What’s Behind Gold’s Dip to $1,160?

Ivan Martchev  |


Last Wednesday, gold hit $1160.06 per ounce on the heels of fresh 52-week high for the U.S. Dollar Index and a rout in emerging markets currencies, particularly the Turkish lira. I do not believe that the rout in emerging markets currencies is over, and I do not believe that the rally in the dollar is over. That means there is more downside for gold, since the inverse correlation of gold and the dollar is well established.

Silver and Gold Price Dip Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

What is most intriguing is that the silver price has been much weaker than gold in the past two years. Last week, silver reached $14.33 per ounce, a level that is below the December 2016 low, when gold traded at $1120. Keep in mind that the two major precious metals correlate but do not track perfectly.

Still, more often than not, when the market for precious metals is hot, silver tends to outperform gold, as it did in the summer of 2016. Also, when the market for precious metals is weak, silver tends to underperform gold, as it did in the winter of 2016 and is doing at the moment.

Gold versus Dollar Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The precious metals complex will continue to be under pressure as the dollar is not done rallying, based on the present trajectory of Federal Reserve policy moves, which still favor a tightening bias. Hiking U.S. interest rates at a time when emerging markets have been on a dollar borrowing binge for the last 10 years is a recipe for disaster for emerging markets, as they borrow in dollars but repay their debts in cheaper Argentine pesos, Turkish liras, or Chinese yuan.

Investors need to remember that dollar borrowing means dollar shorting as dollar borrowers sell those dollars to use as they please when they take the loans, but they have to buy those dollars back when they repay the loans. This situation can result in a short squeeze, particularly if the loans are large.

The U.S. Dollar Index is exhibiting a pattern that traders call an inverted “head and shoulders” bottom. The “head” is at 88.50 and the “shoulders” are at 95.50. A breakout above the neckline that we had last week projects a 7-point move above it, or 102.50, so a break above 100 on the U.S. Dollar Index in short order is a high probability event, if you put any sort of stock in chart sorcery.

The Broad Dollar Index is Much Stronger

Trade Weighted United States Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Furthermore, there is now a very confrontational and overdue push by the Trump administration to try to balance the U.S. trade deficit. While I agree with President Trump that we have been taken advantage of in trade policy by many U.S. trade partners, I am not sure whether his confrontational approach will work. If it does, a smaller trade gap, coupled with Federal Reserve quantitative tightening, should cause a “heck of a rally” in the dollar, to use a favorite term of George W. Bush, who oversaw the largest trade gap (as a percentage of GDP) ever seen in this country.

United States Balance of Trade versus Current Account to Gross Domestic Product Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

While Mr. Trump is right to be upset about the trade imbalance, the fact remains that the U.S. current account deficit is only 2.4% of GDP under his tenure, while his Republican predecessor saw the same deficit become as large as 6%. Perhaps this is why the Broad Dollar Index is doing much better than the U.S. Dollar Index (which is not adjusted for trade numbers). I would not be surprised to see the Broad Dollar Index make an all-time high in Trump’s first term, if he can start rebalancing the trade picture.

If one looks at the Trade-Weighted Broad Dollar Index and extrapolates the numbers on the U.S. Dollar Index, the latter should be between 110 and 115. Because several emerging market currencies are from major U.S. trading partners but are not part of the U.S. Dollar Index, we get this obvious divergence.

Chinese Yuan versus China Foreign Exchange Reserves Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The biggest part of the trade imbalance to fix is with China, since the Chinese yuan is a major contributor to the Broad Dollar Index but is not part of the U.S. Dollar Index. Most of the proposed Chinese tariffs kick in on September 5, so we are not yet past the point of no return. Still, the Chinese are a very “save-face” type of people, so I wonder what this whole Trumpian friction will end up achieving in the end.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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