A Look at the Euro and Gold

While we focus on the USDX for most moves, which is the truest indicator of asset price direction over the last 10 years or so, the euro is the largest component of the USDX, and thus, the most important single currency to watch to determine the USDX direction.

Perspective is everything.  Here's a quick look at the euro over the last 5 years compared to gold.

Note that the direction is well correlated, with gold outperforming or underperforming in large intervals.  Since October, 2008, gold has been a bit behind the curve because of the forced deleveraging episode that occurred and created the gold buying opportunity of a lifetime.  Since this summer, gold has been gaining ground, as one would expect to see in a gold bull market.

Let's get a little more detail with just the last 6 months of movements.

You can see a very strong correlation with the various up and down movements.  If we consider the euro the constant (which isn't true, but it makes visualizing easier), then we can see that gold has generally been gaining ground since the summer, notably the end of June.  Nonetheless, with every euro upswing, gold rises, and vice versa--only the magnitude of the rise or fall changes.

Now, note the month of November, circled.  The correlation is not strong at all.  We believed we'd see a reasonable consolidation in gold given that we expected the euro to be indecisive, leading to a generally sideways movement in the USDX.  We got the latter, but gold has had a mind of its own as of late.  As we discussed Wednesday, we doubt that the correlation is going away between the USDX and the gold price (though it may be! we have to consider the possibility), so either the euro is due for a big breakout that will allow the USDX to fall, or gold is ahead of itself right here.

Gold has been consolidating since our call on the top on Wednesday.  We've been watching the 1 minute EURUSD charts and the spot gold price, however, and for every minor rise the euro takes, gold rallies strongly.  For every minor dip the euro takes, gold loses very little.  This is seasonal strength and leads us to believe that we will probably not see less than 1070 on the gold price, and it's likely we will not see a dip at all below 1100.

Thus the big question is "what is the euro (relative to the US dollar) going to do next?"

Here are a few things we're watching.

We showed the following chart on Wednesday.  There is a clear up channel for the euro, with strong resistance in the 150 region (150.50 to be exact).  The resistance line (red) and the lower channel up trend line are forming a right triangle.  The euro, at some point, should break to the upside above 150.50.  That will take the USDX down and gold up.  It will push the USDX toward 72 very quickly (and probably put a couple hundred dollars on the gold price).  There's also a chance, however, that the euro breaks below the bottom channel line, around 148.  If we get a close below that level, we'd expect to see a big dollar rally.  We don't think that will happen, so the bullish euro/dollar case is for the euro to break out in the next few days.

There is a potentially bearish case, though.

Conceivably, we could be looking at a head and shoulders top for the euro, with the neckline around 147.50 and a downside target of AT LEAST 142 (1.42).  That would likely set off a larger dollar rally and decline in gold price.  We doubt that this is the scenario at hand given that gold is seasonally strong now, the dollar is being used as a carry trade currency, and there's still more technical downside in the dollar before we have an oversold condition.  But anything's possible...

So, let's simplify this so that we have some points around which to make decisions.

The clear gold bullish case will be for a bullish euro.  The obvious point for trading will be for gold to break out when the euro breaks out above 150.5.  But, if you're looking to accumulate gold, we'd want to anticipate an up move.  So, look for the euro to touch 148 in the next few days and bounce.  If it touches that level and turns upward, gold's probably as cheap as it will get for now.  If it doesn't turn down further before it breaks out, we'd buy the breakout.  For those that don't have enough physical gold in their possession, incrementally buying beginning right here is probably the safest bet--moves in the euro and gold may happen very quickly, and gold is so bullish right now that there's no guarantee we'll see a lower price in the short term.

The bearish case is for a break below the lower trend channel, which is probably a warning that the head and shoulders will be activated.  If that's the case, it may be wise to take profits in more than gold since the dollar will likely rally and cause more assets to sell off.

We're buyers of gold on any bounce in the euro off of 148.  We'd cut any losses if the euro turned again and broke down below 147.50.  If the trend continued such that the USDX rose above its 50 dma, we'd probably short the stock market (needs more study there near that time, if it occurs).  We do not short gold in this environment EVER--there are too many unknowns and gold may go on sudden and monstrous rallies at any point with the reckless behavior of countries, central banks, and politicians.  Note that last year, even during the credit crisis, gold sold off and then began gaining ground even as other assets continued to decline.  Gold is, undoubtedly, the safest investment out there at this time.