Topping Dollar Likely Catalyst for Gold Breakout

Fri, Jan 20, 2012 - 10:11am

There are many moving parts to the gold story, all displaying varying degrees of influence over time given the ever-changing nature of correlations. What appears to have had the strongest affect on the price of gold over the last six months has been the USD and open interest in gold futures, while negative real interest rates have had no correlation. Although trends in speculative interest for gold (open interest) are difficult to forecast, it is far easier to predict trend changes in the USD. With that in mind, the dollar appears to be forming an intermediate-term top, which would have bullish implications for the price of gold ahead.

Gold Variables

Investopedia explains 'Correlation'
Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

As shown in the image below, the two most consistent correlations to the price of gold are total open interest for gold futures (top panel) and real interest rates (middle panel, shown inverted). A bit more inconsistent is the relationship between gold and the USD as there are times when gold is seen as a safe haven and can trade in step with the dollar (bottom panel, USD shown inverted).

The last six months for gold looks fairly similar to 2008 in which open interest for gold plummeted and the USD rallied strongly (shown inverted). What is in stark contrast to 2008 is the current trend in negative real interest rates, suggesting gold should have traded flat over the last six months and be closer to its highs (middle panel).

What appears to have led to the gold sell off in the last six months has been a rise in risk aversion where investors risk appetites have fallen and led to a decline in futures activity (likely also affected by the MF Global fallout) and a general flock into the USD as a safe haven. The gold decline was not due to a massive disinflationary trend like in 2008 when real interest rates jumped (shown inverted in the middle panel below) as real interest rates remain near their lows and are still negative.

Source: Bloomberg

Because real interest rates remain near their lows over the last six months while gold has corrected, the correlation between gold and real interest rates has collapsed from a near perfectly negative correlation to no correlation (middle panel below). Conversely, in the middle of 2011 both gold and the dollar were more or less trading in the same direction and so the correlation between the two was low (top panel) but then beginning in December the negative correlation between the USD and gold resurfaced and gold sold off as the USD rallied. Currently the correlation between the USD and gold rests at -0.7433 and so if we are about to witness an intermediate-term top in the dollar, then gold should be forming an intermediate-term bottom.

Source: Bloomberg

USD Likely Forming Intermediate-Term Top

Definition of 'Market Breadth'
A technique used in technical analysis that attempts to gauge the direction of the overall market by analyzing the number of companies advancing relative to the number declining. Positive market breadth occurs when more companies are moving higher than are moving lower, and it is used to suggest that the bulls are in control of the momentum. Conversely, a disproportional number of declining securities is used to confirm bearish momentum.

Market technicians use breadth to determine the health of a trend and whether a trend change may be approaching. During strong trending markets there should be a strong number of stocks advancing while few should be falling. As a top approaches more and more stocks begin to fall with fewer stocks advancing until eventually the number of stocks falling overwhelms and a top is formed.

I use the same principal when viewing the USD. The widely followed USD Index is disproportionately weighted towards the Euro and has very low Asian (ex-Japan) and Latin American exposure. For this reason the trends in the USD Index largely reflect the USD/EUR exchange rate.

USD Index Weights

Source: Bloomberg

To get a better sense of the true strength or weakness for the USD I’ve created a table that measures 30 foreign currencies and 4 precious metals performance relative to the dollar over various time periods. An intermediate top in the USD is usually formed when more and more foreign currencies stop their relative decline and begin to advance, and this is exactly what has been occurring with the dollar currently. As seen in the table below, over the last month only five world currencies and precious metals have declined relative to the USD while 29 have advanced, and over the last trading week (5-days) 31 world currencies and precious metals have advanced relative to the USD.

Source: Bloomberg

With the dollar index hitting a 52-week high just three days ago, you wouldn't have guessed that the USD has been incredibly weak and is actually declining against most world currencies, likely signaling a coming intermediate top. The USD Index appears to be forming a bearish wedge and a break below the lower trend line would likely see gold break out of its bullish wedge formation.

Source: Bloomberg

With real interest rates remaining negative and near their 52-week lows, global central banks expanding their balance sheets (See “Central Banks to the Rescue!”), and with the global economy on the mend (which should bring money out of safe havens like the USD), the fundamentals for owning gold remain strong and a technical breakdown in the USD Index may be all the spark gold needs to continue its advance. Given gold still remains in one of the most oversold conditions in a decade, investors may well be rewarded in the months ahead if the USD Index breaks down and gold rallies.

Source: Bloomberg

About the Author

Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()