The correlation between the U.S. dollar and gold is well known. Gold is priced in dollars so when there's trouble in the world, investors will take their money out of the greenback and park it in shinier assets. When things are going well, money comes out of gold and is re-directed towards riskier investments.
Of course, nothing is ever that simple because there are other factors that impact the movements of commodities. Supply and demand are important, but the U.S. dollar and gold can move in the same direction if both assets are perceived as safe havens. With that in mind, currencies will generally lead the moves in commodities. So if the dollar is surging it is very difficult for gold to rise unless there's a major crisis abroad that causes investors to simultaneously buy gold and U.S. dollars. More often though, when the dollar falls, gold rises but when the dollar rises, gold could be up or down depending on the catalyst. In the past year, gold lost more than 7 percent of its value and it's no coincidence that during this same period the trade-weighted Dollar dropped almost 5 percent.
China: Base Metals Consumer
But the U.S. dollar is not the only currency that affects how gold, base metals and commodities move. In fact, the following chart shows that over the past year, there's been a stronger correlation between the Chinese yuan (white line) and gold (orange line) than the U.S. dollar (green line) and gold. China is the demand story.
More than half of the world's steel, copper, nickel and cement are bought by China and they buy about 47 percent of world aluminum. So if you want to consider where gold and base metals are headed, you have to look at the outlook for the U.S. dollar, China's economy and its currency.
The dollar has had a great run in 2018 so even if it falls, U.S. interest rates are not expected to peak until the middle of 2019. Rising interest rates are positive for the greenback, especially in an environment where the Federal Reserve is one of the only central banks tightening monetary policy.
The Most Important Currency
Yet the Chinese yuan is still the most important currency to watch because China could support their economy by weakening their currency. Before the most recent tariffs, their economy was slowing and with the trade war raging, we should not only see slower growth in China but also active efforts by the Chinese government to support their export sector by weakening their currency.
If the yuan continues to decline, it reduces the country's purchasing power and their ability to buy base metals. A weaker yuan is double the trouble for commodities because it's a reflection of how their economy is doing and impacts their ability to buy. The yuan is a managed currency so it only falls when the government wants, and so far they have been slowly guiding it lower. However if the Chinese government opts for a one-off devaluation, which they are considering more seriously, the aftershocks for commodities can be significant. Oil, steel and copper were hit harder than gold but none of the commodities escaped unscathed when China suddenly devalued its currency in August 2015.
If you are trading commodities, you need to be following the moves in currencies. In the base metals and gold markets, that means keeping a close eye on the U.S. dollar and Chinese yuan.
Written by Kathy Lien. Read more from the author here.