Wednesday, February 17, 2010

The Dollar, Euro and Gold

Dec 19, 2009


"Whenever a taboo is broken, something good happens, something vitalizing. Taboos after all are only hangovers, the product of diseased minds, you might say, of fearsome people who hadn't the courage to live and who under the guise of morality and religion have imposed these things upon us." ~ Henry Miller, 1891-1980, American Author

What we warned of seems to have come to pass. Since publishing the two articles titled "The Gold Bull; time for a breather or? And "Bonds and Gold", gold has shed almost 127 dollars. This is but a small drop in the bucket in comparison to the gains Gold has made in the past few months. We are not against gold, in fact, we are long term bulls, but we cannot simply ignore the short term developments and blindly hope that Gold will race higher. No market, not matter how strong it is can rally upward indefinitely without pulling back and Gold is no exception to this rule. Thus what we have said so far in our previous articles and what we have to say now might spoil the current party, but that's life; all parties must end in order to make way for new ones down the line.

In the short to intermediate time frames, we would like to point to several new factors, which suggest that Gold could potentially pull back more, the dollar could mount a stronger than expected rally which should lead to a rather strong pull back in the Euro and other competing currencies. Certainly, the dollars rapid move from 74.57 to a high of 78.50 has caught a lot of traders with their trousers down.

The dollar has broken out of its falling wedge formation; this is a bullish development and the result is usually much higher prices as is being witnessed in real time right now.

The dollar broke out very strongly from this falling wedge formation and it also managed to trade past its main down trend line. This suggests that this move up has some legs behind it and that the dollar now could potentially trade well past 80. We are waiting for one more confirmation; if this confirmation comes through it will indicate that the dollar could trade well past 80 and possibly as high as 86.

One other factor that could drive the dollar even higher is the dollar carryover trade. We have seen the effects of previous carryover trades and the rapid effects they have on the currency in question as the unwinding process gathers steam. Too many individuals borrowed dollars to go long other currencies and if the dollar continues to rise, this could trigger a domino effect. As one group seeks to close out their positions, it could trigger the stops of another group and set of a chain reaction.

Thus the dollar could mount a very strong rally that could even catch the most optimists of dollar bulls by surprise; the rapid move up from a low of 74.50 to a high of 78.50 in just a few days has certainly taken a lot of individuals by surprise. Always remember no matter how bullish or bearish an investment is, nothing trades down or up forever, in between, there are always intervening counter rallies; some of these rallies are strong and some are weak.

The Euro broke down very strongly from its rising wedge formation. It is also trading below its main up trend line and this clearly validates that the Euro has put in a top and is now in a corrective phase. It could potentially trade all the way down to the 130-133 ranges.

The rising wedge formation in Gold has resulted in a down side break out and gold could potentially trade below 1000 again. This rapid move down should lead to some sort of relief rally between now and January, but ultimately Gold should at least test the 990-1000 ranges. This is where the real battle will begin. If Gold fails to hold above 990 and trades below it on a weekly basis then next level of support falls in the 940-950 ranges and a break below that would take Gold down the very strong support zone of 900.


Gold has moved from the contrarian investment category more to the main stream investment category, at least in the short to intermediate time frames. There is too much excitement both in and out of the Gold camp in terms of Gold. Almost everyone is negative on the dollar. Extreme sentiment always produces a strong move in the least desired direction. This is exactly what took place last time the dollar mounted a strong rally.

The strong rally in the dollar is indicating that at the very least gold will test the 990-1000 ranges before stabilising. If it fails to hold here, it could be an early indication of an even stronger pull back.

Certainly, the rapid move up by the dollar followed by rapid a breakdown in Gold and the Euro in the last few days suggests that speculation was rampant in all 3 markets with traders aggressively purchasing Gold and Euros while shorting the dollar. Speculators, however, are very happy to play the market both ways and can easily short the same market they were so enthusiastically supporting.

The unwinding of positions due to the dollar carryover trade could lead to a much stronger rally than most expect. Remember what happened to the New Zealand dollar a few years ago. Everyone was borrowing Yen to go long the New Zealand dollar. The Kiwi collapsed and the Yen soared. If something like that should come to pass now, it would result in a very strong pull back in the commodities sector.

Finally, one of the most glaring and most significant of developments and we spoke of this to our subscribers early in the game was the fact that the Dollar did not confirm the series of new highs Gold put in recently. What do we mean by this?

Gold went to put in a series of all time new highs, so by the same token the dollar should have traded below its March 2008 lows or at the very least tested them. On the 17th of March 2008, the dollar put in a multi decade low when it traded all the way down to 70.80 and ended the day at 71.30. On that day Gold traded as high as 1014; from 1014 to its recent highs, it gained an additional 21% and so at the very least the dollar should have traded 3-5% lower than its March 17, 2008 low. Instead we find that when Gold traded to 1227, the dollar was trading roughly 4% higher than it was trading on the 17th of March 2008. On a daily basis, the dollar did not even trade below 74.50 and on a monthly basis it was able to hold above 75. This is a very strong positive divergence signal in favour of the dollar.

When we combine this very strong positive divergence with all the factors mentioned above especially the dollar carryover trade, one could argue that the dollar could potentially mount a very strong rally. The rapid move in the past few days has certainly caught many off guard and could be an early signal of what lies in store the dollar, at least for the next 3-6 months.

The dollar has already traded above several key points; the first being 76.42, the second 77.50, and today it tested 78.50 before pulling back. We are waiting for one more development, which should provide an early warning signal of whether or not the dollar is going to significantly past 80.

This would mean competing currencies could experience very strong corrections and if the surprise (surprise for those who were not expecting it) rapid breakdown in the Euro is anything to go by; traders should brace themselves for a potential shock in 2010.

In terms of Gold, traders need to watch how gold holds up when it tests the 990-1000 ranges for this will be a key factor in determining in which direction it trades in the next 3-6 months. If it holds up well in the face of a strong dollar then we can assume a bottom is close at hand, if, on the other hand, it falters, then it could potentially trade a lot lower.

Finally, let's not forget that the Gold ETF is now the 6th largest holder of Physical Gold, so if the sell off gathers steam, this ETF could exacerbate the situation and accelerate the decline if it is forced to sell Gold to deal with redemptions.

The key factor to remember though is that the Dollar's strength should not be a long term development and that the pullback in Gold should be a short term development. Traders should thus view strong pull backs as buying opportunities and the stronger the pull back the greater the buying opportunity. However, as we had warned in early December when Gold was trading close to its highs, taking some money of the table would have been the prudent thing to do. No matter how good an investment is, it is always wise to take some money of the table when one's investments have appreciated significantly.

"The crisis of yesterday is the joke of tomorrow." ~ H.G. Wells, 1866-1946, British-born American Author

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