Relationship Between Gold and Currency Valuation

Apr 7, 2021 06:43 PM ET
Relationship Between Gold and Currency Valuation

There have been three instances of historical gold price spikes since 1971. On January 1, 1980, a single ounce of gold fetched a record $875. Around 21 years later, one ounce fetched $1,920, but this was nothing compared to the $2,075 peak reached on August 3, 2020. 

Interestingly, every instance that the yellow metal fetched record prices coincided with a financial crisis in some parts of the world economy. Also, many currencies lost substantial value during this period. Already, you might be starting to see some relationship between gold and currencies. In the paragraphs that follow, we will walk you through the effects of gold on currencies and why there is a relationship in the first place.

Why is gold important to begin with?

In The Power of Gold, Peter L. Bernstein begins the first chapter by retelling a story told by John Ruskin many years ago. Ruskin was a man of many talents but excelled as an art critic in Queen Victoria’s England. In Ruskin’s story, a man boarded a ship, and in his hands, carrying a heavy bag containing all his wealth in gold coins. 

Before long, the ship got caught up in a terrible storm. Fearing that he would lose his wealth if the ship went under, the man strapped the bag on his body and bailed into the sea. The bag’s weight sank the man promptly to the sea bottom. “Now,” Ruskin asked, “as the man was sinking, had he the gold? Or had the gold had him?”

This is not entirely true of the relationship between man and gold, but it is not far-fetched either. The yellow metal has different meanings in different religions and cultures. Some researchers have shown that gold has significance in certain magical contexts too. However, the most important meaning of the metal is perceived in economic contexts. Here, gold has for centuries signified material richness and has helped to structure societies in hierarchies. It is said that Mansa Musa, the richest man in history, wowed crowds with his gold possessions, and he was worshipped for the feat. 

Gold is rust-resistant, easily malleable, and hard to mine. These qualities enabled the metal to underwrite much of the global financial system from time immemorial until the 20th century. The yellow metal is also a raw material used in crafting various forms of expensive jewelry. In most parts of the world, societies ascribed mythical qualities to the metal. These factors elevated gold to immense significance, and to such an extent, countries would go to war to secure more gold.

Gold and the Bretton Woods financial system

In the penultimate year of WWII, the US gathered several countries in a New Hampshire city called Bretton Woods to strike out a plan for the future's international monetary system. After reaching consensus and appending signatures, two institutions were born, the World Bank and the IMF. These would be the gatekeepers of the New World Order. Part of this order was that the US dollar would be convertible to gold and that all the other currencies would be convertible to the dollar. 

Once again, human beings were conceding to the supremacy of the yellow metal as the underwriter of an orderly and stable financial system. Not even three decades later, the same human beings saw a fundamental flaw in a gold-backed financial system. The money supply could not keep up with demand, and this was holding back monetary policies that would spur further economic growth. 

After the Nixon declaration of a “temporary” withdrawal from the gold standard, inflation spiked, especially in the US. In response, the Fed tightened benchmark rates further and further to stem the price growth. A wary market dumped the dollar in favor of more gold, which investors viewed as more stable. 

Gold price

Gold as an inflation hedge

Following the underperforming of the US dollar and other currencies relative to inflation, investors turned their attention to the yellow metal that has stood the test of time. The metal became a favorite asset in periods of economic recession characterized by high inflation rates. 

Let us use the gold-USD relationship to illustrate this point. The figure below shows the US dollar index's performance (DXY) over the past year juxtaposed against the price of gold in the same period. The chart starts in late March, just after economies around the world had begun to feel the impact of the coronavirus pandemic. 

Gold as an inflation hedge

Notice that the dollar's value started to fall steadily while gold price spiked to a record high in less than five months. By early 2021, the gold price had barely budged from record performance, but the DXY still fell. How do we explain the difference? Inflation!

Inflation refers to the deterioration in a currency's purchasing power due to an increase in the prices of goods and services at an unusually high rate. Investors anticipate inflation when recessionary headwinds start to bombard an economy. This is exactly what happened when countries started to go into lockdowns in March 2020. 

Not wanting to incur losses for holding dollars, investors rushed into the gold market to buy the metal, hence driving up the price. 

The amount of gold in a central bank’s reserves affect currency value

If you have not seen a direct link between gold and currency by now, then here is another scenario. Since gold is the ultimate asset for inflation hedging, a country with more gold bars is seen as having a stronger currency. For example, the US Fed has the largest gold holdings, as per the table below. As such, this is one of the many reasons the dollar is standard for global trading. 

central banks ranked by largest gold holdings

Conclusion

For thousands of years, gold has facilitated global trade. One would have imagined that technological advancement and knowledge acquisition would have found a suitable substitute by now. Nonetheless, the metal remains important to global finance's stability by offering an avenue to safety when all other assets face the risk of annihilation.

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