The market for gold bullion has increased dramatically in recent years. Gold is valued not only as an industrial metal, but as a store of value relative to paper currencies. The risk of inflation is quite real. Investors who fear the effects of inflation historically have bought precious metals like gold and silver to offset the effects of inflation.

Gold is mostly traded over-the-counter by private investors or through the futures market. The price of gold is influenced by supply and demand, like any other market. Since gold is seen as a hedge against inflation, however, a major additional influence on the price is the foreign exchange markets. The gold market is worldwide; investors from multiple countries are fleeing to gold as a safe haven due to economic and financial turmoil.

The foreign exchange (forex) market is the largest market in the world. Hundreds of billions of dollars, sometimes even trillions, flow in and out of this market daily. Participants include central banks, international businesses, international banks, tourists, travelers and traders. The foreign exchange market facilitates global commerce and travel.

As conditions within the forex market change, investors in different countries alternately buy and sell gold. A recent example of an extreme shift happened in the Eastern European country of Belarus in May 2011. Belarus’s central bank devalued the currency by an astonishing 56 percent (priced in U.S. dollars). The immediate effect was hyperinflation as prices rose by over 50 percent in response to the newly devalued currency. (1) Investors who were holding gold and silver experienced a profit of over 50 percent, as the price of gold and silver in the Belarusian ruble rose in response. The economy of that unfortunate country is currently in a state of collapse.

Obviously, the type of event that occurred in Belarus is relatively rare. Nevertheless, to use another example, the ongoing devaluation of the U.S. dollar by the Federal Reserve has resulted in investors buying gold and selling dollars. The foreign exchange market has a large influence on the gold market and the entire precious metals market including silver and platinum.

In the forex market, the U.S. dollar has a unique effect on gold. The U.S. dollar is the world’s reserve currency. A reserve currency is held by foreign central banks and global financial institutions as well as foreign governments to settle debts and international trade obligations. The U.S. dollar has played this role for decades, since the end of World War II. Importantly, commodities like oil and gold are priced in U.S. dollars.

What happens with the value of the dollar in foreign exchange markets thus directly impacts the price of gold. Gold prices tend to closely track the exchange rate of the U.S. dollar. Foreign investors owning gold measure their profits or losses by converting gold from dollars to their own currencies.

The impact on gold from the foreign exchange market has two main components: investor interest and Federal Reserve policy. A weak dollar drives down the exchange rate and sends the prices of oil and gold up. Likewise, a strong dollar has the opposite effect. Investors must take this into account when buying gold as a hedge against inflation.

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