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Currencies Waver, Stocks Go Back-and-Forth - What Will Be the Outcome for Gold?

Based on the August 19th, 2011 Premium Update. Visit our archives for more gold & silver analysis.


 

We are marking a dubious 40-year anniversary this week. It was on August 15, 1971 that President Richard Nixon unilaterally "closed the gold window," severing the dollar's ties to gold forever, possibly one of the most significant policy decisions in modern economic history. It was a part of dramatic measures meant to deal with the nation's huge balance of payments deficit, its weak growth, and inflation. Speculative attacks on the dollar had begun in the late 1960s as concerns mounted over cost of the Vietnam War and America's rising trade deficit. Other countries were increasingly reluctant to take dollars in payment and demanded gold instead.

It's very possible, looking back in hindsight, that Nixon had no choice. There was panic in the markets and Great Britain had tried to redeem $3 billion for American gold. The official dollar debts in the hands of foreign authorities were so large that America's gold stock would be insufficient to meet the swelling official demand for American gold at the convertibility price of $35 per ounce. It's seems reasonable to think that America had no interest in giving away the contents of Fort Knox to foreign governments.

And so, Nixon ended the greenback's precious-metal guarantee thus creating the current floating exchange monetary system in which currencies are backed by fiat, or trust. In other words, the currency has value because the government says so. No longer would the U.S. permit other countries to exchange their dollars for gold. (Under the agreement only the U.S. dollar was required to be convertible to gold.) At 40 years of age fiat currency is looking frayed and worn at the edges. At the time of the making of the Bretton Woods agreement, the U.S. was the world's largest creditor. Now it is the world's largest debtor. At that time people took it for granted that each generation would have a better life than the last. That is no longer true.

Having looked back at history, now it's time to look at the future. To see how the precious metals will behave let's begin the technical part of this essay with the analysis of the Euro Index. We will start with the long-term chart (charts courtesy by http://stockcharts.com).

$XEU Euro Index

In the long-term Euro Index chart this week, we see yet another attempt for the index to move above the short-term declining resistance line. The previous move above it was not verified and has since been invalidated. It's unclear whether this will be seen once again.

The most recent move above the resistance line was followed by a move back to it. If the breakout does hold and is verified, a rally in the Euro Index will likely follow. This would almost certainly result in lower values for the dollar and perhaps higher precious metals prices. A breakdown however, will clearly be bearish and likely lead to further declines for this index and may have a negative impact on gold and silver prices as well.

$XEU Euro Index

In the long-term USD Index chart, we do not really see any reflection of the recent moves in the Euro Index. The situation is very tense here and the index has been moving back and forth between an important support level and an equally important resistance level. It is now within a tight trading range and it is probable that a breakout or a breakdown will be seen soon. The direction of this move will likely determine the direction of the next significant move for the dollar.

Whatever happens in the USD Index will likely have a big impact on gold and the rest of the precious metals sector. Based on the recent correlation between the dollar and gold, a significant move for the dollar will probably result in the classic impact where the exact opposite is seen in the price of gold. That is to say that a significant rally in the USD Index will likely be accompanied by much lower price levels for gold. Conversely, a large decline will likely lead to much higher prices for gold.

US Dollar Index - Cash Settle

In the long-term S&P 500 Index chart, this week's price action is quite similar to what was seen last summer. A sharp and significant decline was followed by a period of back-and-forth price action for the next several months. Because of the important recent signals from the 30-year bond market, it is even possible that the stocks could rally before any consolidation is seen. Long-term yields have plunged and this has historically resulted in a rally for stocks.

What we wrote on August 12th in our essay on the possible top in gold is very much up-to-date:

(...) the situation for stocks in general looks bullish in the short term. With the general stock market having significant negative correlation with gold, this implies lower prices of the yellow metal and analysis of gold itself confirms that. Based on the points made above, it does appear that we are quite close to a local top and long positions in gold at this point seem very risky, at least for the short term.

To confirm that the basic correlations remain pretty much the same, let's take a look at this week's Correlation Matrix.

Correlation Matrix

As we may see, gold continues to be negatively correlated with the general stock market in the short term (30-day column). This means that if stocks rally, lower gold prices are likely even though gold is currently close to its all-time high price.

The long-term coefficients between gold and the dollar are also negative and the implication here is that if a significant rally is seen in the USD Index, gold's price will probably move lower. The effect will also likely be negative upon silver and gold and silver mining stocks. The exact opposite (i.e. a move higher in gold, silver and mining stocks) is likely to happen in case the USD Index declines sharply.

Summing up, the situation is very tense and unclear in the currency markets. A breakout and a confirmation of it are about the only way the picture will be clarified for the euro and the dollar. Each index is presently at a crossroads and whichever breaks out and significant rallies will determine whether the impact upon gold prices and the precious metals sector overall will be positive or negative. As far as the general stock market is concerned, Thursday's decline in stocks was quite volatile but did not necessarily change the overall outlook. It still seems that the weeks ahead could very well be bullish for stocks although this upturn may not be seen immediately. At this point it seems extremely important to keep track of the general stock market as it's significantly correlated with precious metals. Any rally in stocks or in the USD Index (only significant ones matter in case of the latter) would most likely result in lower prices for gold, silver and mining stocks.

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Thank you for reading. Have a great and profitable week!

 

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