The following analysis from Fortis Bank Nederland - The Metals Monthly February 2010 takes a look at how gold and other metals behave during the dollar bull markets:

The dollar’s rise to a seven month high against the euro in early February provoked sharply lower gold and base metals prices. Yet from its trough on 25 November 2009, the dollar’s latest rally has seen it rise by just 7% - not much by historic moves. Could this be the start of a dollar bull period? If so, much bigger shifts up in the dollar’s strength can be expected over the next few years. Previous such dollar rallies have seen a rise of between 20% and 56%. If that sort of rise happened, what might happen to metal prices?

Using a broad gauge of the US dollar’s strength, the Federal Reserve’s trade weighted major currencies index, it is clear that the US dollar has seen a slow decline in its external value over the past 30 years. However, this decline has been erratic, punctuated by (sometimes-lengthy) periods of dollar strength.

We have identified since 1980 two great dollar bull markets, two significant bear markets, and, more recently, two shorter periods of dollar bull and bear markets.

The first bull market occurred between September 1980 and February 1985, when the dollar rose on its major currencies index from 93.3 to 145.1, an increase of 56%. The second was from June 1995 to January 2002, when it rose from 80.6 to 112.6, an increase of 40%. The two periods of dollar decline followed those booms, and extended from February 1985 to December 1987, when the dollar fell an astonishing 40% in two and a half years (partly due to the September 1985 Plaza Accord, which saw concerted government forex intervention), and then much more recently from January 2002 to April 2008, over which period it fell 38%.

From then there was a short but sharp dollar recovery, which saw it rise by 21% from July 2008 to February 2009, and then another bear market, in which it slipped 15% from March 2009 to November 2009. Since then it has risen by about 7%, suggesting another bull run might be developing.

What will happen to metals’ prices if we see another major dollar rally, similar to those of the recent past? Clearly, the dollar price of metals does badly when the dollar is rising, with only zinc in the first dollar bull period, platinum and palladium in the second, and gold in the third, managing to rise in price. All of the other metals in each period saw substantial price falls.

Similarly, in the dollar bear markets most Of course correlation does not mean causation, and, as always, there are four possibilities. As well as (1) our conjecture that the dollar move is causing the metal prices’ move, the metal prices’ move could be causing the dollar moves (2); another common factor could be causing both to move (3), or it is simply a matter of coincidence (4).

We can probably rule out (2), as the metals’ markets, even gold and copper, are simply not large enough to impact on currency movements, particularly the US dollar. Of the commodities, only oil, given the US’s huge trade deficit, could have such an impact. The role of (4) is always going to have an influence to some degree, but the uniformity of our findings probably rules it out as the main explanation. That leaves (1) and (3) and – at least to some extent – we know (1) has to be the case.

This is because the price of metals is not set in the US, but worldwide, for although producers and consumers in the US and other dollar-linked countries are major players in these markets, they are not the entire market. Thus if for whatever reason the dollar was to fall by 10% in one day against every other currency in the world, then unless the price of each metal also falls 10% when measured in those other currencies, the dollar price of the metals must by definition rise. If the dollar price rises by 10%, then the price in other currencies would be unchanged.

There is a good reason to believe the price of metals in other currencies will fall a bit, because there will be a real impact from a rise in the dollar price of a commodity, and the dollar area is important for producers and consumers of most metals. Put simply, a 10% rise in the dollar price after a10percentage dollar devaluation will see demand from dollar-based consumers decline, and production from dollar-based producers increase. This will have the impact of reducing the world price (for world demand has fallen and world supply has risen) and so the price in other currencies will fall by a certain amount, meaning the dollar price will rise by somewhat less than 10%.

Of course, the fall in price in non-dollar areas will also have an impact on production and consumption there, and so the balance will presumably depend on the patterns of production and consumption between dollar and non-dollar areas. It seems reasonable to assume that the more important the dollar area is to a commodity, the smaller the change in the dollar price will be – after all, if the dollar area accounted for all production and consumption of a commodity, the exchange rate would be largely irrelevant.

Therefore, there is certainly an impact on metals’ prices from dollar moves. Yet in many of the examples above, the move in metals prices has been far in excess of what could have been ‘predicted’ by the dollar move. To put it another way – the swing in either direction, up or down, has been extreme. This could be explained in a number of ways. It might be the case that the dollar did cause the impact expected, but that the other factors were even more important. In this scenario, the commodity prices would have gone up or down, even if the dollar had not moved. This would mean that it is simply a coincidence that they tended to move in the expected direction (and on occasion, when the metal price move was smaller than the dollar move, they did not).

Another explanation is that the dollar move was a catalyst for an even larger move. For example, if the dollar is strengthening and the gold price is falling, investors in the US and other dollar areas take fright and sell their holdings, thus putting more pressure on the gold price, meaning it declines more than the dollar rose. Thus in an explanation the metals’ prices moved in the direction they did because of the dollar move, but in an exaggerated fashion. Finally there is always the possibility that a third factor was influencing both – such as in the rally of 2008-2009, when it was the financial crisis propelling both the dollar higher (on safe-haven demand) and metal prices lower (with the exception of gold, which benefited from its own safe-haven).

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