The gold price ended Monday up $2.20 as a report by the US Commodities Futures Trading Commission (CFTC) revealed that a short position in the futures market had been created possibly with the intent to buy physical gold during Tuesday’s gold auction by the Bank of England. The idea is that a speculator can sell futures contracts in gold and cover them by buying physical gold at the auction and delivering it against the futures contract obligation. The problem arose when it appeared that more gold was short than what the Bank of England was going to auction, and so a short squeeze rally ensued.

If this is really the case, we should see the gold price remain strong for a few days and then drift back down again, all else being equal. You may ask yourself why on earth I am writing about this, since a short rally is really a non-event, unless of course you’re short.

The reason is that the gold price failed to rally since the last week of November, while the dollar has declined by about 11% against the euro. This has surprised some, because in principal at least, the gold price should respond to weakness in the US dollar. The theory is that because gold is priced in US dollars, any weakness in the US dollar should cause an increase in the US dollar gold price as long as the international gold price remains relatively constant.

So why didn’t the gold price increase in relation to the dollar’s decline? Well, there are two possible reasons. First of all, it is possible that while the declining dollar put upward pressure on the gold price, there may have been physical selling of gold, which of course would tend to lower the gold price.

According the World Gold Council, “statistics released by the London Bullion Market Association show that a sharp upturn in gold market activity occurred during the last month of 2000. Net clearing figures for December jumped to the highest level for six months, increasing from a daily average 18.6 million ounces (578.5 tonnes) in November to 23.6 million ounces (734.0 tonnes)”.  This indicates that there may well have been strong selling of physical gold. Also, the short increase in gold futures contracts as reported by the CFTC might also imply physical selling of gold, which could explain why the gold price did not increase while the dollar weakened.

But there is another explanation. It is true that the dollar weakened against the euro, but that may not necessarily mean that the dollar weakened against other currencies. It could also be that the euro strengthened against most currencies and that would imply that the US gold price should not have been expected to increase.
While the euro gained 12% against the dollar, it also gained 20% against the yen. During this time, the dollar gained 7% against the yen. The point is that the gold price is inversely correlated to the dollar exchange rate but you have to look at the dollar against a basket of foreign currencies. Just picking the currency of the week is going to result in confusion and misleading conclusions.

The dollar has not yet declined in any meaningful way against the majority of foreign currencies, which is why the gold price has not had a significant rally. Since its inception, the euro has been a disaster and the recent strength in the euro against the dollar of late is a reflection of the euro, not the dollar. We have to keep our eyes on the dollar in order to make sense of the dollar denominated gold price.

My money is still on an eventual decline in the dollar of historical proportions that should result in a substantial increase in the dollar denominated gold price. I see no reason to change that or any evidence that a decline in the dollar can be avoided.