A Peak Point

Gold and the Dollar: Going Higher Together?

Once in a blue moon, I change my mind after another look at the facts and after taking another look at the charts of gold and the dollar index more closely and in conjunction, it seems the moon's just turned golden.

Last week, I wrote about how I believe the dollar is going to move higher and possibly significantly higher. I still believe this to be the case. However, in my review of the aforementioned charts, I no longer believe that the dollar going higher means gold is going lower. In fact, it may signal that gold is about to move higher, significantly higher.

2010: Year of the Great Sync-Up - So Far

If we examine the one-year or year-to-date charts of gold and the dollar index in conjunction, something interesting emerges. Rather than trading inverse to each other as is historically true, gold and the dollar appear to be trading together.

In "eyeballing" the charts below, it is very clear that early this year both gold and the dollar started to trend in a correlated but not causal fashion. And while the 63% YTD correlation between gold and the dollar is rather unimpressive on its own, it starts to shine a bit when compared to the 25% correlation for the last thirty years.*

This near-term correlation is reinforced by the fact that gold and the dollar index are up 10.6% and 5.6%, respectively, year-to-date.

When compared to the puny thirty-year correlation and gold's 26.0% gain to the dollar index's 4.3% decline in late 2009 as shown in the charts on the previous page, it seems something unusual is happening this year. Gold and the dollar are doing the same dance.

Flight to Safety

The name of that dance is "Running from Risk".

The year-to-date gains in gold and the dollar reflect the safe haven status of each. The former due to its being an accepted medium of exchange as early as 1400 B.C. and the latter as the world's current reserve currency.

However, there's been increasing chatter about the fact that the dollar may not retain that status since it is a fiat currency backing a potentially unsustainable deficit in a time of slowing economic growth. In fact, in certain circles, there's some discussion about the world losing its fiat currency system entirely for some period of time if the debt storm of the last 30 years topples the very system that created it.

Should this be the case, should the world be without a paper currency system, it is widely accepted that the currency left standing will be gold.

While this may be true on a long-term basis, I contend that gold and the dollar are co-existing currencies in the near- to mid-term as opposed to competing currencies due to the safe haven status of each.

In a time of tremendous uncertainty, there is more than enough distress to support a rise in gold simultaneous to a rise in the dollar among other safe haven assets.

Specifically, the sources of stress include but are not limited to the following.

• The possibility of another bout of recession in the United States.
• The likelihood that the employment picture will remain weak or worsen in the United States.
• The likelihood that the U.S. housing market will correct back to its historic mean, suggesting another 25%+ decline.
• The possibility that a housing market correction will trigger another series of MBS and mortgage-related problems for banks.
• The possibility that CMBS and commercial real estate mortgages may trigger problems for banks.
• The likelihood that if points 4 and 5 should come to pass, there will be another wave of crisis across the financial system.
• The guarantee that if there is another wave of crisis across the financial system, lending, or bank credit, will dry up completely.
• The possibility of slowing global growth.
• The possibility of the global economy falling prey to deflation and depression.
• The possibility that the debt of some the peripheral euro-zone countries will default or need to be restructured.
• The possibility that German banks own too much of that sovereign debt to survive such a default or restructuring.
• The likelihood that if German banks begin to suffer, the euro-zone banking system will enter a period of crisis and dislocation.
• The likelihood that a euro-zone banking crisis would cause the U.S. to act as Lender of Last Resort to the euro-zone while also acting as the backstop to the U.S. financial system.
• The likelihood that the U.S. will be toppled by its attempt to save the global financial system due to its finite nature and its obligation to service what will prove to be an unsustainable deficit.
• The guarantee that the dollar and U.S. Treasurys will weaken significantly if not collapse in the face of the U.S.'s failed attempt to save the global financial system.

I admit that the events laid out above are of the worst case and extreme nature, but even if the first three play out as seems increasingly likely, investors are going to seek safety period. They may attempt to flirt with risk as has been demonstrated by the S&P 500's extreme volatility of the last nine months, but in the end, when the distress becomes bad enough to provoke fear and outright panic, safety will win.

Mid- to long-term, however, I believe we will see a reversion back to the historic and inverted relationship between gold and the dollar.

And as the charts above show, it seems more likely that gold will win.

The Fed Is Supporting Gold and the Dollar - For Now

Perhaps crudely, I interpret the Fed's recent statement to mean: we're up a crick without a paddle.

The Fed admitted there's a problem - a sluggish economy - and that there's little the Fed can do about it due to the Liquidity Trap that I've been writing about (August 3 and 10 and March 1).

While some may say that the Fed's announcement to direct the retired proceeds from its MBS portfolio toward fresh Treasury investments is an attempt to do something through quantitative easing, I respectfully disagree.

For a Fed that has been willing to reach in to its bag of monetary tricks and throw absolutely anything and everything at the problem, the Fed did nothing. This suggests the Fed may believe its bag is empty.

In lieu of the recent FOMC statement, I believe the Fed is supporting both gold and the dollar. It is supporting gold in admitting that we are in a period of "unusual uncertainty" and thus promoting the previously discussed flight to safety and it is supporting the dollar in not cranking up the printing press for now and in promoting the same flight to safety.

The Federal Reserve's stance, then, is currently bullish for both gold and the dollar.

Will the Double Top Fail?

I have been writing about gold's confirmed minor double top along with its potential major double top since June 11.

As a chartist first and foremost, I have thought that gold would fall prey to at least the minor double top and its target of $1,060 per ounce and very likely the major top and its target of about $900 per ounce. In addition, this latter level is where it seems gold could land in "eyeballing" the chart.

However, I am coming to believe that my interpretation of these double tops was wrong and that both may fail.

First, the charts of gold and the dollar index YTD provide strong reason to believe that both will continue to trade together. While the relationship is not causal, I do believe the dollar is set to rise as detailed last week, suggesting that gold may too rise. In other words, the combination of those charts may trump the gold chart and those double tops alone.

Second, a cursory scrubbing of the fundamentals supports this parallel ascent due to the fact that both gold and the dollar will benefit from and be supported by a flight to safety.

Third, the decline in the minor double top's first peak to its trough is slightly less than the 10% many technicians like to see in gauging the likely success of a double top.

Fourth, both the minor double top and the major double top are of a variety (Adam and Eve) that are the least successful of the various types of double tops.

And so while gold is caught in a confirmed minor double top that carries a target that would confirm the major double top, I am coming much closer to believing that this double top will go unfulfilled. My conviction in this possibility would be complete if the target of the major double top did not coincide with the level where it seems gold may land in simply "eyeballing" the chart.

Summary

In short, there is reasonable evidence that gold and the dollar have been trading in tandem for much of 2010.

I also believe that the dollar is likely to go higher due its ultimate reserve currency safe haven status in a time of distress and uncertainty. I am coming to believe that gold is likely to go higher for its safe haven status as well and I very definitely do not think such a move is prohibited by the dollar's ascent as I did before.

As such, I think gold and the dollar are co-existing currencies for the near- to mid-term and this seeming Odd Couple is likely to head higher before splitting up in the end.

While it's impossible to know how high either might go, I think the dollar index could move up by more than 40% from current levels before falling back below its historic lows as detailed in The Dollar's Going Higher (August 13).

As for gold, the charts provide no guidance in this regard because the long-term chart of gold is straight up and without a ceiling. In fact, there are some veteran traders who have been calling for a significant move up in gold and those traders may be vindicated for the chart of gold more than allows for such a possibility.

In the end, however, any gains in gold and the dollar index will be driven by a continued and perhaps frenzied flight to safety, and thus the magnitude of those gains may depend on the severity of what investors are fleeing.

Notes: *The correlations referenced on the first page are of the most basic sort - simple regression analysis with no correction for auto-correlation, and thus the actual numbers are of less importance than the distance separating them.

Abigail F. Doolittle
Peak Theories Research LLC
www.peaktheories.com
[email protected]
518-391-9313

Abigail F. Doolittle

Abigail F. Doolittle is the founder of Peak Theories Research LLC, which is an on-line research firm dedicated to providing investors with a macro long-term view on the financial markets and the economy. The firm's research begins with the analysis of charts and then ties in various economic fundamentals to better understand the trends pointed to in the charts. She has more than 12 years of experience in the financial services industry.