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Gold reached a 16-year high of $438.30 an ounce yesterday. That was before it was reported that the U.S. trade deficit narrowed in September (following the report on trade gold tumbled by nearly $6 an ounce). Surprisingly, the Euro briefly traded above $1.30 the dollar after yesterday’s trade report. However, shortly after the surge in the Euro the dollar began to rebound.
With the price of gold losing momentum the issue of a price correction arises. Geopolitical unknowns aside, the basic conclusion is that either a dollar crisis must soon emerge to support gold or the price of gold will correct. Given recent trends in the COT data, such a correction threatens to be deep.
Dollar Slide Stabilizes, But Fears Remain
Fearing the negative implications of $1.30+ Euro, in recent days EU policy makers have stepped up their verbal interventions. As for Japan, it goes without saying that officials are prepared to re-establish a policy of Yen debasement -- this is especially the case since the Bank of Korea declared that it would take action to slow “excessive'' gains in its currency yesterday. Despite these dollar positives, it is nearly universally held that the U.S. dollar will weaken further from current levels over the longer term.
Expectations for a weaker dollar are present not only because the Bush/Republican victory(ies) threaten to weaken the dollar’s fundamentals (i.e. the ominous ‘twin deficits’), but also because when it comes to the dollar the U.S. has adopted a policy of ‘benign neglect’. Quite frankly, that no major U.S. official has expressed any concern about the slumping greenback while most of the world is nearing a tizzy speaks volumes.
The simplistic observation is that so long as the dollar’s decline remains orderly the U.S.’s unofficial policy of benign neglect will remain. However, there comes a point when this policy could be exposed for what it really is: an orchestrated devaluation.
“There is no universally accepted definition of a currency crisis, but most would agree that they all involve one key element: investors fleeing a currency en masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated.” Paul Krugman
Arguing that investors will flee the U.S. dollar en masse, at first, seems ridiculous. After all, it is in the interest of Asian central banks to fund the U.S. current account deficit to keep their exports (to the U.S.) strong. Moreover, it would seem to be in the interests of the U.S. to increase savings and adopt policies to reduce deficits (budget and trade), to ensure sustainable economic growth. But alas, the potential for investors to flee the dollar is in play because U.S. demand for foreign capital has increased dramatically. Indeed, the ‘flee the dollar’ theory is in place because the dated data from the Treasury suggests that foreign investors have already begun to curb their appetite for U.S. assets, and the most recent data (referring to yesterday’s third largest on record current account deficit) shows that the U.S. still requires a massive daily influx of capital to sustain its current account deficit.
Gold Pause Worrisome To Traders, Not To Owners
The sometimes over-excitable Theodore Butler recently penned an even handed article entitled “Do or Die?’ A summary statement reads as follows:
“Either the tech funds liquidate at lower prices, or the dealers cover at higher prices. No one knows which it will be. We do know that, in gold and silver, the dealers have never panicked and covered shorts at higher prices.”
Being, sometimes, a myopic bull, Butler could have downplayed the COT data and instead focused on the fundamentals. He didn’t, because he knows - as any short term gold/silver player does – that a mammoth task sitting in front of gold/silver bulls: either break the commercials backs or welcome a price correction.
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Spot Gold
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Net Commercial Short Interest
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Weekly
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as a % of open interest (future/options)
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424.20 **
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40.80% **
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427.50
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42.88%
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419.35
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42.56%
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414.70
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42.35%
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415.40
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42.20%
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411.70
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37.37%
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408.50
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33.09%
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405.25
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31.21%
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398.10
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31.52%
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407.25
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35.79%
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406.20
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35.76%
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401.30
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29.77%
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399.50
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28.19%
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390.95
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24.01%
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Unprecedented
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** Gold has rallied sharply since this point ~ Commercial net short interest as a % of open interest has likely also increased.
That the COT is suggesting a serious price decline is important to short term traders, not long term gold/silver owners. To be sure, while the former hold time sensitive positions in futures/options, the owners of the hard metal simply await any further U.S. dollar decline.
Conclusions
U.S. policy makers have undoubtedly learned the lesson of 1987. That lesson being – remembering Baker’s statements on the eve of an unwelcome dollar crash – keep your devaluation plans quiet for fear of spooking the herd. Even so, that U.S. policy makers have learned to bite their tongues does not mean that the long-term health of the U.S. dollar can somehow be magically improved. Indeed, reckless/unavoidable government spending plans on top of a mushrooming pile of debt bode well for dollar uncertainty as far as the eye can see.
Turning a blind eye to longer term dollar fears, the immediate realization is that the price of gold is likely to decline in the immediate term should the dollar continue to stabilize. And while geopolitical unknowns could serve to support gold – as well as the unknown that is China (which is of constant speculation) - what is known is that “the dealers have never panicked and covered shorts at higher prices.” If a steadfast silver bull can come to grips with this reality so should the investors that is thinking of buying/accumulating more gold at current prices.
In sum, either the dollar crisis arrives soon or the price of gold corrects.
If you want to rid your mind of the vague definitions associated with term ‘currency crisis’ implant ‘competitive devaluations’ instead.
“Competitive currency devaluations almost always end in tears.”
Roach. Dec 6, 2002.
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