Are We Re-Entering A Phase Where Gold And The U.S. Dollar Both Rally?

by: Simit Patel

Unfortunately my forex trading has suffered a bit of late, most notably because I've been short the U.S. dollar. Because the U.S. continues to run both a budget deficit (federal government spends more than it takes in, thus adding to the national debt) and a trade deficit (imports greater than exports), I think the U.S. dollar will continue to fall in value, as it has been doing steadily for the past 11 years. However, in the short-term, I'm starting to think we may be in for some dollar strength.

The chart below of the U.S. dollar/Canadian dollar exchange rate is the first exhibit supporting this thesis. I was expecting a break below the bottom of the green range. Instead, we broke out to the upside. Do we have even more room to the upside?

(Click to enlarge)

Of course, the situation in Europe, Japan and Britain are all characterized by extremely high levels of debt. While the U.S. also has high debt, a case can be made that these regions, particularly Japan whose debt/GDP ratio is over 2, are even worse. And so, capital could lose confidence in these economies due to their solvency concerns, and seek another currency for safety. The status of the U.S. dollar, its role in international trade, and the size of the U.S. economy still make the U.S. dollar a compelling option - at least for now.

Also of note is that gold has rallied sharply the last two days, a time when the U.S. dollar rallied sharply as well. See the gold chart below.

(Click to enlarge)

Gold bugs will already be familiar with the relationship between gold and the global sovereign debt crisis - so long as countries and supranational entities like the eurozone remain insolvent, demand for gold is likely to be strong against a panic out of these currencies and their corresponding bond markets. Put another way, gold is a form of money with no connection to debt, and in a world where all money is increasingly connected to insolvency issues, gold has great value.

From this perspective, I think a repeat of the scenario in the second half of 2010, in which both the U.S. dollar and gold rallied on concerns in the eurozone, could repeat itself. During this time U.S. equities also tended to rise, and I consider it likely for that trend to repeat itself as well.

With that said, I still do not feel comfortable taking on a long position in the U.S. dollar. Generally speaking, I'm not inclined to ever be bullish with any type of conviction on a currency that is running a twin deficit. But in light of the recent price action, historical developments from 2010, and the events going in the rest of the world, I don't think I'll be shorting the U.S. dollar just yet. I'm still interested in shorting the U.S. dollar, but I would prefer to see some signs of weakness emerge first.

I prefer to speculate on currencies via exchange rates in the spot forex market, but traders can use the ETF (NYSEARCA:UDN) for bearish positions in the U.S. dollar or (NYSEARCA:UUP) for bullish positions in the dollar. Currencies I do like include the Canadian dollar (NYSEARCA:FXC), Australian dollar (NYSEARCA:FXA) and China's renminbi (NYSEARCA:FXI) (even if China is contracting, I think this is only a temporary recession - not a terminal depression). Of course, in the long run of this global sovereign debt crisis, I'm quite confident no currency will be able to outperform physical gold (NYSEARCA:PHYS).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long physical gold.