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I thought I would share a little-discussed flow of capital between gold, the U.S. dollar, and emerging-market equities. These are represented in the following graphs as GD-PM, DXY-Z, and EEM, respectively.

This link makes sense when the time is taken to understand the motivation of global capital in seeking out the best store of value relative to the best profit opportunity. Let’s start with the U.S. dollar. When the dollar goes up in value (zone A in the graph), gold tends to decline in value—but not always. When the dollar declines in value (zones B and C in the graph), gold often goes up in value.

Here is where the story gets a bit complicated but also more interesting. Emerging-market equities tend to trend with the price of gold as priced in dollars. There is a good reason for this. When gold is rising, often when the dollar is declining, the values of many raw commodities are also rising. Since many emerging-market economies are driven by the prices of the raw commodities they produce, it is easy to understand how rising gold, rising emerging-market stocks, and a declining dollar all make sense. This is nicely illustrated in zones B and C in the following graph.

Source: FastTrack

Let’s take this newfound understanding of global capital flows that drive markets and look at what has happened in just the last several months. Keep in mind this is a very short-term view in the eyes of global capital flows. The U.S. dollar has risen, gold has moved lower, and emerging-market stocks have declined. Granted, some of the decline is due to the general decline of global equities, but this short-term weakness in emerging-market equities is exacerbated by the strength of the U.S. dollar.

Source: FastTrack

To extend this discussion into the “geek” realm of understanding, we could go further to explain that the strength of the U.S. dollar is partly because our economy is doing so well and partly because real interest rates in the U.S. are very attractive to global investors. The attractiveness of domestic interest rates and the resulting strength in the dollar is one reason the Fed may be hesitant to continue to raise rates later in the year. That is a discussion for another day.

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