US Dollar Correlation to Gold Signals Risk to Longer-Term Trend

The correlation between the US Dollar and Gold prices has picked up considerably as of late, as a fear of excessive US fiscal and monetary stimuli have increased the lure of gold as a hedge against dollar weakness. In fact, the 20-day rolling correlation between the Euro/US Dollar and COMEX Gold futures now stands near record-highs after having fallen near all-time lows earlier this year.

Though any statistician can tell you that correlation does not imply causality, the strong link can hardly be cast away as a spurious coincidence. The earlier breakdown in the Euro/US Dollar-Gold correlation was arguably a function of the resurgence in the US Dollar as a safe-haven currency. As markets back away from excessive US fiscal deficits and oversupply of US Treasury bonds, the US Dollar could potentially suffer over the medium-to-long term.

On a shorter-term basis, risk-averse investors have kept short-term US Treasury rates at incredible historic lows. 1-Month Treasury Bills now yield an absolutely miniscule 0.06% annual return. Investors are sure enough that the US Treasury can meet its obligations through the very near-term, but ballooning yields (and dropping prices) on 10 and 30-year bonds emphasize investors’ shaken confidence in Treasuries and the US Dollar.

Markets typically view the steepness of the yield curve (spread between short and longer-dated interest rates) as a sign of market growth expectations. The yield curve is typically at its steepest when short-term interest rates are low but markets expect economies and yields to return to their longer-term potential. In 2003 we saw the 2-10 Treasury yield spread hit its highest in at least three decades. Such a steep yield curve signaled that markets expected the US economy to recover and that the US Federal Reserve would need to raise short-term rates.

Yet the more recent steepening of the yield curve has been far from what we saw from 2001-2003. In this case, we believe such steepening is driven more by fear than by medium-to-long-term growth expectations.