While the U.S. dollar continued to strengthen, gold prices fell to a five-month low in the past week; a trend which has accelerated sharply this week, pushing trading volume of gold to a five-year low. Many investors blamed gold’s tumble for the shift back to equities, but it was the stronger dollar that was the real culprit.

Why? Gold is denominated in U.S. dollars, so when the dollar is strengthening in value, the underlying gold price goes the opposite direction to maintain the same value for global investors not dealing in U.S. currency. Central banks around the world have an asset preference to hold either the U.S. dollar or gold for their reserves – so if one is strengthening, then the other is weakening. There used to be almost an 80% negative correlation between these two, but that has weakened since the 2008 financial crisis. This softening demonstrates that the U.S. dollar is less preferred as a reserve currency than it used to be.

To be sure, over the past week, gold had almost everything working against it. On top of the strengthening U.S. dollar, investors switched heavily out of gold, and back into both equities and fixed income. The Dow Jones Industrial Average and S&P 500 continued to reach new highs, while the U.S. 10-year Treasury yield fell by seven basis points. China also has reduced its purchase of gold, while ongoing miner strikes in South Africa have led to price instability in precious metals in general.

Interestingly enough, because the euro moves in the opposite direction of the U.S. dollar, there is a growing positive correlation between the euro and gold prices.

My View: In the short-run, gold prices will follow the movement of the euro because of its negative correlation to the U.S. dollar. And this negative correlation between the U.S. dollar and gold should be a clear signal that the U.S. dollar remains the base currency or reserve currency in the world, despite ongoing talks about quoting commodity prices in other global currencies.

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