify these relationships. Now, it’s true that over the last year, gold has rallied and the dollar has fallen. However, over the last couple of weeks, both the dollar and gold have rallied, and I think there is a significant change in the underlying nature of their relationship that could cause this to continue throughout the summer.

The primary reason for the dollar’s strength has not been the domestic economy. The strength should be attributed to the global fear of a collapsing euro, which attracts money to the US dollar as a flight to safety.

We’ve talked at length about the troubles in Ireland and Greece. Well, Spain and Portugal are right behind them. The global credit markets are already pricing in the pending defaults. Greek ten-year bonds are yielding north of 16% and Ireland and Portugal are both above 9%. This compares to the UK Gilt ten-year yield of 3.3% and the US ten-year Treasury note’s yield of 3.1%.

The European Union is caught between balancing what the Union’s lenders will accept as payment versus what rights of autonomy the borrowers will relinquish to remain in the Union itself.

The new catch phrase is a “re-profiling” of debt. This word isn’t even in spell check, however, this invention by the European Central Bank (ECB) is really a synonym for “default.”

They want to extend the maturity dates of Greek debt. The euro has fallen 7% as we’ve hunted through Webster’s Dictionary looking for “re-profile.” The re-profiling, or restructuring, of Greek debt would seriously devalue the EUR50 - 80 billion the ECB has already contributed monetarily and would devastate the value of the European Union’s political solidarity.

The same fear of a euro collapse has attracted money to the gold market. This week, gold hit an all-time high priced in euro. Investors are looking for a safer holding facility for their liquid cash than the euro currency can provide.

This move has been extended as the ECB has chosen to cancel its June meeting while re-profiling studies are being completed for their newly scheduled July meeting. Consequently, there have been four trading days in the last ten where both gold and the dollar have rallied more than half of one percent. This compares to only six days in the last 12 months when this has happened.

The rise in the dollar has also coincided with a flood of money into US Treasuries and a decline in the US stock market. Commercial traders are aggressively rotating their positions from stocks to bonds as the Eurozone drama is playing out. This is taking the classic low yield/high growth stock market relationship and turning it into a low yield/no growth scenario more consistent with times of fear.

We’ve seen commercial money buying ten-year Treasury notes in six of the last seven weeks and selling in the stock indexes in each of the last four weeks. 

Reconciling relationships means being able to cope with change and allow the relationship’s participants to grow in their own directions. Being able to recognize these changes in the marketplace as they are happening requires a sound combination of reading the back stories and quantifying the participants’ actions.

By Andy Waldock of Commodity and Derivative Advisors

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