Why will the US dollar fade as gold is set to shine?

Since the end of World War II, the dollar has been the world’s most important currency and is currently used in more than 80% of international trades (foreign exchange transactions).¹ Following the introduction of the 1944 Bretton Woods Act, which was an international monetary system that tied the US dollar to the gold price, it has been the global reserve currency.

In recent years the US dollar has performed well, rising in value versus a basket of other major currencies. As the worlds reserve currency US dollars tend to be in demand during times of uncertainty. They are also used to buy US government debt, which along with the US dollar, is usually considered a ‘safe haven’ asset class. With US interest rates rising, investors have also been attracted to the higher yields offered by government bonds.

However, we believe this trend will begin to change and our outlook for the US dollar is negative both in the short and long term:

In the short term the US dollar could weaken. Easing monetary policy by the US Federal Reserve is the main factor. The US is expected to lead the way and cut interest rates sooner than other Western countries and this could potentially diminish the allure of the dollar. Higher relative interest rates in the US, compared to other developed markets, typically increases the value of the dollar by attracting more capital from abroad. So, a decrease in interest rates does the opposite and could prompt investors to withdraw their money from the US and move to areas with higher interest rates.

In response to Russia’s invasion of Ukraine, and in a significant shift in approach, the US has used the currency’s dominance like a weapon - imposing financial sanctions on Russia and confiscating Russian US dollar denominated assets.

The acceleration of the weakening of the US dollar’s dominance is a relatively new development and it’s gaining traction due to geopolitical tensions, such as the ongoing Russia-Ukraine conflict. The recent weaponisation of the US dollar has put other autocratic nations on alert.

As a result, some countries are looking for alternative homes for their foreign reserves. Countries like China, Brazil, India, Malaysia and Bolivia are increasingly considering ways to cut out the US dollar and trade directly with each other in alternative currencies.

The demand for gold has surged and its price has strengthened to $2,111/troy oz at the beginning of March, but this is counter intuitive. It has risen when interest rates and inflation have been rising. For an asset such as gold, which neither produces anything nor generates an income, you would expect it to fall in value. As a result, there is renewed interest in understanding why gold has grown so strongly.

Gold’s shining performance has, in part, been due to the US dollar’s loss in popularity as store of wealth among some foreign governments, but there are other reasons too.

As outlined earlier, the weaponisation of the US dollar means alternatives are being considered. The US dollar is not only used in trade but also as an asset class for countries to store their foreign reserves.

For example, in April 2021 China’s foreign deposits, private and public reserves, reached over $1trillion, the majority in US dollars. But following Russia’s invasion of Ukraine, China has had to look elsewhere. Gold offers a quick solution for an alternative to the greenback.

Other reasons for gold’s increasing popularity, include:

• The preference for gold instead of gold miners. High inflation has meant Gold mining companies are struggling to keep costs down and this has made holding the actual metal a more attractive proposition than investing in the mining sector. It has also become easier for investors to access the precious metal directly, which has helped drive demand for gold from retail investors.
• Heightened geopolitical instability. Fears about a broadening conflict in the Middle East saw investors flock to the yellow metal, which has historically outperformed during times of greater uncertainty.
• Demand from central banks. As mentioned earlier, an increase in sanctions has resulted in central banks of countries opposed to the US to step up their purchases of gold to diversify away from the US dollar. The limited supply of gold, as production flatlines, has also prompted central banks to buy more gold. Central banks are now buying more tons of gold than at any other time since records began in 1950 – they now account for 33% of monthly global demand for gold.²

Gold has long been viewed as a ‘safe haven’ asset, prized for its intrinsic value and perceived stability. As mentioned, investors often turn to gold in times of economic volatility, seeking refuge from currency fluctuations and geopolitical tensions.

Gold has other added benefits. It’s a good asset to include if you want to create a diversified portfolio as its performance is less correlated to the stock market.

There are risks to owning gold too though. When interest rates are high, as they have been recently, gold typically becomes less attractive as it’s not an income generating asset. If investors favour gold too much they could also miss out on other opportunities when markets rally.

All of these factors are interlinked and as with other asset classes they don’t always perform as one would expect. Some predict the gold price could continue to surge as it is entering new territory and setting new all time highs this month ($2,347 at the time of writing).

Bloomberg shows market forecasts range from $1,709 to $2,727 per troy oz. However, as can be seen by gold’s performance over the last five years, it’s not always been on the upward trajectory.

While we don’t forecast the dollar’s dominance will end, its influence may have waned. While the strength of the US economy has played its part, there’s an uncertain future ahead as the currency will be influenced by a myriad of things, such as the Fed’s policies, the US election and rising government debt.

Gold and the US dollar have often had an inverse relationship. However, the reasons for the rise in the gold price have evolved and the dollar’s weakening is now due, in part, to some countries seeking an alternative.

By staying informed and monitoring key developments, investors can take advantage of some opportunities and mitigate risks when exposed to gold and the US dollar.

[1] Revisiting the international role of the US dollar (bis.org)

[2] What strong gold says about the weak dollar, FT.com, April 2023