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The dollar & gold: Quo vadis?

Saturday, 6 Feb 2010

Summary

We all have been a little surprised at the dollar's rise and gold's demise.  Today we put the pieces of this puzzle together, and tell you how to make money with it.

Topics Covered

  1. The puzzle
  2. Putting the pieces together
  3. How to make money off this idea

Background

  1. The puzzle

This week

  • the Australian dollar was thumped down a four month low of USD 0.8634/A$
  • the dollar hit an eight-month high against the euro, closing this Friday at $1.3636/euro,
  • but the yen strengthened to 89.36/$, and
  • gold skidded $50, falling 2.3%, to $1,056/troy ounce

Normally, during such worrisome turbulence you would expect that gold would have risen, no? Surely gold is a "safe haven": so why has it fallen? This is the puzzle.

 

2. Putting the pieces together

Let's start with the easy one first, the Australian dollar.  It fell because of mis-aligned expectations.  Punters had expected the Reserve Bank to raise its main lending rate yet again during its policy meeting. As this rate hike did not happen, punters lost heart and sold out.

The dollar's rise against the Euro and fall against the yen is easy to understand, too,  if you focus on one word: volatility. When it rises, carry trades are unwound. When carry trades are unwound, the old carry currencies rise as they are bought back.

This is exactly what happened this week. The "carry currencies" rose: the dollar rose sharply against the Euro, and the yen rose against the US dollar. This is because carry trades keep being unwound. 

But why did gold fall?

Again, it has everything to do with volatility.  With the VIX index rising, the carry trades got unwound, so the carry currencies rose.  This means that for holders of non-US dollars, the price of buying gold rose: you had to pay, for instance, more euro per dollar, and thus more euro per ounce of gold.  This will have been especially true for holders of Australian dollars. 

So my guess is that primarily European-based hedge funds, those trading in Euros, sold their gold holdings in order to participate in the dollar gain. The same logic applies to Aussie- and Kiwi-based hedgies.

 

3. How to Save/Make Money Off This Idea

  1. Always consult your financial adviser first.
  2. Buy the dollar (and yen) , e.g. via ETFs.
  3. Sell/short gold, if you believe with me that the VIX will keep rising in the wake of the market's continued demise and thus the dollar's rise. 

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