2008 Repeat: Get Ready for Another Round of Deflation

Includes: DIA, QQQ, SPY
by: Graham Summers

A few weeks ago, on November 10, I wrote an article Three Reasons Gold Might be Making a Head Fake.

In it, I noted that Gold’s recent rally was largely due to Dollar devaluation (Gold had failed to hit new highs in other world currencies) as well as several other factors that disconfirmed the precious metal’s explosive rise. I wrote:

Unless we start seeing confirmations of Gold’s breakout coming from other precious metals or gold mining stocks, then we could very well see Gold stage a massive reversal in the near-term. A Dollar rally (which I believe may be starting) would certainly hit Gold hard since most of the precious metal’s gains have come based on Dollar devaluation (see Reason #1 above).

Last week, Gold proved my point staging a sharp reversal falling 6% in two days’ time. Those caught on the wrong side of this trade got absolutely obliterated.

The reason for the reversal? A sudden, and sharp US Dollar rally (which I also predicted on November 11). Indeed, last week the “short the Dollar, go long everything else” crowd got hammered when the Dollar rallied more than 2% in a little less than 48 hours.

The question now is whether last week’s carnage was a mere blip in the continued Gold rally/ Dollar drop or if this is indeed the start of something more significant. To determine this, we’ll take a look at the bigger picture for both assets.

Since Gold’s rally is hinging on continued Dollar weakness, we’ll start with the Dollar first. Below is one year chart for the US currency:

As you can see, the Dollar has been in a steep downtrend since March 2009 when the Federal Reserve announced its Quantitative Easing program. Since then, we’ve seen multiple rallies to the 50-day moving average, but no real test of that level until last week.

Taking a closer look at last week’s action, we see that the Dollar has staged its first real breach of its 50-day moving average. This is major as it is the first time the Dollar has achieved anything resembling real strength from a technical analysis standpoint in well over nine months.Indeed, when we draw in the trend line for the Dollar, we see that we also got a clear break of its downtrend. This development is also major since the trend-line has served as a point of resistance no less than nine times since May. To see the Dollar break above it and the 50-day moving average is a strong indicator that this is no mere head-fake and may well in fact be the start of a serious trend reversal.

This is absolutely critical because it was a Dollar rally that crushed stocks and commodities last year. Indeed, the first major warning sign of the October-November nightmare was the Dollar catching a bid, a process that began a massive short-covering in the US currency (the entire world was borrowing in Dollar or Yen at the time) which kicked Oil (black) and stocks (blue) in the teeth as more and more investors piled into the greenback on an increased flight to safety (see below).

I’ve warned multiple times that we are setting up for a repeat of last year. Looking at what happened last week, we may be in the beginning stages now (the Dollar is beginning to Rally). Indeed, if the Dollar’s moves form last week are the real thing (not a head-fake) then this may be the first warning sign that another round of deflation is around the corner.