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Furthermore, structural changes experienced by all developingeconomies coupled with a robust financial, economic and socialexpansion will likely provide a consistent source of gold demandin years to come. The combination of population and disposableincome growth will likely lead to direct gold purchases in theform of jewellery and investment, and indirectly via electronicgoods, many of which contain gold components (Chart 9).Further, an increase in commodity prices stemming fromemerging-market demand can lead to higher local inflation rates.In turn, higher inflation may then lead to gold purchases as aresult of inflation-hedging activities. Providing additional supportare emerging-market central banks that are likely expand theirforeign reserves and, as they look to diversify, continue toacquire gold as they have done over the past five years.Gold’s negative correlation to the US dollarWhile the strength of the relationship between gold and theUS dollar – measured against a trade-weighted basket ofother currencies – has fluctuated over time, it has remainedpersistently negative in the longer term. At times therelationship is complicated by periods where the US dollar andgold move in the same direction, often driven by a flight ofcapital to quality assets. However, barring the effect of gold’suses beyond a store of value, gold functions like any othercurrency.The relationship between the US dollar and gold has been welldocumented. In particular, a World Gold Council commissionedstudy found a consistently negative correlation between goldand the US dollar over various time periods. 15 Put simply,depreciation in the US dollar against a basket of currenciestypically translates into higher gold prices. However, thisrelationship can be extended to the other major developedmarketcurrency baskets and could become increasinglyapparent if the US dollar’s main trading currency status wereto diminish. When the value of a major currency falls againstother currencies, gold prices in that particular major currency areconsequently boosted by its depreciation. 16Chart 10 highlights the persistence of the negative correlationbetween returns on various trade-weighted currency indicesand returns on gold in that currency. Correlations over the wholeperiod are negative. For the 12-month rolling window charted,positive correlations occur less than 10% of the time.Gold’s negative correlation to developed-market currencies,not just the US dollar, provides part of the investment rationalefor those concerned with weaknesses inherent in the globalmonetary system.Gold’s conditional correlation protects againstextreme movesAs has been shown in previous research, gold’s capitalpreservation qualities come to the fore during extreme events. 17Its low correlation to traditional risky assets such as equities andcommodities forms part of its ‘foundation asset’ credentials.However, the negative correlation gold has with risky assetsduring extreme market moves 18 further enhances its status as acapital preserver.Currency drawdown risk, or losses generated by peak-to-troughdeclines in the underlying currency, is thus a key issue facingemerging-market investments. Historically, many emergingmarketeconomies have battled with weak currencies as a resultof high inflation stemming from the imports of commoditiesand durable goods priced in western currencies. As has beenseen during a number of episodes over the past two decades,emerging markets are prone to crisis. In fact, during the past25 years, emerging-market currencies fell by more than twostandard deviations (or 3.6%) slightly over 3% of the time, asmeasured by monthly returns. In 1.3% of the instances, thedrop was greater than three standard deviations (or 5.4%) whilethe worst monthly return saw emerging-market currencies shed8.2%. In other words, while such events do not seem frequent,they occur more often than would be expected from a ‘normal’distribution, and tend to be fairly severe. These results areparticularly disconcerting given that currency is only part of therisk associated with emerging-market investing.15 Capie, F., Mills, T., Wood, G., Gold as a hedge against the US dollar, September 2004. https://www.gold.org/download/get/rs_archive/rs_30.pdf16 O’Connor and Lucey (2012) Gold’s negative relationship with the US dollar, The Alchemist, Issue 66.17 http://www.gold.org/download/rs_archive/WOR5963_Gold_Hedging_against_tail_risk.pdf18 Measured as a low probability (2+ standard deviation) move in the market.Gold Investor | Risk management and capital preservation