An analysis of dollar and gold price movements over the last one year,Sep 08 to Sep 09 provides us with very interesting information. The gold price has moved from $850 per ounce (Sep 08) to above $1000 as on date (Oct 09) and dollar index has moved from 73.48 (Sep 08) to 78.22 (Sep 09). The overall movement of the dollar and the gold is show in figure 1. We can clearly see three main segments of this movement. Each period provides us with good indication about the prevailing sentiments in the global economy. The periods are Sep 08 till Dec 08, Jan 09 till April 09 and May 09 till Sep 09.
1. Sep 08 till Dec 08
Let us step back and see what was the prevailing sentiment during this period. Lehman had collapsed, credit ratings plunged and risk premiums sky rocketed. There was a perception of the global economy moving towards dooms day. Investors started moving towards safe assets. Equities worldwide faced a meltdown with most of the equity assets being sold off and money moved into safe assets like Gold.In the immediate aftermath, Gold price increased from $740 per ounce(11 Sep 08) to % 902 per ounce(26 Sep 08). Yields rose during this period (Figure 3). Once the fear of imminent economy and currencies got reduced, the money started moving into US treasuries. Figure 3 shows the impact of this movement. Yields plummeted across all the tenures. $ strengthened on the back of this buying of US treasuries. Gold prices fell in face of this sustained dollar rise. The correlation between US $ index and gold during this period was -0.689. The movement of Dollar index and Gold price is shown in Figure 2.
2. Jan 09 till April 09
With the collapse of the economies worldwide, brought about by the financial crisis, governments rolled out stimulus packages aimed at provided support to their respective economies. Banks and Financial institutions were provided support and money was pushed into the economies. This resulted in a slow built up of liquidity in the global economy. Once the fear of the Sep 08 till Dec 08 period was diminished, this increased liquidity resulted in a rise in equities and commodity prices. Asset prices across the spectrum started rising. A brief about his liquidity movement has been discussed in a previous post on Indian Equity markets price rise. Both dollar and gold rose simultaneously during this period (Figure 4), indicating that the fears of debasement of the US $ were very remote. With the recovery of the US economy still far away, dollar debasement due to the high fiscal deficits of the US government were not a concern.
3. May 09 till Sep 09
Global economy was expected to recover quickly and most of the fears seen in the period1 were removed. Emerging markets were expected to lead the recovery phase. Emerging market assets were being bought and money started moving into these economies. Risk appetite increased and this resulted in the fall in the US $. Also with the increasing confidence on the recovery, risks of higher inflation caused by the fiscal deficits were playing on the minds of the investors.The high fiscal deficits and inflation fears also led to the dollar losing value. Gold prices started increasing with the fall in the US dollar (as shown in Figure 5). The correlation between Gold price and Dollar index was back to -0.68.
Looking back we can see the movements and the reasons for these movements which can aid us in providing a glimpse of what may happen in the future. Going forward the main themes are,
a) The increase in the prices of assets caused by the liquidity push could lead to creation of a new bubble. This would only lead to increasing gold prices and dollar being sold off both on concerns of inflation and dollar becoming the new "yen" in carry trade
b) Recovery gets prolonged and the impact of high inflation is not felt. This would lead to the dollar regaining some of its strength.
My bet is more on (a) happening rather than (b).
