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Gold has hit a rough patch in recent weeks as several factors combined to push the metal away from the $700 mark down into the $640s. In particular, rising short term interest rates and a wave of European central bank sales have continued to put pressure on gold, which has been unable to make much recent headway and remains largely range-bound.

With momentum having stalled in the gold market, US Gold Corp. (NYSE:UXG) has been my worst performer over the past several months, and is now off some 17% from my purchase price. Certainly the stalled gold market has put pressure on the shares of this junior miner, but I am not yet ready to declare the gold bull market dead. In fact, I used the recent pullback in UXG shares to double my position yesterday at $5.05, lowering my cost basis to $5.60.

My bullish case for gold right here is fairly simple, with two main components. First, I believe that gold prices have been largely manipulated in recent months by the central banks, which have effectively capped the price at $700. This was enough to turn the technicals for gold bearish, and so the technical traders have fled the market. However, having expended a lot of gold reserves to keep gold prices in check, European central banks are now left with startling little ammunition with which to fight off another attack on the $700 mark. Meanwhile, central banks of developing countries (the BRICs and the Middle East) will begin buying gold to diversify away from the dollar. Thus, I believe the trend toward central banks being net sellers will reverse itself over the second half of this year, putting upward pressure on gold prices.

Second, the recent extension of the subprime crisis to several major hedge funds indicates that default rates are in fact rising and not stabilizing, and housing continues to show signs of further downside. The spreads on subprime loans look set to widen once again, which is going to put even more pressure on housing and on the economy in general.

The implications of this crisis for Fed policy appear to be very clear, and the Fed can very quickly stabilize the housing market by ratcheting down interest rates in the second half. I believe they will have to do this to prevent subprime problems from spreading, but this will put very serious pressure on the dollar as interest rate differentials narrow (and perhaps even flip) between the EU and U.S. government bonds.

My second point directly contradicts what the market has been indicating with the recent rise in bond yields, but I believe that the bond market is currently mistaken about the future direction of interest rates. Additionally, the sharpness of the recent move in interest rates to the upside indicates that the demand for U.S. government bonds appears to be waning below 5%, which means that any Fed cut would likely lead to a exodus from the dollar and an equally sharp downward movement of the currency.

Overall, my sense is that despite the fact that the U.S. credit system and housing market appear to be weaker now than they were in February, gold prices are significantly lower than they have been at any point this year. Given that central bank policy looks poised to reverse and that the risks to the dollar are increasing, gold offers the attractive combination of protecting against a financial market catastrophe while at the same time giving substantial upside potential.

UXG continues to be a promising junior explorer under the management Rob McEwen, who grew Goldcorp into one of the world’s premier mining companies. While drilling remains in its early stages, McEwen’s recent purchase of surrounding properties to US Gold’s Nevada holdings indicates that he believes the area shows real promise, as demonstrated by the recent release of a few initial drilling results on these properties.

The UXG story is still in its very early stages, but has the management, the land holdings, and the strong financial position for exploration success. I continue to tout the long term bullish case for gold, and UXG looks to have some of the best prospects for success if gold prices continue to show strength.

Disclosure: Author is long UXG

UXG 1-yr chart:

uxg

Source: U.S. Gold Corp. Should Gain On Shaky Dollar