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A New Era for Gold Bulls

Gold bears; watch out.  The dollar’s showing signs of weakness, China’s lumbering in the distance, and speculative shorts are running for cover.

 

After bottoming out at $1050 just slightly over a week ago gold is back on the climb, and appears ready to go farther.  Truth be told, it is hard to picture a scenario that is bearish for gold in the short term.  Gold has been strengthening against the euro through the last couple of weeks and shows signs of decoupling from the dollar.  Let’s take a look at a couple of scenarios and their impact on gold:

 
Greece

Workers took to the streets in protest over budget cuts last Wednesday and public sentiment has been growing more poisonous by the day, punctuated by a bombing outside JPMorgan in Athens.  Logistical details of the bailout remain murky, but continuing details about currency swaps and Greece’s accounting adventures should give the market a better idea of what to expect.  If for some reason Europe decides to let Greece default (unlikely) its economy will crash and drag down the euro as the reverberations ripple through the surrounding countries. EU leaders have pledged their support for Greece but it is unclear what this support will consist of and to what extent the IMF is going to get involved.  EU member states remain divided on the terms of the bailout and whether there should even be a bailout, not to mention the bureaucratic nightmare of organizing an aid package from such a wide coalition of interested parties.  Sweden, for example, does not use the euro but is willing to contribute. However the crisis gets resolved the question remaining is not whether the euro will drop, but by how much.  The strength of the bailout will be measured less on its ability to recoup losses from Greece than its success in staving off additional aid requests from the rest of the PIGS.

 

Gold vs. the Dollar
Gold vs. Dollar

Speaking of currency, seasoned traders may have noticed the decoupling of gold and the dollar’s inverse relationship.  Looking at the above graph one can observe the close correlation between gold and the dollar, albeit in opposite directions.  Gold and the dollar have a long-standing relationship, and while they normally trend in opposite directions they both tend to rise together during crises.  When Long Term Capital Management imploded in 1998 the gold and dollar moved upward in tandem as investors fled to safe assets.  As fears subsided gold and the dollar went back down in value but gold fell farther. This pattern was repeated during the 1st Iraqi War, the 2nd Iraqi War & the Asian defaults. This phenomenon appears to be losing its reliability, however.   Since the start of February gold has become less and less responsive to the dollar’s appreciation.  The inverse relationship of recent years has weakened to the extent that both the dollar and the gold can finish the day up without the expectation that the other is down. Gold and the dollar have become competing flight-to-safety type assets.

 

Deflation vs. Inflation

There are two camps for holding gold, one that it is a hedge against inflation, and second that it is a hedge against deflation.  In an inflationary environment the purchasing power of a currency diminishes against an index of goods. Gold has a history of outperforming other assets in inflationary environments.  There is only a limited supply of gold while governments have the power to print unlimited amounts of paper currency (effectively reducing the value of every denomination). Therefore, in periods of high inflation or hyperinflation gold is likely to be a strong performer.  One scenario where inflation (or stagflation) is likely to occur would be the Federal Reserve refusing to raise the federal funds rate for fear of damaging the economic recovery and increasing unemployment.

If inflation is the byproduct of too many dollars chasing too few goods deflation is the byproduct of too many goods and not enough interested money.  Increasing the money supply will not prevent deflation if no one is spending or no banks are lending.  Expanding the money supply loses its effectiveness when interest rates are at zero.  In a deflationary environment currency is almost the last thing anyone wants to own as its intrinsic value can drop all the way to zero and be permanently lost in the case of default. Gold is an excellent store of value for deflationary situations. If the world is headed for a double dip recession the combination of excess capacity/inventory and feeble demand is likely to cause deflation.
 

Recent Events & Short Term Outlook

April Gold Futures


The above graph tracks the April gold contract.  After trending downward since December the technicals are looking very bullish.  Earlier this week gold broke out of its descending triangle formation, moving almost $30 in a single day.  Technicals remain bullish despite the market’s knee-jerk reaction to news that the Federal Reserve was raising the discount rate .25 basis points and the IMF trying to unload 191 tons of bullion.  Raising the discount rate will have more of an impact psychologically than it will fundamentally.  It is foolish to think that traders are not pricing the eventual rise of interest rates into the asset.  Furthermore, gold looks like it may be forming a pennant, which has historically indicated the price will continue to move upward.

There are plenty of reasons to be bullish on Gold even if you don’t trust the voodoo science of technical modeling.  Money around the globe is flowing to safety in the face of intercontinental default risk.  Anyone who’s been listening to Marc Faber or watching what George Soros is really up to should see that Gold and the dollar will continue to benefit from the trend.  Even if gold doesn’t it has demonstrated a growing resilience to the dollar’s upswings and if nothing else, is likely to trade on a more fundamental basis.  International demand for gold continues to remain strong as indicated by the large bulk purchases from Asia. Gold’s status as an international currency can only stand to rise as so many other currencies appear ready to crash and burn.  Whether it be from a love for all things shiny, or simply a sound understanding of macroeconomics, this looks like a great time to be long gold.

 

Trading Recommendations: Buy now (currently at 1125) with a stop at 1070 (below major support) and target the 1200-1240 range.

Disclaimer:This is not a solicitation to buy or sell any security.  A purchase or sale of a security may result in a loss of principle.  Please consult with an expert advisor who can explain the risks of any investment you consider.

 

Author: Gregory Ceponis gceponis@fmxconnect.com

Contributors:
Julian Vignaud julian@fmxconnect.com
Vince Lanci vlanci@echobay.com


 



Disclosure: None