Monitoring the dollar as we move through Q4 is going to be critical. The strength of the currency stands to increase against a basket of global currencies should the Federal Reserve raise rates. This will create a risk-off environment where investors decrease their net long positions in precious metals and into other, riskier asset classes to earn a higher return as the monetary policy backdrop will be favorable. Meanwhile, observing volatility relative to the dollar will be key to determining the level of conviction the Federal Reserve has in hiking rates at the December FOMC meeting.
Source: Huffington Post
The dollar has significantly strengthened as the Federal Reserve has gained increasing conviction that it will raise rates at the December FOMC meeting. In reality, a 25bp increase to the Federal Funds rate is really nothing. While it may stand to benefit the net interest income levels of TBTF banks, it's nothing more than a confirmation to investors that the American economy could see a pick up in inflation over the medium-term. If the size of the increase were to be a few percentage points, then this would be a whole different game.
Another way to view the American economy's strength is actually through a strengthening of the Mexican peso against the dollar. I know that seems counterintuitive but does have an indirect effect. With the Presidential election being one of the key sources of heightened volatility over the last two months, any sort of positive support that occurred for Trump caused a depreciation in MXN/USD. Now that Clinton has a strong lead in most polls, MXN/USD has begun to appreciate. In the last month, the currency is up about 4%, which is a rather large shift in FX.
How does this depreciation of one pair signal strength for the U.S. dollar? It takes away uncertainty from the markets that the Presidential election could be a toss-up. That kind of uncertainty would likely give support to gold, but as it eases away, we're seeing more and more net longs leave gold for equities. Additionally, the decreasing uncertainty with the Presidential election gives the Federal Reserve support that no grievous changes will be made to the financial system in the upcoming year, such that a rate hike at the December meeting is justified. To gauge the uncertainty over the final two weeks of the campaign, I'd watch the volatility on the MXN/USD relative to the probability that the Federal Reserve raises rates, as reported by the CME Group.
Source: CME Group
In theory if the Federal Reserve raises short-term interest rates, then we should see the yield curve flatten, as demand for shorter-dated maturities will increase and with the risk free-rate higher, we should see a risk-off environment such that investors allocate a higher amount of capital out of gold and into equities or other asset classes. I think the amount of the interest rate increase at the December Federal Reserve meeting is not anything to run home about, as it is just 25bp and would be only one of the four "projected" rate hikes this year.
With the dollar's strength intact, once again, we have to think about how gold might move. A retracement to a lower support level, in my view, is likely. It has already traced down to a key 61.8% Fibonacci level, but could easily dip, in the short-term, to the next retracement right around the $1,210/oz level. I believe this happens if we receive more certainty on the Presidential election outcome, providing more conviction for the Federal Reserve, and if the companies reporting earnings show YOY improvements. As a reference, roughly 35% of the S&P 500 reports earnings this week.
Piling into inverse gold ETFs, like 3x leveraged bear gold miners (NYSEARCA:DUST) would be one of the ways to maximize returns from a gold correction. Safer options are the SPDR Gold ETF (NYSEARCA:GLD), VanEck's Gold ETF (NYSEARCA:GDX), or the iShares Gold ETF (NYSEARCA:IAU). I'd expect these three securities to see weakness in the coming months based upon the data presented above.
The dollar's relative strength is showing that the Federal Reserve has the support it needs to raise interest rates at the next FOMC meeting. That's a negative for gold, even in light of last year's historical bull run after the meeting. That situation was entirely different and major negative macro events occurred that led to gold's sharp rise. For now, investors should focus on gold continuing to retract in the short-term.
Disclosure: I am/we are long DUST.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Active day-trade on DUST due to the ETN's decay component.