Three Factors Affecting Gold Here

I commented about a month ago that I thought gold could move back to the $625 area before beginning a decent fall towards the $450-$500 range. My reasons hinged mainly on the dollar and rates rising giving gold one less support. Also mentioned was the Paul Volker-like stance the Fed has undertaken on inflation which also provides a reason for gold to correct. Now that the market has moved back towards the $625 area (it actually bested it by 50 pts on a scream last week but has since fallen back), where do we go next? I think the direction hinges on 3 variables. Whether the dollar continues to rally, Fed policy and the deficits.

In regards to the former, I am a cautious bull in regards to the Dollar. Earlier today, I wrote that the overall picture for the dollar was cautiously bullish. It was not an outright bullish stance because the models in most cases pointed to lower dollar index levels. The failure up at the 92.50 level was a major one few months back. But a bounce from the current levels, back above the moving average trends, reinforcing the power model, would be a bullish development and perhaps sends the dollar thru that 92.50 over the next few months.

With regard to the Fed, policy may look like it is moving towards a pause but like I wrote this morning, 6 month funds is near 5.50% and the Eurodollar curve could be factoring in 2 more hikes. The fact that the Fed governors came out so strong in the spring via jawboning indicates to me that these will not allow inflation to rise dramatically (though what really is inflation?) and as a result, the market is pricing in such an action via the Fed funds and the Eurodollar markets. Gold’s big reason for rally the past few years was reserve diversification and inflation prospects (one can say terror but how do you manage such?). With the diversification trend slowing and inflation prospects falling (thanks to the Fed’s jawboning and rate policy which is now constrictive by the way), Gold’s bullish case loses steam.

The last variable is the much talked about twin deficits. Do you think the US Government is going out of business? If you do, do not read on. Personally, I actually believe that the republicans will actually clean up the mess in the next few years for political reasons. Huge deficits do not garner votes. Thus, I think if the white house gets its wits together, and the Iraq situation improves, the fiscal deficit should shrink. The trade deficit on the other hand is something worrisome when the economy is not growing. Since the economy is growing, the gold market will not gain support as a result putting further pressure on prices.

From a technical model perspective, the long term trend model continue to argue for higher prices so gold bulls still have a reason to argue for their super forward forecasts. There are cracks in the armor though as the intermediate term model is now neutral and threatening to break down. Further, my short term model, which I use to trade the metal from day to day, is positioned on the short side. My last short gained 20 pts so I am looking for the 600 level gains.

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