The Effect of Gold on Currencies

As the price of gold continues to climb, many investors have begun to wonder what the yellow metal’s price movements impact is on currencies across the globe. 

While there is much conversation on the factors that move the price of gold, the idea of gold affecting currencies is discussed to a lesser degree.   

Read on for an in depth look at the ways in which the precious metal shapes and shifts currencies and the economy as a whole.

The effect of gold on currencies: The gold standard

Although the gold standard has not been used since the 1970s, it is important to understand what it was and how it worked, as it is one of the first and largest examples of the yellow metal affecting currencies. 

What is the gold standard and how does it work?

The gold standard is a monetary system in which the value of a country’s currency is directly linked to the yellow metal. When countries use the gold standard, a fixed price at which to buy and sell gold is set as a way to determine the value of the nation’s currency.

For example, if the US went back to the gold standard and set the price of gold at US$500 per ounce, the value of the dollar would be 1/500th of an ounce of gold. This would offer reliable price stability.

By introducing the gold standard, transactions no longer have to be done with heavy gold bullion or coins. It also increases the trust needed for successful global trade ― the idea is that paper currency has value that is tied to something real.

The goal of this type of monetary policy is to prevent inflation as well as deflation and to help promote a stable monetary environment. 

When was the gold standard introduced?

The gold standard was first introduced in Germany in 1871, and by 1900 most developed nations, including the US, were using it. The system remained popular for decades, with governments worldwide working together to make it successful, but when World War I broke out the system became difficult to maintain. Changing political alliances, higher debt and other factors led to a widespread lack of confidence in the gold standard.

When was the gold standard replaced and what replaced it?

The demise of the gold standard began as World War II was coming to an end. At this time, the leading western powers met to develop the Bretton Woods agreement, which would be the framework for the global currency markets until 1971.

The Bretton Woods agreement was developed at the United Nations Monetary and Financial Conference, held in Bretton Woods, New Hampshire, from July 1 to 22, 1944. Under the agreement, currencies were pegged to the price of gold, and the US dollar was seen as a reserve currency linked to the price of gold. This meant that all national currencies were valued in relation to the US dollar since it had become a dominant reserve currency.

Despite valiant efforts from governments at the time, the Bretton Woods agreement led to overvaluation of the US dollar, which led to concerns over exchange rates and their ties to the price of gold.

By 1971, Nixon had called for a temporary suspension of the dollar’s convertibility. Countries were then free to choose any exchange agreement, except the price of gold. In 1973, foreign governments let currencies float; this put an end to the Bretton Woods system, and the gold standard was ousted.

From the 1970s to today, most countries have run on a system of fiat money, which is money issued by the government that is not backed by a commodity. The value of money is set by supply and demand for paper money and supply and demand for other goods and services in the economy. The prices for those goods and services, including gold and silver, can fluctuate based on market conditions.

Most recently, market watchers have begun to wonder if US President Donald Trump will bring back the gold standard. 

The effect of gold on currencies: The US dollar and inflation

There are many factors that are currently molding gold prices. Factors such as the movements of the US dollar, present interest rates, geopolitical turmoil, fear over a slow in economic growth, as well as supply and demand are dominating what happens to the precious metal.

The US dollar

While many see the greenback as a catalyst that pushes and pulls gold, due to the fact that there is a long-standing relationship between the two, it can be said that the yellow metal also has an affect on the US dollar. 

“Gold’s relationship with the dollar is determined by US-based gold supply and demand, as well as by the status of the dollar as the reserve currency globally,” said the World Gold Council in a report.

Most recently, the greenback has been lower than in previous years and has lost some of its spotlight to gold. Since the precious metal has a negative correlation to a thriving US dollar, the greenback’s recent decline has been supporting the yellow metal and its upward price movements.

When the dollar is down, investors turn towards gold as a safe haven, which has the tendency to keep the greenback in a stagnant position. 

Additionally, gold has interesting currency-like tendencies. BMG Bullion notes that gold retains its purchasing power yearly. The yellow metal can be bought and stored and it has the ability to be converted into money in a variety of currencies, which is currently appealing to gold investors since the dollar is  relatively stagnant and precious metals prices are on the rise. 

On the flip side, when the US dollar is thriving, gold tends to decline due to the fact that it becomes too expensive to hold for investors who are not US-based. 

Inflation

Much like its relationship with the US dollar, most investors and industry experts look at gold’s relationship to inflation as inflation having an affect on the yellow metal.

Gold tends to act as a defence or protection against inflation. When the cost of living begins to rise (inflation), the stock market tends to plunge. If you are an investor with assets that are directly negatively affected by a volatile market, you will need something in your portfolio to balance that out — enter gold. 

Over the past 50 years, investors have been witnesses to the gold price making huge gains when the stock market is crumbling. 

As Investopedia points out, “This is because, when fiat currency loses its purchasing power to inflation, gold tends to be priced in those currency units and thus tends to arise along with everything else.”

Additionally, the yellow metal has also been used as a hedge against deflation. Although this situation has not occurred since the Great Depression of the 1930s (and to a much smaller degree after the 2008 financial crisis), deflation occurs when prices drop, the economy is in a downturn and excessive debt looms.

As a result, market participants make the decision to hoard cash, and the safest place to hold cash is in gold. Again, while this situation is not commonplace, many investors keep the yellow metal in their portfolio on the off chance that another massive period of deflation takes place.

US and Global Economy

The state of the US and global economy also has a unique relationship with the yellow metal as it tends to be in a weakened state when gold is thriving. As of late, the US Federal Reserve has also taken to cutting interest rates in order to offset the slow in economic growth.

“To add further complexity to the global marketplace, the US Federal Reserve cut interest rates by 0.25 percent, signalling weakness in the US economy. The currency wars continue, as they inch closer to fiats intrinsic value of 0,” Brian Leni, found of Junior Stock Review, told the Investing News Network (INN).

“While I can’t predict the ebb and flow of any commodity, I think it’s safe to say that the world is, unfortunately, ready for higher gold prices and, with it, we are most likely to see some type of climactic event which will trigger a reset for the global economy,” he added.

Brien Lundin, editor of Gold Newsletter, shares Leni’s sentiment, telling INN, “The global economy is now completely dependent upon not only easy money, but ever-easier money. Not only that, but a decade of exorbitant debt creation has ballooned the US federal debt to levels that will no longer allow for higher rates, much less anything approaching historically normal rates.”

The effect of gold on currencies: Gold producing countries

Before breaking down how the price of the yellow metal affects some of the world’s top gold mining countries, let’s take a look at the foreign exchange market, as it is what these countries trade on.

What is the foreign market?

The foreign exchange market, also known as forex, FX or currency market, is the largest financial market in the world and is the deciding factor of the exchange rate for global currencies. 

Those who trade on the FX market are able to buy, sell, exchange and speculate on currencies. The FX market is comprised of banks, FX market dealers, commercial companies, central banks, investment management firms, hedge funds, retail FX dealers and investors. Additionally, the FX market allows currency conversion for international trade settlements and investments.

From here, a country’s currency is broken down into two categories — free float and fixed float. The value of a free float currency is determined by free market forces such as supply and demand relationships. For countries with a fixed float, that region’s governing body sets its currency’s relative value to other currencies. Free floating currencies include the US dollar, Japanese yen and British pound, while examples of fixed floating currencies include the Chinese yuan and the Indian rupee.

Finally, currencies on the FX market are traded in pairs, so one currency’s value in that pair is relative to the value of the other.

Countries that import and export gold

Due to the fact that the value of a country’s currency is strongly tied to the value of its gold imports and exports, that nation cannot avoid being affected by the yellow metal’s price movements.

Because of this, a country that exports gold or has access to gold reserves will experience an uptick in the strength of its currency when metal’s price rises, since this increases the value of the country’s total exports.

This means that when the price of gold climbs, it creates a trade surplus or inevitably helps those nations offset a trade deficit. However, countries that import large amounts of the yellow metal will generally have a weaker currency when the price of gold goes up. 

Countries that specialize in producing gold products, but lack their own reserves, will be large importers of gold. In return, these regions end up being particularly susceptible to growing gold prices. 

Additionally, when central banks buy gold, it affects the supply and demand of the domestic currency, which could escalate to the creation of inflation. This is mostly because of the fact that banks rely on printing more money to purchase gold, and thereby create an excess supply of the fiat currency.

Top gold producing countries

Last year’s gold mine production worldwide was estimated to be approximately 3,260 tons, which is an increase from 2017’s 3,230, based on numbers reported by the US Geological Survey. For more information on the top 10 gold producing countries, click here. 

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Securities Disclosure: I, Nicole Rashotte, currently hold no direct investment interest in any company mentioned in this article.