From February 5th to March 17th the US dollar fell approximately 6.5%. During the same time the gold price in US dollars increased by almost 17%. Clearly speculators bought gold on the assumption that the dollar would continue to fall.

Then came the rhetoric: Jean-Claude Trichet, the president of the European Central Bank, expressed concern about exchange-rate volatility, which he called “excessive”. Then both Morgan Stanley and Goldman Sachs came out and said the dollar’s decline could trigger the first coordinated currency market intervention in 13 years. As a result the dollar rallied 2% and gold fell 12%. It was short-lived: the dollar reversed course and declined again within days, giving up the entire 2% while the gold price increased by just over 3%. Today the dollar is up again and gold is down. This volatility is here to stay, for at least a while.

The US dollar exchange rate is for all practical purposes the single largest determinant of short term gold price volatility, while monetary inflation is by far the largest determinant of long term gold price changes. Speculation, which comes and goes, can from time to time override either of these influences on the gold price. It usually becomes evident when such speculation takes over and if one can avoid getting caught up in the frenzy then gold remains an excellent store of wealth over the long term.

For the time being it looks like the volatility in the gold market is going to stay with us. There is overwhelming bearishness towards the US dollar and speculators have been flocking to gold to such an extent that the swings in the gold price are an amplified echo of the dollar’s trading activity. Even though fresh money is coming into the gold market I don’t see it as being over-crowded yet. There is good reason to be bearish on the dollar: it hasn’t reached bottom.

Growing risk aversion and the realization that risk has been under-priced has caused investors to take a second look at the currency valuations of debtor nations, resulting in a dramatic decline in the exchange rates of the South African rand, the Turkish lira and the Icelandic krona, for example. Since the beginning of the year the rand is down 21% against the euro, the lira is down 14% and the krona 22%. We can now sadly add the United States dollar to the list of debtors’ currencies: it is down 7% against the euro since the beginning of the year.

The collision course between US consumers’ living standards and reality remains on track: US durable goods orders fell 1.7% in February after falling 4.7% in January. The ISM index of manufacturing activity for February came in at 48.3, indicating a contraction in manufacturing activity. These are coincident indicators and not leading indicators, meaning they merely confirm that the US economy is already in a recession, which will be recognized as a depression, in my opinion.

Meanwhile French and German business confidence is increasing. I will be very surprised if the euro countries escape an economic contraction while the US adjusts to reality although I would not be surprised if those nations fare better than the United States. That stems primarily from the fact that euro nations, until December at least, had trade surpluses while the US is the world’s largest debtor nation. That leaves the world dependent on Japan, China, Canada and a few OPEC nations for capital.

Regardless, Europe and Britain are following the United States’ lead and creating vast new quantities of money while doing their best to hide the inflation by focusing on inflation expectations instead of reality. It will bite a chunk out of their living standards nonetheless. Monetary inflation causes price increases and that is the reason I am still focused primarily on gold for my investment capital, even though I think the gold price could, and should, decline in the short term.

As I’ve been saying for two weeks, I would like to see the gold price fall even further, to perhaps the low $800s, and that might help to get a few very short-term players on the sidelines again, which would “cleanse” the market and give me much more confidence in future gold price rallies.