Dollar::Oil::Gold

How many times have we wondered on the between Oil , Gold and Dollar prices and how each is influenced by the other. What are the drivers that are responsible for the price fluctuations.

In the past 2 years Crude Oil has fluctuated between $40 to a record of $148 per barrel, that's almost 4 times the lowest price. Gold has touched record highs..

Let's examine the issue, first by understanding the economic value of each and then examining the correlation between them

Gold

Fundamental Economic Theory and Common Sense give us 2 principles..

1. In times of turbulence choose certainty and safety over uncertainty
2. Make sure that your savings don't lose purchasing power with Inflation

If you leave aside the last 60 years and delve into history, humanity has been subject to wars, rebellions, coups and what not.... In such times could you have trusted your savings in some bank deposits or in a currency that can depreciate or disappear anytime ?

Naturally the primary mode of savings was something that will not lose REAL value over time, have a universal appeal and have a relatively low cost of maintenance. Gold fits the bill perfectly and over time not just individuals but central banks of most major countries held some of their reserves in Gold.

Post World War II as the world became by and large peaceful.. trust in the "system" grew. The focus was no longer as much on preserving real value of savings but growth. The mode of savings shifted to avenues that provided the opportunity to get real growth. Stocks and Bonds became popular modes of investment. Gold lost some sheen but the fundamental economics (preservation of real value) meant that it was still relevant more as a safety net rather than a growth vehicle.

Oil

Growth in demand fueled by energy hungry and rapidly growing world economy, scarce and depleting reserves coupled with in elasticity in supply meant that this scarce resources was in great demand. To add fuel to the fire most of the large reserves were in countries that were in the unstable mid-east.

All these factors meant that this commodity was in great demand and also the price was not just fluctuating with demand but also the geo-political climate of countries which sat on the bulk of the reserves.

Dollar

The rise and rise of global trade meant that most countries needed a highly liquid currency that had universal appeal and could readily be used as the currency of choice for international trading. The rise of trade coupled with the rise of US as the dominant world economy meant that the US dollar came to be widely accepted as the global currency.

As a natural extension to this US was the dominant trading partner for most other nations and those who had trading surplus again "invested" their surplus with the dominant trading partner. So US Dollar became the popular currency for countries to maintain their foreign exchange reserves. Growth in US economy fueled growth in trade and growth in US economy also meant a stronger dollar. So "investment" in the dollar was rewarded by strengthening of the dollar and as a result it became the more popular choice over keeping reserves in Gold.


Understanding the reasons behind the price of each of Gold, Oil and Dollar now makes understanding the correlation between them much easier.

A] Deceleration in US Economy will lead to fall in dollar and rise in Gold

As the US Economy slows down and the US Government borrows through the nose to pay for the ballooning fiscal deficit it is logical that the need for the dollar (for trade with US) will reduce, the dollar will depreciate which will mean that the anyone who "invests" their surpluses in the dollar will run into losses. Both these factors combine to put downward pressures on the dollar and the dollar will depreciate.

As a natural consequence of the fall in dollar is that the reserves will now have to be "invested" in alternatives which at least preserve the real purchasing power and for that there is nothing better than Gold.

So the capital will move away from demanding dollar to demanding Gold. So a fall in the dollar is accompanied by a rise in the price of Gold.

As the biggest economy and one with the largest influence on mid-east geo-political situation any real or perceived fall in demand from the worlds largest economy is sure to send the Oil prices falling.

B] Rise in uncertainty puts a premium on safety

Common sense isn't it. As the fear that the stock markets may crash, fear of war, lack of confidence on the economy or any uncertainty of any kind puts a premium on safety. Wouldn't many prefer a decent pay and safe job than one which pays well but constantly has the uncertainty of getting laid off ? Similarly rise in uncertainty puts premium on "safe" investments like Gold and hence a premium on their prices.

Surprisingly even the dollar is considered to be a "safe" investment and hence if uncertainty is the dominant emotion in the market, the capital will move away from riskier investments like Stocks into Dollar and Gold. In which case both will rise while the stock market crashes.

Similarly rise in uncertainty of a financial deceleration will mean that oil futures fall as fewer investors are willing to pay the premium on oil futures. Usually a real fall in demand is counter productive to the Oil cartel so in times of uncertainty the spot price of the oil also falls ensuring that higher oil prices are not a causal factor that lead to economic deceleration and eventual fall in real demand

C] Rise of BRIC [Brazil, Russia, India and China]

This has not been a dominant factor in the past but my prediction is that this is what will primarily influence the prices of dollar, gold and oil in the not too distant future.

Rise of these economies has meant that the relative importance of these countries as trade partners will increase. naturally the countries who are trade partners for BRIC will want to maintain an (increasing) part of their forex reserves/investments in the currencies of BRIC. This will reduce the importance/demand of the dollar as the currency of choice and thereby put downward pressure on its price.

Similarly increasing demand for Gold and Oil from BRIC will combine to flare up Oil prices and put demand driven inflationary pressure on Gold


To summarize, while there is no perfect correlation between Gold, Oil and Dollar the prevailing economic circumstances dictate how these commodities move in relation with each other

- Recessionary US : Dollar Weakens, Gold Strengthens and Oil Weakens
- Uncertainty : Dollar Strengthens, Gold Strengthens and Oil Weakens
- Rise of BRIC : Dollar Weakens Gold Strengthens and Oil Strengthens

Naturally the prevailing circumstances will be a combination of these factors and in most cases the predominant factor will influence how the three move in relation to each other.

Irrespective of what happens it appears that Gold is destined to go higher and the dollar will weaken. So a short dollar long gold investment strategy is definitely likely to yield handsome returns.