Dollar on a free ride = Opportunity in Gold

The U.S. dollar has enjoyed a free ride since economic troubles got highlighted in the Euro-zone.

Concerns over Sovereign debt accompanied by more downgrades had encouraged assets to begin leaving the European region causing the Euro to drop. The Euro is perceived by many as an alternative to the dollar. As the Euro was increasingly being pressurized by debt concerns in Greece and fears of a contagion in other member nations especially the PIIGS countries, the dollar kept rising vis-à-vis its weakening counterpart.

Recent U.S dollar strength points to Europe’s problems and not an end to the worries over rising deficits and debt in the U.S.

Also, it’s not about any improvement in the U.S economy as many macro economic variables like high unemployment still indicate caution. Currency markets have always been a relative game. Currently, the issues in the EU look uglier than that of the U.S as markets attention has been more focused on them.

What has surfaced over the past few weeks is the political problem of running a single currency in a region where there is no single government. This situation could be workable if all the countries within a currency area followed the same fiscal policies. The chance that all the countries will follow similar paths with respect to economic policy is close to zero.

As a consequence, the Euro fell to around 1.33 levels to a dollar. The dollar index rose to 82 levels. This momentum may last until we have some satisfactory solution to the issues, both economic and political. The way out sought through IMF bailout is still a temporary patch.

The U.S dollar will continue enjoying its free ride till the EU remains an area of focus. Still, nothing has really changed for the good in terms of economic policy for the United States. Fiscal deficits are large and are expected to remain so for the upcoming decade. The current policies like the US health care reform still contribute towards increasing deficits. How long this upward movement in the dollar will last is uncertain at the present time. It looks increasingly likely that over time the United States dollar will come under selling pressure again.

Investors in gold have seen prices fall from its peak. This fall has been accompanied by increased volatility, which has caused some investors to question their allocation to gold.

However, long term fundamentals of gold are still extremely strong. Gold would ideally continue to appreciate until the policymakers keep running deficits, creating more debt and printing more money.

Looking at past patterns of the Dollar and Gold provides some useful insights. The recent rush to the dollar has been triggered by rush to safety on account of problems in Europe. Since the crisis broke out in 2007, the dollar has rallied thrice on occasions that demanded rush to a safe haven currency. The pattern had been a sharp move upwards in the dollar index followed by a quick decline after a peak as underlying crisis eases.

Chart I: Dollar and Gold

Source: Bloomberg

As seen in the chart above, strength in the dollar has led to a fall in gold price in two of the three occasions previously. Even this time, strength in the dollar caused by weakness in the other currencies has led to a fall in the price of gold.

The average increase in dollar has been around +13%. The current increase in dollar has been around +9%. This suggests that there could be some more upside in the dollar. Gold prices on an average have fallen by -9%. Current loss in gold price from its peak also amounts to -9%.

One significant opportunity to notice is that each time as the dollar starts moving lower after it peaks, gold prices start rising. On an average, dollar has fallen by -9% post its peak and gold prices have increased by +11%.
This suggests that the current fall in gold price could be an excellent opportunity to add more gold to the kitty.

To conclude, fundamental factors and price patterns both suggest that current correction in gold could act as an excellent opportunity to buy. There is an increasing probability that economic and fiscal woes in the US take center stage resulting in dollar weakness or gold just starts gaining in a process of establishing itself as a monetary unit irrespective of dollar strength / weakness on a relative basis.

Disclaimer:

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments.

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