The Dollar Index Vs. Gold & Commodities

The recent downtrend in precious metals has been independent of price activity in the US dollar index. This action is an example of how the traditional inflationary fundamentals do not apply to current financial markets and economies. In the past, the consensus has been that the US dollar has performed to the inverse of many commodities, gold being weighted the heaviest of them all against the dollar. However not only is that assumption not true in all cases throughout history, but even if it were hypothetically true, we are still watching these supposed long term trends decouple under the influence of long overdue secular changes and recent economic and monetary policies set by those in charge. There is no reason think that gold is going to underperform based on strength in the dollar, or outperform based on weakness in the dollar.

To specify on those particular trends, gold has plenty of catching up to do. This catch up game is independent of the dollar index for it was gold that was in a bear market for 20 years, even as the dollar had devalued rapidly during that time. If you used gold to gauge inflation during that time period, your measurements would have been very much off. I say that the gold-dollar correlation isn’t reliable because the market has shown me that it has not been by at times not correctly pricing the two relative to economic conditions, and because the dollar’s fundamentals are now more than ever based primarily on the strength of other currencies. I believe that the dollar index will be in a bull market before it ever collapses.

This chart shows that while there has been and inverse gold/dollar correlation between 1986-1990 and roughly 1996-2005, there was also a period from 1990-1996 where the correlation was weak and at times non-existent. In addition, gold hasn’t always been an accurate measure of inflation as some have argued. Gold stayed in a trading range of about $300-$450 for 20 years. If it was a measure of inflation, then needless to say it was off by a wide margin. For the record, I do believe that gold can at times be a measure, a hedge, and a symptom of inflation, but attempting to draw conclusions on inflation using gold and the dollar can end with misleading results.

The correlation breaks down again in the beginning of 2009 as the dollar has been volatile while gold has been steady and ascending. In my opinion the main reason behind this has been the extremely loose monetary policy from the US central bank which up until recently, had investors (rightfully) believing that inflation would set in domestically. However that hasn’t been the case and it’s been the US that has sent the inflation to other countries who have been attempting to peg their currency to ours. If that knowledge had been foreseen by the market, then I believe that the dollar would not have sold off so hard after QE 1 and in the latter part of 2010 and instead would have outperformed other currencies.

Most who have predicted a dollar collapse have suggested that the fiscal problems of the United States are greater than other countries because we are a debtor nation. I do understand the magnitude of our ballooning national debt and sluggish GDP which is being held up only by the Fed’s policies, however despite China and India’s resource demand and Brazil’s oil, the United States is still in better fiscal shape than nations abroad.

The US has:

– The largest economy in the world
– The longest living form of government in the world
– The least corrupt government in the world
– The largest army in the world
– The most technological advances in the world
– The largest army in the world
– The most natural resources in the world
– The largest holdings of gold in the world

As bad as things are in the here, our economy does not have the structural issues like that of Japan, China, or any other emerging or developed nations. We are certainly on the wrong path, but our problems can be solved with tightening of monetary policy and a reduction in spending. Other countries are dependent on US monetary policy for growth – most of which has been artificial and solely the result of US monetary policy. If the US chooses to get its fiscal deficits in order and take a pro-business stance, than our economy will certainly deflate for a few years while credit contracts and domestic jobs are made but the consequences for other nations would be much more severe. The countries that are dependent on American demand will suffer an excess of supply and a drying up of demand as their country will no longer be fully of our liquidity.

The dollar index like gold, will remain the safe haven investment for the world. As nations begin to fall like dominoes, the US will watch and will most likely be the last one standing before it is our time. Though I say this, in no way am I suggesting the dollar will even come close to being as good as gold – no pun intended. The amount global money printing will force assets like commodities higher, but the key thing to understand is that it is the emerging market demand that is in the drivers seat at this point, not the weakness in the dollar. We will certainly see prices rise here, and perhaps even hyperinflation, however we won’t have our day of reckoning before everyone else does and given the neo-keynesian bias that most policy markers have, they will try to devalue before they attempt austerity. India for one, already has a 20% inflation rate… that’s hyperinflation, we do not have that here yet.

Breaking Down The Future Of The Dollar Index

The dollar index loves to trade in shoulder head shoulder patterns. In fact, it has completed no less than 8 shoulder head shoulder patterns in the last three years. It’s my opinion that within the next year we may get another reverse head and shoulders that breaks us above the 2010 highs.

Something else that’s worth mentioning is the symmetrical wedge pattern that has been building for the last 5 years. This is a long term bullish indicator and it means that the dollar was oversold in both late 2009 and late 2010. Given the financial and economic climate that we’re in, it could only take another EU nation to go under in order (or dare I say Japan) for the dollar to look more attractive to foreigners. Either way, the next country, or several countries to go will not be the US.

An Update On Gold

Gold has been beat up but the bottom I called of $1325 has held and support has adjusted as I suggested it may to $1308. This keeps the 2 year moving trend intact and signals that gold is ready to get back above $1400 and maybe even test $1500 by summer time.

I used this chart last week to point out where the support level was for the price and on the RSI. Since then, those support levels have held and the price has bounced higher. I don’t expect any type of re-testing of the lows here and I’m certain that we’ve seen the bottom.

Today gold snapped that upper trendline that had been holding us down since the beginning of the year. I like that the open and closing prices for today made for a long candlestick which signals a decisive break of resistance. The bullish crossover in the MACD shows that long positions are gaining momentum which further solidifies the breakout.

The bottom line here is to not use the dollar index as a main component of your gold/commodities analysis. If you do use it, be sure to fully research the fundamentals in each market as both assets are used universally across the globe and have more demand and liquidity than any other asset. Both gold and the dollar are going to see strength in the future though gold will most surely outperform the dollar. I don’t think gold will have trouble getting to $1500 by the middle of this year but the dollar’s fate will be much more reliant on foreign insolvency and how long other emerging markets will be able to sustain themselves with 5-20% domestic inflation rates.

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About Aaron Basile
Market Technician, Equity/Commodity Trader, Austrian Economist, Contrarian Investor

6 Responses to The Dollar Index Vs. Gold & Commodities

  1. Jason Burack says:

    “In addition, gold hasn’t always been an accurate measure of inflation as some have argued.”

    The question is why has Gold underperformed for so long? Gold has not kept pace with inflation up until AFTER the 2008 crash. Now, (FINALLY!!!) it’s gaining purchasing power rapidly (especially towards other commodities when you measure how much an oz of gold buys of the Rogers Raw Materials fund).

    The answer to me is simple why Gold did not keep pace with inflation and underperformed for so long: 100% pure manipulation. Western central banks were selling, leasing and trying everything in their power to cap the price. They have lost the lid now and are now in a managed retreat. They can only manipulate the price in the short term. The genie is now out of the bottle. Also, a lot of the Eastern central banks, which happen to be the creditor nations, are now net buyers of gold. This is a tug of war between the West and the East and we are seeing the transfer of wealth back from west to east occur with accumulation of gold and these countries having trade surpluses and being creditor nations. Also, I don’t think these exporting countries will crash provided they drop the Dollar Pegs. It is becoming very costly to maintain the Dollar Peg now….

    • aaronbasile says:

      Part of the manipulation in years past has been just adding stigma’s about gold like calling it a “barbaric relic” and giving talking heads who hate gold some airtime to bash it. I’m sure that the market could have pushed gold higher (maybe not extremely higher) throughout the 80’s and 90’s, but investors really just forgot about gold and forgot about inflation and gold became known as a dangerous asset due to how volatile it was in the late 70’s.

      Gold at least should have risen 1-2% annually to keep pace with the government’s “official” inflation from 1980-2000. However I belive that the manipulation made it underperform, and the sheer lack of interest made it so it didn’t even increase at all.

  2. Pingback: Dollar Sentiment Weaker Than Ever – The Market Is Telling You To BUY « Aaron Basile

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