Whenever a taboo is broken, something good happens, something vitalizing.  Taboos after all are only hangovers, the product of diseased minds, you might say, of fearsome people who hadn't the courage to live and who under the guise of morality and religion have imposed these things upon us.

Henry Miller, 1891-1980, American Author What we warned of seems to have come to pass.  Since publishing the two articles titled “The Gold Bull: Time for a Breather or?� and “Bonds and Gold,� gold has shed almost $127 per ounce. This is a small drop in the bucket when compared to the gains gold has seen in the past few months. 

We are not against gold. In fact, we are long-term bulls, but we cannot simply ignore the short-term developments and blindly hope that gold will race higher. No market, not matter how strong can rally upward indefinitely without pulling back and gold is no exception to this rule. Thus, what we have said so far in our previous articles and what we have to say now might spoil the current party, but that is life. All parties must end in order to make way for new ones to come. 

In the short to intermediate timeframes, we would like to point to several new factors that suggest gold could potentially pull back more. The U.S. dollar could mount a stronger than expected rally that should lead to a rather strong pull back in the euro and other competing currencies. Certainly, the dollar’s rapid move from 74.57 to a high of 78.50 has caught a lot of traders with their trousers down. 

The dollar has broken out of its falling wedge formation. This is a bullish development and the result is usually much higher prices as is being witnessed in real time right now.

Chart 1 -- USD Index     

The dollar strongly broke out from this falling wedge formation and managed to trade past its main down trend line.  This suggests that this move up has some legs behind it and that the dollar could potentially trade well past 80.  We are waiting for one more confirmation that will indicate that the dollar could trade past 80 and possibly as high as 86.

Another factor that could drive the dollar even higher is the dollar carryover trade.  We have seen the effects of previous carryover trades and the effect they have on the currency in question as the unwinding process gathers steam.  Too many individuals borrowed dollars to go long other currencies and if the dollar continues to rise, this could trigger a domino effect.  As one group seeks to close out their positions, it could trigger the stops of another group and set off a chain reaction.  

As a result, the dollar could mount a very strong rally that could even catch the most optimistic of dollar bulls by surprise.  The rapid move up from a low of 74.50 to a high of 78.50 in just a few days has certainly taken a lot of individuals by surprise.  Always remember – no matter how bullish or bearish an investment is, nothing trades down or up forever, in between, there are always intervening counter rallies.  Some of these rallies are strong and some are weak.  

Chart 2 – Euro Index

The euro broke down strongly from its rising wedge formation.  It is also trading below its main up trend line.  This clearly validates that the euro has put in a top and is in a corrective phase and could potentially trade all the way down to the range between 130 and 133.

Chart 3 – Gold Continuous Contract

A downside breakout has resulted from the rising wedge formation in gold.  Gold could potentially trade below $1000 per ounce again.  This rapid move down should lead to some sort of relief rally between now and January, but ultimately gold should at least test the range between $990 and $1000.  This is where the real battle will begin.  If gold fails to hold above $990 and trades below it on a weekly basis, the next level of support is $940 to $950.  A break below that would take gold down to the very strong support zone at $900.

Conclusion

Gold has moved from the contrarian investment category into more of the mainstream investment category, at least in the short to intermediate timeframes.  There is too much excitement both in and out of the gold camp.  Almost everyone is negative on the U.S. dollar.  Extreme sentiment always produces a strong move in the least desired direction.  This is exactly what took place the last time the dollar mounted a strong rally. 

The strong rally in the dollar is indicating that at the very least gold will test the $990 to  $1000 range before stabilizing.  If it fails to hold here, it could be an early indication of an even stronger pull back.

Certainly, the rapid move up by the dollar followed by rapid a breakdown in gold and the euro in the last few days suggests that speculation was rampant in all three markets with traders aggressively purchasing gold and euros while shorting the dollar.  However, speculators are happy to play the market both ways and can easily short the same market they were so enthusiastically supporting.

The unwinding of positions due to the dollar carryover trade could lead to a much stronger rally than most expect.  Remember what happened to the New Zealand dollar a few years ago.  Everyone was borrowing Japanese yen to go long the New Zealand dollar.  The Kiwi collapsed and the yen soared.  If something like that should come to pass now, it would result in a very strong pull back in the commodities sector.

Finally, one of the most glaring and significant developments was that the U.S. dollar did not confirm the series of new highs gold put in recently.  What did we mean by this?

Gold went to put in a series of all-time new highs.  By the same token, the dollar should have traded below its March 2008 lows or at the very least tested them.  On March 17, 2008, the dollar put in a multi decade low when it traded down to 70.80 and ended the day at 71.30.  On that day, gold traded as high as $1014.  From $1014 to its recent highs, it gained an additional 21%.  At the very least, the dollar should have traded 3% to 5% lower than its March 17, 2008 low. 

Instead, we find that when gold traded to $1227, the dollar was trading roughly 4% higher than it was trading on March 17, 2008.  On a daily basis, the dollar did not even trade below 74.50 and on a monthly basis it was able to hold above 75.   This is a very strong positive divergence signal in favour of the dollar.

When we combine this strong positive divergence with the other factors mentioned (especially the dollar carryover trade), one could argue that the dollar could potentially mount a very strong rally.  The rapid move in the past few days has certainly caught many traders off guard and could be an early signal of what lies in store for the dollar, at least for the next 3 to 6 months.   

The dollar has already traded above several key points.  The first being 76.42, the second 77.50, and today it tested 78.50 before pulling back.  We are waiting for one more development, which should provide an early warning of whether or not the dollar is going to trade significantly past 80. 

This means that competing currencies could experience very strong corrections.  If the surprise (surprise for those who were not expecting it) breakdown in the euro is anything to go by, traders should brace themselves for a potential shock in 2010.

In terms of gold, traders need to watch how well gold holds up when it tests the $990 to $1000 area.  This will be a key factor in determining which direction it trades in the next 3 to 6 months.  If it holds up well in the face of a strong dollar, then we can assume a bottom is close at hand.  On the other hand, if it falters, it could potentially trade a lot lower.

Finally, let’s not forget that the Gold ETF is now the 6th largest holder of physical gold.  If the sell off gathers steam, this exchange-traded fund could exacerbate the situation and accelerate the decline if it is forced to sell gold to deal with redemptions.

The key factor is that the dollar’s strength should not be a long-term development and that the pullback in gold should be a short-term development.  Traders should view strong pullbacks as buying opportunities and the stronger the pull back, the greater the buying opportunity.  However, as we had warned in early December when gold was trading close to its highs, taking some money off the table would have been the prudent thing to do.  No matter how good an investment is – it is always wise to take some money off the table when one’s investments have appreciated significantly.

The crisis of yesterday is the joke of tomorrow.
H.G. Wells, 1866-1946

British-born American Author