For those of you who don’t already know, gold and the US dollar have a very special relationship. Together, they share an inverse relationship.
In other words, the price of gold and US dollar often head in opposite directions. When the price of the US dollar goes up, gold tends to go down. On the other hand, when the price of the US dollar goes down, the price of gold tends to soar.
Why do they share this unique relationship?
How Global Currencies Work
To understand why gold and the US dollar share such a unique relationship, we would need to first understand how global currencies work.
The Gold Standard
For a very long time, the major currencies around the world are all backed by a proportionate amount of gold reserves. This gave rise to what we call the gold standard.
However, ever since President Nixon took the United States off the gold standard in 1971, many countries have since followed suit.
Instead, most countries today adopt a free-float or controlled-float currency system that is backed up with international reserves, which includes foreign currency reserves such as US dollars, Euros and of course, gold.
The Effect On Market Forces
As a result, almost every country in the world holds large quantities of US dollars and gold as part of their international reserves. Each country has their own international reserves which they use to control price fluctuations of their own currency by selling or buying their own currency with the international reserves that they have.
Alternatives To Each Other
Because gold and the US dollar are two of the most trusted and widely traded international reserves available to countries all around the world, they are also perfect alternatives to each other.
The world has faith in gold’s value because of its position and importance in trade and currency since time immemorial. It is also a precious metal which availability on earth is limited and finite. On the other hand, the US dollar became the foreign reserve currency of choice because of the United States’ status as the strongest economy and country in the world.
What Happens When Market Confidence Is Low
However, because the US dollar is ultimately still just a piece of paper backed by the US government, the world tends to trust gold more when the global economy falters and stock markets come crashing down.
As a result, when a global recession hits and market confidence is low, monetary authorities around the world tend to trade-in their US dollar reserves for gold reserves. When that happens, trillions of US dollars are sold and used to buy gold instead, putting a huge selling pressure on the US dollar while driving up the demand for gold.
This results in the price of US dollars going down while the price of gold appreciates due to the high demand.
What Happens When Market Confidence Is High
On the contrary, the opposite happens when market confidence is high and the economy is booming. Since the majority of global trade is conducted in US dollars, a booming economy naturally creates more demand for the US dollar.
At the same time, the monetary authorities of all the countries around the world would also be trying to balance their international reserves after all the gold that they’ve bought during the recession. As a result, they would slowly try to sell off their gold reserves and replace them with US dollars instead.
This would create an enormous demand for the US dollar and an overwhelming supply of gold since they are all trying to trade-in their gold for US dollars.
As a result, when market confidence is high, the value of the US dollar tends to rise while the value of gold tend to drop.
Their dynamics and status as perfect alternatives to each other as international reserves is what creates such a unique and inverse relationship between gold and the US dollar.
DollarsAndSense is a website that aims to help people make better financial decisions, one interesting bite-sized article at a time. Like us on Facebook to stay in touch with our latest article.
DollarsAndSense Malaysia is a website that aims to help people make better financial decisions, one interesting, bite-sized article at a time. Like us on Facebook to stay in touch with our latest articles.