The Gold-Dollar Correlation Explained and Why it Broke Down

Last week, I had posted on how the euphoric gold hype was really just a proxy for a weak dollar investment and there are more highly correlated and efficient means to exploit currency changes than buying an anachronistic, useless metal.  Additionally, there’s talk of a dollar crisis and what it portends for commodity prices.  When the pitches on TV for selling gold for cash are running around the clock like they are now, doesn’t it make you wonder whether we’ve reached bubble territory?  Sounds similar to home flipping frenzy and the internet bubble news cycle to me.  Often times, by the time main street is talking about a hot trend, the smart money is already on the way out and newcomers are left holding the bag when the bubble bursts.

Regardless, a visual always helps.  As such, I thought it would be instructive to demonstrate what the correlation is between gold and the US dollar index, how strong the correlation is, and when it breaks down.  Since it’s easier to visualize a positive correlation above the line, I actually used the inverse dollar basket ETF.

How does correlation work?

In short, the correlation coefficient runs from -1 to 1 with -1 being a perfect inverse and 1 being a perfect correlation.  For instance, the returns of the S&P500 and the Dow Jones Industrial Average are pretty highly correlated, so the correlation coefficient is very close to 1.  Generally, when one index is up, so is the other – as well as the magnitude.  When one is down, so is the other.  There was a slight divergence during the Financial meltdown in March due to the higher proportion of Financials in the S&P compared to Industrials in the DJIA, but for the most part, you can count on a pretty strong correlation outside of crises.

Conversely, you can expect that any of the inverse ETFs will have very close to a -1 correlation with the index they track.  When something has virtually no correlation, like say, stock market returns on days that it rains, the correlation is close to zero.  Opinions vary, but statisticians generally consider something at .6 or higher to be pretty highly correlated.  .8 is very strong.  between .4 and .6 is mildly correlated and anything between -.3 to .3 is usually considered not well correlated at all.  My rain/return example is probably somewhere between -0.1 to 0.1 (especially since it would depend on where you are when it’s raining! – no logical correlation).

What is the Correlation between Gold and the US Dollar?

Well, normally, there’s a pretty good negative correlation.  As the dollar weakens, the price of gold increases, since gold is denominated in US Dollars but widely used in global markets and by central banks of foreign countries.  There’s a long history surrounding gold as a currency throughout civilization and without boring you with the details, due to its relative rarity and historical significance, it has never quite lost it’s luster as a proxy for value even though it has very little practical utility from an industrial or economic standpoint.

Gold is where people turn to when they think there’s a possibility of complete disaster – i.e. if paper currency went out the window due to untold disaster, the thinking is that gold would still be a tradable currency.  If hyperinflation were to kick in, rather than burning dollar bills in your furnace for warmth, you could buy firewood with gold (this has actually happened throughout history).  There are other tales of people trucking a wheelbarrow full of paper currency to the store to buy a loaf of bread during periods of hyperinflation.  As far-fetched as this scenario sounds for society today in America, people still cling to the notion of the end of days (of currency).
That being said, let’s get to the good part.  I constructed the following graphical representation to demonstrate a few things:

1. The correlation between gold and the US Dollar Index Bear (Inverse of the Dollar, so this ETF represents a Weakening dollar) is pretty highly correlated normally.  As the dollar weakens, gold goes up.
2. This correlation breaks down during a massive crisis.  This anomaly occurs because while Americans may view gold as a flight to safety from our vantage point, the rest of the world views the US dollar as the safest currency in the world and by bidding up Treasuries (I shorted Treasuries shortly thereafter for the easiest money I ever made – see How to Short Treasuries) during the financial crisis, the dollar strengthened considerably against all foreign currencies.  The net result was that both gold AND the US dollar strengthened during the Feb/March lows during a mass flight to safety.  Usually they move in opposite directions, but due to these unique circumstances, the negative correlation broke down and even reversed.
3. Once relative calm was restored and the rest of the world saw our spendthrift administration doling out cash hand over fist through various bailouts, stimulus packages and now, and attempted health care “reform” bill that the country can ill afford, our future economic prospects are in question and hence the strength of our currency is under attack.  The correlation is now back to normal – falling dollar=rising gold.

I had overlayed the S&P500 ETF SPY on the right side to demonstrate the crash in March and the breakdown in the correlation.  The bars represent monthly buckets of correlation between the Dollar Bear Index (see this currency ETF list) and the Gold ETF GLD.

As I had stated in my prior article on the gold-weak-dollar correlation, anyone buying gold now thinking they’re buying something of increasing intrinsic value somehow is fooling themselves.  Gold is actually flat or declining in terms of other currencies and just because you may live in the US, do you want to continue to plow your money into a flat useless asset?  If you feel the currency will continue to depreciate, there are more effective means to invest in that trend or even through the use of leveraged ETFs but I don’t think they make good investments for the typical retail investor – they’re really there for traders to exploit a near term trend and then get out.

If you have your heart set on buying a commodity that is increasing in value due to a weakening US dollar, why not consider buying one that actually impacts your daily life?  You could buy an agricultural commodity ETF that impacts what you pay for food or oil is another commodity denominated in US Dollars that is at least impacted by currency fluctuations, but is actually much more impacted by global events and supply/demand constraints.  While a shortage of gold in the world would likely have no impact on your wellbeing (OK, maybe you have to pay more for that necklace), a shortage of oil sends heating and gasoline bills skyrocketing.  As such, there are several ways for the retail consumer to hedge energy prices on their own.

It seems to make a heck of a lot more sense to me to either play currency ETFs or Hedge energy and food prices than to buy gold.

What are your thoughts?

Tagged as: Gold Dollar Correlation