Wednesday, May 13, 2009

Dollar and gold

US Dollar has been depreciating again in recent weeks as risk appetite comes back to the market. At the same time, gold price has been steadily rising (see chart below).

(click to enlarge)

What determines the price of gold? I tend to think two things matter most: $ and inflation. Of course, $ and inflation are interconnected. Higher inflation tends to correlate with lower $ value. I call the negative correlation between US dollar and gold the first order in determining gold price.

The second order factor is risk appetite. It can be measured by market volatility, for example, VIX. As discussed previously, gold is attractive to investors for various reasons. During panic time, gold, same as US dollar, is often treated as investment safe haven. So no wonder gold and the Dollar often move in the same direction. This is evident in the graph above, from mid January to early March this year.

Of course, in the short run, gold price may be complicated by many other things. One such thing is liquidity. In the summer of 2007 and 2008, during the height of the market panic, gold, for a brief period, dropped sharply with the rise of market volatility. This was because a lot of institutional investors were force to sell in order to meet margin calls: They had to sell their gold holding to raise cash.

Finally, I share with you a graph of the dollar and gold with longer history, dating back to early 90s.

(click to enlarge)