This essay is based on the Premium Update posted on July 11th, 2009

In the recent two Premium Updates I briefly discussed inflation and its effect on gold prices. I showed a chart indicating the massive increase in the amount of money that had been recently pumped into the system. I've looked deeper this past week into the issue of inflation researching what some of the smartest people have to say on the subject. There are those, like billionaire investor Warren Buffet, who believe that inflation is inevitable:

"A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it's going to inflate its way out of the burden of that debt."

Then there are those, like Nobel Prize winning economist, Paul Krugman, who don't believe that inflation is just around the corner. Although the Powers That Be have increased the money supply by a trillion dollars, most of that money is sitting in commercial bank vaults as excess reserves and not out in the real world creating "inflation" by buying up cars, houses and flat screen TVs.

Although in ordinary times the Fed's recent actions would cause "inflation", wrote Krugman in a New York Times article, these are not ordinary times.

"Banks aren't lending out their extra reserves. They're just sitting on them -- in effect, they're sending the money right back to the Fed. So the Fed isn't really printing money after all."

In my opinion, banks aren't lending yet, but that is likely to change. Think about it in market terms - the short run situation may be irrational and emotion-driven (banks may fear to lower cash reserves in case additional regulations are introduced), but in the long run, it is the fundamentals that drive prices. Banks have money but want to earn more, so they will eventually lend it to earn interest.

Nobody can be absolutely sure what the future holds for inflation, however, in my view, the vast majority of signals are screaming "inflation ahead".

Let's begin this week's analysis with the U.S Dollar chart (charts courtesy of http://stockcharts.com).

U.S. Dollar

The USD has been trading sideways since its sharp pullback at the beginning of June. Back then the correction was significant, but only in terms of range, not in terms of time. It is often the case that requirements of both time and range need to be fulfilled before prices can resume their previous trend (in this case, down).

Please take a moment to study the following weekly chart:

Taking into account weekly closing prices, we are now very close to a resistance level, which, unless we see a confirmed breakout, makes lower USD values in the near term more likely.

As far as implications for the USD Index are concerned, we have been trading sideways for approximately a month now, a considerable amount of time, thus making the correction more likely to be completed soon. This is naturally bearish news for the U.S. dollar and bullish for the precious metals market.

General Stock Market

In the previous Premium Update I warned that (...) there are signs that the general stock market may move lower in the short term. Should that be the case, it could affect the prices of precious metals, particularly silver. Still, I believe that this would only be temporary.

This has been the case this week, as the SPY ETF moved lower on higher volume:

Not only has the general stock market moved below the May lows, but it has done so on a relatively (compared to the previous week) high volume, which makes this move more important. Additionally, the head-and-shoulders formation appears to be completed:

The breakdown below the neck level (currently below the 90 level) has been confirmed by a relatively high volume just after it materialized. Additionally, we witnessed a brief pullback to the neck line, which did not close above it, thus confirming the formation. Unless we see a sharp move above this line (89 level) on Monday or Tuesday, the technical picture remains bearish for the general stock market.

Gold

This week has been disappointing for precious metals investors as gold, silver and corresponding equities followed the general stock market lower.

Gold moved lower despite the technical similarity to a previous pattern that was followed by higher prices. Higher prices were likely, but of course, not guaranteed. In order to make calls that have the greatest probability of being correct, it is important to always take what the market provides and use it on an "as is" basis.

Currently, gold appears to be close to bottoming out, as it seems to be forming the zigzag correction pattern. As mentioned in the past, precious metals tend to correct in a zigzag fashion, and this time we could see another example of this tendency, meaning that the bottom is rather near. Meanwhile, the medium term chart has not changed much in the past week.

The bullish cup-and-handle formation is still intact, even though the "handle" is now considerably bigger. This does not change the overall bullish implications this chart has on gold prices. Additionally, the Stochastic Indicator, which has proven a valuable tool in timing local bottoms in the past, is also suggesting that the bottom is rather near. While I have left the detailed descriptions for my Subscribers, I will provide you with one more chart from the premium version - one of our indicators suggests that higher prices are likely in the future.

The SP Short Term Gold Stock Bottom Indicator has flashed a "buy" signal on Friday, as it turned up after having declined below the dashed horizontal line. In the past, similar action meant that a bottom is already in, or that it will be in rather soon. Last time it was the case at the end of June, and the HUI Index has indeed put a local bottom. Currently, it may mean that precious metals are still vulnerable in the immediate term, but they are not likely to consolidate much longer.

Summary

The long-term situation remains inflationary and favorable for the precious metals sector; however, the short-term situation is rather cloudy. In the very recent past, precious metals have taken the general stock market's lead, while the dollar has been trading sideways without a decisive breakout or breakdown from its trading range. The long- and medium-term trends are down for the USD Index, so a breakdown from here is more likely than another counter-trend upswing. Still, a significant plunge in the general stock market may negatively affect prices of gold, silver and corresponding equities.

Investors who are already in the market and plan to keep their positions for at least several months don't need to trade the rest of the downswing. Short-term Speculators might want to wait a little longer before opening long position in the precious metals market.

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