Thursday, May 27, 2010

Correlation Breakdown

Over time, the price of gold typically has a fairly strong inverse correlation with the value of the U.S. dollar, meaning that they tend to move in opposite directions. But lately the dollar and gold have been moving higher in lockstep as the long-term inverse correlation has broken down (see chart below). There are a number of plausible reasons for the breakdown in the normal relationship between these two asset classes.

Start with gold. We are currently engulfed in the middle of a perfect storm of uncertainty: fears of eventual currency debasement in developed economies, worries about the long term viability of the Euro-zone, geopolitical tensions in Korea and Thailand, new signs of stress in the banking system, and even the recently attempted terrorist attack in New York City. That is one hearty list of unstable conditions, which has been supporting the gold trade recently.

As for the dollar, the trade-weighted dollar index, which is based on our largest trading partners, is made up of approximately 58% Euro. So, movements in that index are largely driven by movements in the Euro/dollar relationship. As the Euro has plummeted in recent weeks, this has been a huge driver of dollar gains. Other fundamentals such as purchasing power parity, real interest differentials, and future growth rates are no doubt operating beneath the surface. But quite simply, recently it seems like the Euro’s pain has been the dollars gain.

The traditional inverse correlation between dollar and gold appears to have recently decoupled. However, if the history of gold and the dollar remains a decent guide, then the longer-term relationship is likely to reassert itself at some point, implying that one of these asset classes is going to be wrong. The key will be in figuring out which one that is.