Description
The documentation about the inter market linkages between gold, USD, Euro and interest rates.
Gold, USD, Euro and Interest Rates – Inter market linkages
Submitted by: Pavitra Sudhindran 2009B02 Ritika Khetawat 2009B12
Table of Contents
Introduction ................................................................................................................................ 3 Facts about Gold as a commodity .............................................................................................. 3 Evolution of Gold as a standard .............................................................................................. 3 Factors influencing the price of Gold ...................................................................................... 4 Facts about the US Dollar .......................................................................................................... 4 Major factors influencing the USD .......................................................................................... 6 Facts about the Euro .................................................................................................................. 6 An overview of Interest rates and Monetary Policy: .................................................................... 7 Inter Market Linkages................................................................................................................. 8 Linkage between USD and Gold Prices .................................................................................. 8 Linkage between interest rates and gold prices ...................................................................... 8 Linkage between interest rates and currency.......................................................................... 8 Illustration of a cross border impact............................................................................................ 9 Evidence from the market .........................................................................................................11 Conclusion ................................................................................................................................12 References ...............................................................................................................................13
2
Introduction
The subprime crisis of 2008 explicitly brought out the fact that markets around the world are inter related and do not operate in silos. A change in Monetary Policy by one nation has an impact, not only on its own economy but on the economies of the world as well. Hence, in this report we delve into the inter market linkages of Gold, USD, Euro and interest rates.
Facts about Gold as a commodity
Evolution of Gold as a standard
The Gold Standard was the oldest system which was in operation till the beginning of the First World War and for a few years after that. Gold Specie Standard: In the version of the Gold Specie Standard, the actual currency in circulation consisted of gold coins with a fixed gold content. Gold Bullion Standard: In the Gold Bullion Standard, the basis of money was a fixed weight of gold but the currency in circulation consisted of paper notes, which could be converted, on demand, into gold and vice versa at a fixed conversion ratio. Gold Exchange Standard: Under the gold Exchange Standard, the authorities converted, at a fixed rate, the paper currency issued by them into the paper currency of another country which operated a gold – specie or gold – bullion standard. The exchange rate between any pair of currencies was determined by their respective exchange rates against gold. However, the Gold Standard regime imposed very rigid discipline on the policy makers. Often, domestic considerations such as full unemployment had to be sacrificed in order to continue operating the standard. For this reason, the system was abandoned during the Great depression of 1929. Bretton Woods System: Following World War – II, policy makers from the victorious allies, the US and UK, took up the task of revamping the monetary system for the non – communist world. The outcome was the Bretton Woods System and the birth of two supra national institutions – the IMF and the World Bank. The exchange rate that was put in place was called the Gold Exchange Standard. It had the following features: ? ? The US Government undertook to convert the USD freely into gold at a fixed parity of $35 per ounce Other member countries of the IMF agreed to fix the parities of their currencies vis-à-vis the $ with variation of 1% on either side of the central parity being permissible. If the exchange rate hit either of the limits, the monetary authorities of the country could intervene in the market.
In return, the member countries of the IMF were entitled to borrow from the IMF to carry out their interventions in the currency markets.
3
Under the Bretton Woods System, the USD became international money. Other countries accumulated and held dollar balances with which they could settle their international payments. The system could work as long as the other countries had confidence in the stability of the USD. The sytem came under pressure in mid 1960s due to various political and economic factors. On August 15, 1971, the US Government abandoned its commitment to convert USD into gold at $35 per ounce and the major countries of the world went on a float. Currently, the world has a variety of exchange rate arrangements from conventional fixed peg, crawling peg to managed float and independent float. Today, Gold is most actively traded on the COMEX, with an average daily volatility of 1.23%.
Factors influencing the price of Gold
The Fundamental Value of Gold is ~$888 as compared to the trading value which is currently hovering around $1400. The Fundamental Value is determined based on the demand/supply balance and mining cost. This shows that there are several factors other than demand/supply balance that influence the price of this commodity.
Factor Gold Supply USD Inflation Monetary Policy Interest Rates % impact 50% 25% 10% 10% 5%
From the adjacent table, we see that while 50% of the price of gold is contributed by the Supply situation of gold, the balance 50% is contributed by macroeconomic factors such as the USD, inflation rates, monetary policy and interest rates.
Facts about the US Dollar
The US Dollar is the official currency of United States of America. It is the currency most used in international transactions and is one of the world's reserve currencies. Several countries use it as their official currency, in many others it is the de facto currency, and it is also used as the sole currency in some British Overseas Territories. Currently, the US government maintains over 800 billion US dollars in cash money (primarily Federal Reserve Notes) in circulation. The amount of cash in circulation is increased (or decreased) by the actions of the Federal Reserve System. Eight times a year, the 12-person Federal Open Market Committee meet to determine US monetary policy. Every business day, the Federal Reserve System engages in Open market operations to carry out that monetary policy. Given below are certain features of US Dollar which make it one of the strongest currencies in the world today:
4
• Invoicing currency for commodities like gold and crude oil: USD is used as the invoicing currency for important commodities like gold and crude oil which significantly impact all major economies in the world. As a result any movement in the USD rates (Euro/USD pair) leads to change in prices of these commodities. For instance, if USD weakens the prices of gold in dollar terms goes up and vice versa. Also, for same price of crude in dollar terms the price of crude in Rupee terms changes when USD/INR rates change. ? World's foremost reserve currency: The USD is the most widely held reserve currency in the world today. Throughout the last decade, an average of two thirds of the total allocated foreign exchange reserves of countries have been in USD. For this reason, the USD is said to have "reserve-currency status," making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact (see currency crisis). Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the U.S. economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly.
U.S. Dollar Index (USDX): The U.S. Dollar Index (USDX) is the creation of the New York Board of Trade (NYBOT). It was established in 1973, soon after the dismantling of the Bretton Woods System, for tracking the value of the USD against a basket of currencies, which, at that time, represented the largest trading partners of the United States. It began with 17 currencies from 17 nations, but the launch of the euro subsumed 12 of these into one, so the USDX tracks only six currencies today. These are Euro, Japanese Yen, Swiss Franc, Canadian Dollar, Sweedish Crona and Pound Sterling. USDX goes up when the US dollar gains "strength" (value) when compared to other currencies. It is a weighted geometric mean of the dollar’s value compared with: Euro Pound Sterling Canadian Dollar Swedish Krona Swiss Franc Japanese Yen 57.6% weight 11.9% weight 9.1% weight 4.2% weight 3.6% weight 13.6% weight
5
Major factors influencing the USD
The major factors influencing the USD can be classified under: External Factors and Internal Factors External Factors: • • Monetary Policy of other major economies of the world (Europe, Japan) Performance of the other major economies of the world
Internal Factors: • • Monetary Policy of the US Fed Health of the US economy • • • Dow Jones Index Unemployment rate Inflation
Facts about the Euro
The Euro is the official currency of the Eurozone: 17 of the 27 Member States of the European Union (EU). It is also the currency used by the EU institutions. The Eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. The currency is also used in a further 5 European countries (Montenegro, Andorra, Monaco, San Marino and Vatican) with and without formal agreements, one disputed territory (Kosovo) and is consequently used daily by some 327 million Europeans. Additionally, over 175 million people worldwide use currencies which are pegged to the euro, including more than 150 million people in Africa. The euro is the second largest reserve currency (26.5% of the reserves in the world are in Euro) as well as the second most traded currency in the world after the U.S. dollar. As of June 2010, with more than €800 billion in circulation, the euro has the highest combined value of banknotes and coins in circulation in the world, having surpassed the U.S. dollar. Based on IMF estimates of 2008 GDP and purchasing power parity among the various currencies, the Eurozone is the second largest economy in the world. The name euro was officially adopted on 16 December 1995. The euro was introduced to world financial markets as an accounting currency on 1 January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1. Euro coins and banknotes entered circulation on 1 January 2002. Also, 27% of the total volume of trade in the currency market is the EUR/USD pair, stressing upon the significance of this currency pair in international markets. 6
An overview of Interest rates and Monetary Policy:
Interest rates are used by the Central Bank of a country to control money supply in the economy by means of monetary policy. Interest rates also impact exchange rate by attracting higher foreign fund flows at higher levels and vice versa thereby leading to strengthening or weakening of currency w.r.t to other currencies. Shown below is a detailed block diagram explaining the monetary policy of a Central Bank (using Interest rates) during upturns and downturns: Central Bank Monetary Policy: Upturn
Economic growth
Monetary Policy: Increase in interest rates
Reduces money supply in economy
Increase in purchasing power/ real income
Increased liquidity or money supply
Curbs Inflation
Higher demand for goods
Inflation
Central Bank Monetary Policy: Downturn
Economic down turn
Monetary policyCut interest rates
Increase money supply in economy
Unemployment
Reduced ProductionFurther unemployment
Fuel demand
Reduced Purchasing power
Reduce demand for goods
Industrial growthLower unemployment
7
Interest rates of all major economies of the world are of importance while analyzing markets. The policies of the following Central Banks are of extreme significance in international markets. ? ? ? ? US Fed European Central Bank Bank of England Bank of Japan
Inter Market Linkages
Linkage between USD and Gold Prices
Gold is internationally denominated in USD. When the USD (Dollar Index) weakens, in order to purchase the same amount of Gold, more dollars have to be paid. The Price of Gold in USD increases as a result. Between 1999 and 2008, the correlation between Gold and the USD* has been at -0.84. However the correlation is not always negative, since Gold is also used as a hedge against inflation. So if the US economy is booming, implying a strong USD, it might happen that the gold prices instead of falling, actually rise. Since in a booming economy, if inflation is high, investors would invest in gold as a hedge against inflation. With inflation, the value of money goes downa dn hence gold is considered a safe investment.
Linkage between interest rates and gold prices
Low interest rates will cause high inflationary expectations. Investors put in their money in Gold as a hedge against inflation. As a result, Gold prices increase Loose monetary policy in a country gives an indication that the economic situation is not good Investors buy gold as a safe haven asset. As a result, Gold prices increase. Low interest rates in the US (for instance) will result in reduced demand for the USD. The USD falls and Gold price in USD increase.
Linkage between interest rates and currency
Exchange rate variability – in itself and vis-a-vis interest rate variability- has in recent years risen compared to previous periods characterised by far more rigid exchange rate regimes, even if the extent of such fluctuations is still a matter of debate. Some middle income Asian countries have all declared that their currencies have floated in post-Asian-crisis period, accompanied by a switch to inflation targeting. The relationship between interest rates, and other domestic monetary policies, and currency exchange rates is complex, but at the core it is all about supply and demand.
8
Short term Impact on Exchange Rates:
Increase in Interest rates*
Flow of funds into the country
Demand for local currency Increases
Local currency appreciates
*Wrt interest rates in another country Long term Impact on Exchange Rates:
Increase in Interest rates
Borrowing becomes more expensive
Economic growth is curbed
Local currency depreciates
Illustration of a cross border impact
Short term effects: ? An interest rate hike in the US ? ? Investors will start pulling out their money from markets offering lower interest rates (say India) and start investing in the US markets.
What does this mean for India? ? ? Reduced demand for the rupee Rupee weakens against the USD
?
What does this mean for Gold prices? ? ? ? USD strengthens, hence Gold price in USD falls * Since rupee is weakening, Gold price in rupee terms should rise The impact depends upon the correlation between USD/INR and Gold prices
* - If the Gold price does not rise due to weak correlation between USD/INR and Gold price, Gold price will increase in rupee terms due to weaker rupee. Evidence shows that there is not much correlation between the Gold prices and the USD/INR. The correlation of gold is highest with the EUR/USD pair.
9
Long term effects: ? An interest rate hike in the US: ? ? ? Signal of slowdown in growth in the US economy (due to increase in borrowing rate) Investors will start pulling out their money from the US and start investing in markets where economic growth is expected (say India)
What does this mean for India? ? ? Increased demand for the rupee Rupee will strengthen against the USD
?
What does this mean for Gold prices? ? ? ? USD weakens, hence Gold price in USD terms will rise Since rupee is strengthening, Gold price in rupee terms should fall The impact depends upon the correlation between USD/INR and Gold prices
Illustration of Parity Price
Illustration of Price parity - Increase in Gold Price (USD) Gold Price in USD 1400 1401 USD/INR Conversion Factor Parity Price 45 0.32 20160 45 0.32 20174.4
Illustration of Price parity - (Depreciation of rupee) Gold Price in USD 1400 1400 USD/INR Conversion Factor Parity Price 45 0.32 20160 45.05 0.32 20182.4
The above two tables show the impact of an increase in Gold Price alone/depreciation of rupee alone on the Gold Prices in rupee. The Conversion Factor of 0.32 is to convert from tri ounce to 10 gm as the Gold prices in India are quoted in Rs./10 gm.
10
Evidence from the market
One of the strangest developments of 2010 has been the strong positive correlation between gold and the dollar as against what we would expect. The correlation coefficient between gold and the USD (year to date) is +0.82 (a strong positive relationship). The same does not hold true for the Euro, which has declined sharply this year amid sovereign debt concerns. The correlation coefficient year to date between gold and the Euro is -0.84 (a strong negative relationship). The reason for this is since the Euro experienced a massive fall owing to the sovereign debt crisis, investors pulled out their money from the European markets and invested in the USD and Gold which were considered safer. Hence, both the USD and the Gold prices increased. Gold vs Other currency pairs In November 2010, the USD fell with respect to all other major currencies, except the Euro and Gold prices hit a record high. Correlation between Gold and Euro/USD weakened significantly, while that between Gold and other pairs strengthened. However in the week after, the Gold prices fell on the USD rising against all major currencies including the Euro – Correlation between Euro/USD and Gold increased
Gold 15 Min, 3 Day 60 Min, 1 Week 60 Min, 2 Weeks Daily, 1 Month USD/CAD AUD/USD -0.84 -0.87 -0.92 -0.86 0.78 0.84 0.86 0.79 NZD/USD EUR/USD GBP/USD USD/JPY USD/CHF 0.74 0.69 0.75 0.78 0.89 0.78 0.66 0.19 0.88 0.84 0.72 0.77 -0.4 -0.85 -0.8 -0.79 -0.7 -0.89 -0.86 -0.69
11
Gold and Interest Rates
As a result of the sovereign debt crisis in Europe, there was a surge in the flow of money into gold in search of a safe haven, but also into USD to escape the European issues. Investors sold European bonds driving their yields higher, and bought US bonds driving their yields lower. Both Gold and the USD rose, negating their usually negative correlation. The inverse relationship between gold and US treasury rates was seen and not an inverse relation between gold and the USD.
Conclusion
From our study, we can conclude the following: ? ? The interest rates, EUR/USD Exchange rate and Gold Prices are correlated However, there is no fixed and certain correlation between them – both in terms of value and sign
12
References
1. 2. 3. 4. 5. 6. 7. 8. Apte, P,G. International Financial Management, Third Edition. http://efficientish.blogspot.com/2010/07/euro-gold-relationship.html http://www.forexblog.org/2008/09/gold-dollar-link-could-break-down.html http://www.dailymarkets.com/forex/2010/11/18/gold-forex-correlations-strengthen-asireland-fuels-risk-aversion/ http://businesstm.com/investment-traders/gold-usd-inverse-relationship/ http://www.coinsite.com/content/faq/dollarvsgold.asp http://ezinearticles.com/?Know-the-Relationship-Between-Gold,-Oil-andForex!&id=3494820 www.bulliondesk.com
13
doc_407447047.docx
The documentation about the inter market linkages between gold, USD, Euro and interest rates.
Gold, USD, Euro and Interest Rates – Inter market linkages
Submitted by: Pavitra Sudhindran 2009B02 Ritika Khetawat 2009B12
Table of Contents
Introduction ................................................................................................................................ 3 Facts about Gold as a commodity .............................................................................................. 3 Evolution of Gold as a standard .............................................................................................. 3 Factors influencing the price of Gold ...................................................................................... 4 Facts about the US Dollar .......................................................................................................... 4 Major factors influencing the USD .......................................................................................... 6 Facts about the Euro .................................................................................................................. 6 An overview of Interest rates and Monetary Policy: .................................................................... 7 Inter Market Linkages................................................................................................................. 8 Linkage between USD and Gold Prices .................................................................................. 8 Linkage between interest rates and gold prices ...................................................................... 8 Linkage between interest rates and currency.......................................................................... 8 Illustration of a cross border impact............................................................................................ 9 Evidence from the market .........................................................................................................11 Conclusion ................................................................................................................................12 References ...............................................................................................................................13
2
Introduction
The subprime crisis of 2008 explicitly brought out the fact that markets around the world are inter related and do not operate in silos. A change in Monetary Policy by one nation has an impact, not only on its own economy but on the economies of the world as well. Hence, in this report we delve into the inter market linkages of Gold, USD, Euro and interest rates.
Facts about Gold as a commodity
Evolution of Gold as a standard
The Gold Standard was the oldest system which was in operation till the beginning of the First World War and for a few years after that. Gold Specie Standard: In the version of the Gold Specie Standard, the actual currency in circulation consisted of gold coins with a fixed gold content. Gold Bullion Standard: In the Gold Bullion Standard, the basis of money was a fixed weight of gold but the currency in circulation consisted of paper notes, which could be converted, on demand, into gold and vice versa at a fixed conversion ratio. Gold Exchange Standard: Under the gold Exchange Standard, the authorities converted, at a fixed rate, the paper currency issued by them into the paper currency of another country which operated a gold – specie or gold – bullion standard. The exchange rate between any pair of currencies was determined by their respective exchange rates against gold. However, the Gold Standard regime imposed very rigid discipline on the policy makers. Often, domestic considerations such as full unemployment had to be sacrificed in order to continue operating the standard. For this reason, the system was abandoned during the Great depression of 1929. Bretton Woods System: Following World War – II, policy makers from the victorious allies, the US and UK, took up the task of revamping the monetary system for the non – communist world. The outcome was the Bretton Woods System and the birth of two supra national institutions – the IMF and the World Bank. The exchange rate that was put in place was called the Gold Exchange Standard. It had the following features: ? ? The US Government undertook to convert the USD freely into gold at a fixed parity of $35 per ounce Other member countries of the IMF agreed to fix the parities of their currencies vis-à-vis the $ with variation of 1% on either side of the central parity being permissible. If the exchange rate hit either of the limits, the monetary authorities of the country could intervene in the market.
In return, the member countries of the IMF were entitled to borrow from the IMF to carry out their interventions in the currency markets.
3
Under the Bretton Woods System, the USD became international money. Other countries accumulated and held dollar balances with which they could settle their international payments. The system could work as long as the other countries had confidence in the stability of the USD. The sytem came under pressure in mid 1960s due to various political and economic factors. On August 15, 1971, the US Government abandoned its commitment to convert USD into gold at $35 per ounce and the major countries of the world went on a float. Currently, the world has a variety of exchange rate arrangements from conventional fixed peg, crawling peg to managed float and independent float. Today, Gold is most actively traded on the COMEX, with an average daily volatility of 1.23%.
Factors influencing the price of Gold
The Fundamental Value of Gold is ~$888 as compared to the trading value which is currently hovering around $1400. The Fundamental Value is determined based on the demand/supply balance and mining cost. This shows that there are several factors other than demand/supply balance that influence the price of this commodity.
Factor Gold Supply USD Inflation Monetary Policy Interest Rates % impact 50% 25% 10% 10% 5%
From the adjacent table, we see that while 50% of the price of gold is contributed by the Supply situation of gold, the balance 50% is contributed by macroeconomic factors such as the USD, inflation rates, monetary policy and interest rates.
Facts about the US Dollar
The US Dollar is the official currency of United States of America. It is the currency most used in international transactions and is one of the world's reserve currencies. Several countries use it as their official currency, in many others it is the de facto currency, and it is also used as the sole currency in some British Overseas Territories. Currently, the US government maintains over 800 billion US dollars in cash money (primarily Federal Reserve Notes) in circulation. The amount of cash in circulation is increased (or decreased) by the actions of the Federal Reserve System. Eight times a year, the 12-person Federal Open Market Committee meet to determine US monetary policy. Every business day, the Federal Reserve System engages in Open market operations to carry out that monetary policy. Given below are certain features of US Dollar which make it one of the strongest currencies in the world today:
4
• Invoicing currency for commodities like gold and crude oil: USD is used as the invoicing currency for important commodities like gold and crude oil which significantly impact all major economies in the world. As a result any movement in the USD rates (Euro/USD pair) leads to change in prices of these commodities. For instance, if USD weakens the prices of gold in dollar terms goes up and vice versa. Also, for same price of crude in dollar terms the price of crude in Rupee terms changes when USD/INR rates change. ? World's foremost reserve currency: The USD is the most widely held reserve currency in the world today. Throughout the last decade, an average of two thirds of the total allocated foreign exchange reserves of countries have been in USD. For this reason, the USD is said to have "reserve-currency status," making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact (see currency crisis). Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the U.S. economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly.
U.S. Dollar Index (USDX): The U.S. Dollar Index (USDX) is the creation of the New York Board of Trade (NYBOT). It was established in 1973, soon after the dismantling of the Bretton Woods System, for tracking the value of the USD against a basket of currencies, which, at that time, represented the largest trading partners of the United States. It began with 17 currencies from 17 nations, but the launch of the euro subsumed 12 of these into one, so the USDX tracks only six currencies today. These are Euro, Japanese Yen, Swiss Franc, Canadian Dollar, Sweedish Crona and Pound Sterling. USDX goes up when the US dollar gains "strength" (value) when compared to other currencies. It is a weighted geometric mean of the dollar’s value compared with: Euro Pound Sterling Canadian Dollar Swedish Krona Swiss Franc Japanese Yen 57.6% weight 11.9% weight 9.1% weight 4.2% weight 3.6% weight 13.6% weight
5
Major factors influencing the USD
The major factors influencing the USD can be classified under: External Factors and Internal Factors External Factors: • • Monetary Policy of other major economies of the world (Europe, Japan) Performance of the other major economies of the world
Internal Factors: • • Monetary Policy of the US Fed Health of the US economy • • • Dow Jones Index Unemployment rate Inflation
Facts about the Euro
The Euro is the official currency of the Eurozone: 17 of the 27 Member States of the European Union (EU). It is also the currency used by the EU institutions. The Eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain. The currency is also used in a further 5 European countries (Montenegro, Andorra, Monaco, San Marino and Vatican) with and without formal agreements, one disputed territory (Kosovo) and is consequently used daily by some 327 million Europeans. Additionally, over 175 million people worldwide use currencies which are pegged to the euro, including more than 150 million people in Africa. The euro is the second largest reserve currency (26.5% of the reserves in the world are in Euro) as well as the second most traded currency in the world after the U.S. dollar. As of June 2010, with more than €800 billion in circulation, the euro has the highest combined value of banknotes and coins in circulation in the world, having surpassed the U.S. dollar. Based on IMF estimates of 2008 GDP and purchasing power parity among the various currencies, the Eurozone is the second largest economy in the world. The name euro was officially adopted on 16 December 1995. The euro was introduced to world financial markets as an accounting currency on 1 January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1. Euro coins and banknotes entered circulation on 1 January 2002. Also, 27% of the total volume of trade in the currency market is the EUR/USD pair, stressing upon the significance of this currency pair in international markets. 6
An overview of Interest rates and Monetary Policy:
Interest rates are used by the Central Bank of a country to control money supply in the economy by means of monetary policy. Interest rates also impact exchange rate by attracting higher foreign fund flows at higher levels and vice versa thereby leading to strengthening or weakening of currency w.r.t to other currencies. Shown below is a detailed block diagram explaining the monetary policy of a Central Bank (using Interest rates) during upturns and downturns: Central Bank Monetary Policy: Upturn
Economic growth
Monetary Policy: Increase in interest rates
Reduces money supply in economy
Increase in purchasing power/ real income
Increased liquidity or money supply
Curbs Inflation
Higher demand for goods
Inflation
Central Bank Monetary Policy: Downturn
Economic down turn
Monetary policyCut interest rates
Increase money supply in economy
Unemployment
Reduced ProductionFurther unemployment
Fuel demand
Reduced Purchasing power
Reduce demand for goods
Industrial growthLower unemployment
7
Interest rates of all major economies of the world are of importance while analyzing markets. The policies of the following Central Banks are of extreme significance in international markets. ? ? ? ? US Fed European Central Bank Bank of England Bank of Japan
Inter Market Linkages
Linkage between USD and Gold Prices
Gold is internationally denominated in USD. When the USD (Dollar Index) weakens, in order to purchase the same amount of Gold, more dollars have to be paid. The Price of Gold in USD increases as a result. Between 1999 and 2008, the correlation between Gold and the USD* has been at -0.84. However the correlation is not always negative, since Gold is also used as a hedge against inflation. So if the US economy is booming, implying a strong USD, it might happen that the gold prices instead of falling, actually rise. Since in a booming economy, if inflation is high, investors would invest in gold as a hedge against inflation. With inflation, the value of money goes downa dn hence gold is considered a safe investment.
Linkage between interest rates and gold prices
Low interest rates will cause high inflationary expectations. Investors put in their money in Gold as a hedge against inflation. As a result, Gold prices increase Loose monetary policy in a country gives an indication that the economic situation is not good Investors buy gold as a safe haven asset. As a result, Gold prices increase. Low interest rates in the US (for instance) will result in reduced demand for the USD. The USD falls and Gold price in USD increase.
Linkage between interest rates and currency
Exchange rate variability – in itself and vis-a-vis interest rate variability- has in recent years risen compared to previous periods characterised by far more rigid exchange rate regimes, even if the extent of such fluctuations is still a matter of debate. Some middle income Asian countries have all declared that their currencies have floated in post-Asian-crisis period, accompanied by a switch to inflation targeting. The relationship between interest rates, and other domestic monetary policies, and currency exchange rates is complex, but at the core it is all about supply and demand.
8
Short term Impact on Exchange Rates:
Increase in Interest rates*
Flow of funds into the country
Demand for local currency Increases
Local currency appreciates
*Wrt interest rates in another country Long term Impact on Exchange Rates:
Increase in Interest rates
Borrowing becomes more expensive
Economic growth is curbed
Local currency depreciates
Illustration of a cross border impact
Short term effects: ? An interest rate hike in the US ? ? Investors will start pulling out their money from markets offering lower interest rates (say India) and start investing in the US markets.
What does this mean for India? ? ? Reduced demand for the rupee Rupee weakens against the USD
?
What does this mean for Gold prices? ? ? ? USD strengthens, hence Gold price in USD falls * Since rupee is weakening, Gold price in rupee terms should rise The impact depends upon the correlation between USD/INR and Gold prices
* - If the Gold price does not rise due to weak correlation between USD/INR and Gold price, Gold price will increase in rupee terms due to weaker rupee. Evidence shows that there is not much correlation between the Gold prices and the USD/INR. The correlation of gold is highest with the EUR/USD pair.
9
Long term effects: ? An interest rate hike in the US: ? ? ? Signal of slowdown in growth in the US economy (due to increase in borrowing rate) Investors will start pulling out their money from the US and start investing in markets where economic growth is expected (say India)
What does this mean for India? ? ? Increased demand for the rupee Rupee will strengthen against the USD
?
What does this mean for Gold prices? ? ? ? USD weakens, hence Gold price in USD terms will rise Since rupee is strengthening, Gold price in rupee terms should fall The impact depends upon the correlation between USD/INR and Gold prices
Illustration of Parity Price
Illustration of Price parity - Increase in Gold Price (USD) Gold Price in USD 1400 1401 USD/INR Conversion Factor Parity Price 45 0.32 20160 45 0.32 20174.4
Illustration of Price parity - (Depreciation of rupee) Gold Price in USD 1400 1400 USD/INR Conversion Factor Parity Price 45 0.32 20160 45.05 0.32 20182.4
The above two tables show the impact of an increase in Gold Price alone/depreciation of rupee alone on the Gold Prices in rupee. The Conversion Factor of 0.32 is to convert from tri ounce to 10 gm as the Gold prices in India are quoted in Rs./10 gm.
10
Evidence from the market
One of the strangest developments of 2010 has been the strong positive correlation between gold and the dollar as against what we would expect. The correlation coefficient between gold and the USD (year to date) is +0.82 (a strong positive relationship). The same does not hold true for the Euro, which has declined sharply this year amid sovereign debt concerns. The correlation coefficient year to date between gold and the Euro is -0.84 (a strong negative relationship). The reason for this is since the Euro experienced a massive fall owing to the sovereign debt crisis, investors pulled out their money from the European markets and invested in the USD and Gold which were considered safer. Hence, both the USD and the Gold prices increased. Gold vs Other currency pairs In November 2010, the USD fell with respect to all other major currencies, except the Euro and Gold prices hit a record high. Correlation between Gold and Euro/USD weakened significantly, while that between Gold and other pairs strengthened. However in the week after, the Gold prices fell on the USD rising against all major currencies including the Euro – Correlation between Euro/USD and Gold increased
Gold 15 Min, 3 Day 60 Min, 1 Week 60 Min, 2 Weeks Daily, 1 Month USD/CAD AUD/USD -0.84 -0.87 -0.92 -0.86 0.78 0.84 0.86 0.79 NZD/USD EUR/USD GBP/USD USD/JPY USD/CHF 0.74 0.69 0.75 0.78 0.89 0.78 0.66 0.19 0.88 0.84 0.72 0.77 -0.4 -0.85 -0.8 -0.79 -0.7 -0.89 -0.86 -0.69
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Gold and Interest Rates
As a result of the sovereign debt crisis in Europe, there was a surge in the flow of money into gold in search of a safe haven, but also into USD to escape the European issues. Investors sold European bonds driving their yields higher, and bought US bonds driving their yields lower. Both Gold and the USD rose, negating their usually negative correlation. The inverse relationship between gold and US treasury rates was seen and not an inverse relation between gold and the USD.
Conclusion
From our study, we can conclude the following: ? ? The interest rates, EUR/USD Exchange rate and Gold Prices are correlated However, there is no fixed and certain correlation between them – both in terms of value and sign
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References
1. 2. 3. 4. 5. 6. 7. 8. Apte, P,G. International Financial Management, Third Edition. http://efficientish.blogspot.com/2010/07/euro-gold-relationship.html http://www.forexblog.org/2008/09/gold-dollar-link-could-break-down.html http://www.dailymarkets.com/forex/2010/11/18/gold-forex-correlations-strengthen-asireland-fuels-risk-aversion/ http://businesstm.com/investment-traders/gold-usd-inverse-relationship/ http://www.coinsite.com/content/faq/dollarvsgold.asp http://ezinearticles.com/?Know-the-Relationship-Between-Gold,-Oil-andForex!&id=3494820 www.bulliondesk.com
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