Issue 50
Gold, the US Dollar and G7 Central Banks
From its $255.50 low, the gold price has rallied by approximately 290% over the past seven years - marking not only the most durable gold price rally in history but, in US dollar terms, the most powerful since gold become freely floating in 1971. However, the sudden price pullback across the precious metal complex during March has raised concerns that the bull run in this sector has drawn to a close.
Although the gold price had been rising before August 1971, we take this as the start point for this rally since it marks the date the US government informed the IMF that the US dollar would no longer be convertible into gold. This consequently led to the collapse of one of the main pillars of the 1944 Bretton Woods system. Highs and lows in the gold price relate to closing prices. Source: DB Global Markets Research.
We disagree. We believe US interest rate and exchange rate trends remain bullish, and are therefore positioning for the dollar to retest its all-time lows – and for the gold price to move above $1,100 by the end of 2008.
However, we believe investors need to be on guard for coordinated central bank FX intervention to rescue the dollar. Indeed every dollar cycle since 1978 has ended with coordinated central bank intervention to correct extreme misalignments in exchange rates.
The dollar, interest rates, equity markets, producer de-hedging, strong fabrication demand and geopolitical risk have all been working in favour of the gold price at some point during this decade. Of these, we believe the most powerful has been the dollar. In fact, we find that the dollar trade- weighted index (DXY) started its long-term downtrend in May 2001, which almost exactly coincides with when the gold price began its long upward march. Indeed, since April 2001 the gold price has risen by almost 300%, and approximately $750 – the most powerful rally since the gold price became freely floating in 1971. In terms of duration, this rally is now seven years old, and consequently also represents the most durable rally in recorded history (Figure 1).
Even so, in real terms, and relative to per capita income, precious metal prices still remain cheap on an historical basis. While gold and silver prices in nominal terms have been rising steadily for the past few years, in real terms they are still trading below the highs hit at the beginning of the 1980s. For gold and silver prices to hit their all-time highs in real terms today would require nominal prices to rise to $1,415 and $80, respectively. If the period of market manipulation in the silver market during 1980 is excluded, then the silver price would need to hit $34.
Further, in terms of G7 per capita income, we have tracked how many ounces of gold and silver could be purchased by an average G7 consumer since 1972.We find that while purchasing power has deteriorated during the current decade, gold and silver prices would have to rise to $2,390 and $80.90 for purchasing power to deteriorate to the levels that prevailed in 1980.
We expect the course of the dollar will continue to play an important role in driving the gold price. In March it fell to a new lifetime low against the euro, and we expect EUR/USD to rise further.
However, such a misalignment in the dollar should not be considered unusual: an overshooting in the dollar has been a typical feature at the end of every dollar cycle since1972 (Figure 4).
In fact, the euro would need to rise above 1.64 for it to push the dollar to its most undervalued level versus Purchasing Power Parity since the birth of floating exchange rates in 1972. Consequently, we believe investors need to consider at what point the dollar is set to embark on a new long-term uptrend since, when this occurs, it is likely to be ferocious. Since 1980, we find that in the first year of a dollar turn, the greenback moves by on average 27% in the first year and a further 14% and in the same direction in the second year (Figure 5).
