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…When the USD starts to rise many assume that this is negative for paper gold ETFs 
such as GLD as well as physical gold. I’m sure you have heard it before, if the USD goes up then gold goes down, and vice versa…but, in reality, this “rule of thumb” isn’t the case and, in actuality, it would be impossible for the USD and gold to trade inversely with each other. Let me explain.
The above introductory comments are edited excerpts from an article* by “SomaBull” as posted on SeekingAlpha.com under the title Debunking The Theory That The U.S. Dollar And Gold Have An Inverse Relationship.
“SomaBull” goes on to say in further edited excerpts:
Why The Assumption?
We first have to ask why so many economists, analysts, and investors believe the above “rule of thumb”. The theory is that
- a rising USD makes investing in Gold/GLD less attractive, as a strong currency means less monetary and economic uncertainty and, conversely, that
- a falling USD makes investing in Gold/GLD more attractive, as a weak currency means inflation and economic uncertainty.
There are 2 major flaws in this theory. The fact is:
- global currencies are all being debased, and
- a strong currency still means inflation.
A Race To The Bottom
In 2008, we almost had a complete meltdown of the entire financial system. If it wasn’t for the quick action by the Federal Reserve and other central banks around the globe, we would have had a severe depression… Trillions upon trillions of fiat currencies have been printed by the major central banks since 2008. This is a race to the bottom. There is going to be no winner in all of this…
U.S. Money Supply
Let’s take a closer look at the U.S. money supply, M1 and M2. As you can see below, M1 has exploded since 2008. In theory, the USD should be down given this growth in money supply.
(click to enlarge)
(Source: FRED)
Now, let’s look at M2. I added the red line into the chart below to show the trend line for M2 growth over the last 35 years. You can see that from 1980 to early 2000s, M2 stayed close to this trend line. Then around 2005 it was above it, and now in 2014 it is substantially above the normal trend. M2 should be around 7,500, instead it’s over 11,000.
(click to enlarge)
(Source: FRED)
The US Dollar Index
The US Dollar Index has moved higher in the last 5-6 years since the 2008 financial crisis, and is up a lot from the 2008 lows. Given the money supply growth (which is inflation), the USD should be lower, but it’s not. The reason is because every other major currency in the world is also being debased by the trillions, just like the USD. The USD just happens to be picked as the best of the worst right now.
[For example,] if the Fed came out tomorrow and said it was going to print $2 trillion USD, and the ECB, the BoJ, and the BoE all came out and said they were each going to print $4 trillion [in their respective currencies], then the US Dollar Index would go up. However, the purchasing power of the USD compared to gold would go down given the increase in the amount of currency that was created. Gold would rise even though the US Dollar Index was also moving higher.
(Source: Sharelynx.com)
While it’s possible that the US Dollar Index might not go down anytime in the next 20 years, the value of the USD most certainly will. They are two separate things. That’s what people get confused about. Gold measures the purchasing power of the USD, not where the USD is trading against a basket of other fiat currencies [the US Dollar Index]. That’s why there is no correlation with gold and the US Dollar Index.
(Source: Goldchartsrus.com)
Follow the Money Supply If You Want To See Where Gold Goes
An increase in the money supply is inflationary, pure and simple, and gold is going to follow the money supply. In 2008, when the U.S. got a whiff of possible deflation, gold was crashing. When M1 and M2 took off after the Fed unleashed the printing presses, so did gold.
(click to enlarge)
Conclusion
We live in an inflationary system and will never see M2 decline or remain flat for too long and, as such, while gold doesn’t follow the money supply to a “T” (it will have wild gyrations above and below it) over time it will continue to trend higher with it.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://seekingalpha.com/article/2447055-debunking-the-theory-that-the-u-s-dollar-and-gold-have-an-inverse-relationship?ifp=0 (© 2014 Seeking Alpha) About “SomaBull”: I have been a successful Private Investor in the market for the last 17 years. My focus has mostly been on the Tech/Internet sector since I started, but 10 years ago I also branched out to the Gold and Silver sector and consider myself a premium authority for everything gold and silver related.
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