A Declining Dollar: A Reason to Buy Gold

For some time now, the price of gold has languished under the weight of a strong U.S. dollar. Because the dollar is the world's reserve currency and gold is priced in dollars, a strong dollar tends to depress the price of gold.

The chart below dramatically shows why the price of gold has fallen during the late 1990s. From 1997 on, notice the almost perfect negative correlation between a rising dollar and the price of gold.

"The major trend is now down for the first time in five years, and the Dollar could fall sharply lower this year. So far, the Dollar has already dropped 8% since its peak in late November, primarily because of the slowing economy. A weaker Dollar should also give gold a shot in the arm since they generally move in opposite directions."

The Aden Forecast

The strength of the U.S. dollar can’t continue forever and it now appears that the best news about the dollar is behind us. There are currently signs in the economy that the dollar is weakening and is ready for a fall, a big fall.

One of the biggest threats to the U.S. dollar is the record high trade deficit. Since 1993, the deficit has significantly increased every year (see chart below). In 1992 it stood at $39 billion. In 2000, it will likely finish the year at $360 billion — an increase of nearly 1,000%.

"This cannot go on forever. In the long run you cannot borrow $400 billion a year from abroad. It may not be a problem for the next two years, but it is probably a problem in the next five years. We're basically selling off the country to foreigners."

David Wyss
Chief Economist
Standard & Poors

This huge trade deficit is putting pressure on the U.S. dollar. A strong dollar makes U.S. goods more expensive overseas and foreign goods cheaper here and therefore, a strong dollar increases the trade deficit. A weak dollar, with all of its negative implications, would, however, lower the trade deficit. Alan Blinder of The Brookings Institution and Princeton University warned of a coming fall in the dollar due to the trade deficit during testimony on December 10, 1999, before the U.S. Trade Deficit Review Commission:

"Another concern is that we may be setting up the dollar for a very big fall, and that brings me to my third and final point. I believe that a lower dollar, indeed a much lower dollar, will ultimately play a major role, indeed the major role, in whittling our trade deficit down, not to zero, but to a manageable size. I think the problem for public policy is simply to cope with the sinking dollar as it sinks."

Should the dollar's decline be sustained, gold will benefit on two fronts. First, because gold is priced in dollars, as the value of the dollar declines, the price of gold will tend to increase. Second, as the value of the dollar declines, foreign investment in U.S. stocks and bonds will decline, adding to the negative momentum in those markets. This will indirectly boost investment demand for gold.

Here are some historical examples of gold’s response to a declining dollar:

• June 1982 - February 1983. The sharp decline in the U.S. dollar caused the price of gold to increase 74% in just nine months, despite the fact that inflation remained moderate.
• February 1985 - November 1987. Gold increased in value by 78% in just 21 months due to a decline in the dollar. The dollar's fall was the deliberate result of the Plaza Accords, an agreement by the central banks of the U.S., the United Kingdom, France, Japan and Germany to intervene in global currency markets to lower the value of the dollar.

"Gold is a potentially huge score. There are encouraging signs that the high water mark has passed for the dollar, financial assets, and the credit boom that has fueled the bull market in paper and the bear market in gold."

John Hathaway, a gold fund portfolio manager

It is best if investors do not wait for the trade deficit to begin taking its toll on the financial markets to acquire their financial insurance in the form of gold. By then, it may be too late to buy gold at attractive prices. Today gold is trading at under $265 per ounce-just above a 20-year low. And $265 gold is lower than the annual peak in each of the past 20 years. In fact, $265 per ounce gold is cheaper than the average annual price of gold in each of the past 20 years. There has never been a better time to buy gold for less.