-- Posted Tuesday, 12 August 2008 | Digg This Article | Source: GoldSeek.com

Below is an extract from a commentary originally posted at www.speculative-investor.com on 10^th August, 2008.

Currency Market Update

Up until the past week or so there has been almost incessant talk in the press and many newsletters about the weak US dollar, but the US currency hasn't been universally weak since last November. Last November was when the Canadian Dollar and the British Pound commenced intermediate-term declines against the US$. Then, in March, the Swiss Franc and the Japanese Yen embarked on intermediate-term declines against the US$, leaving the euro and the A$ as the remaining holdouts. These holdouts finally buckled over the past fortnight, meaning that all six major non-US currencies are now in intermediate-term declines against the US$.

The intermediate-term advance in the Dollar Index is probably still in its infancy, but just as the US$ bottomed against one currency and then another over an 8-month period it will probably top against different currencies at different times. Also, we suspect that the dollar's topping sequence will be similar to its bottoming sequence. For instance, we think there's a good chance that the Canadian Dollar will be the first of the dollar's fiat currency competitors to complete its intermediate-term decline, while the euro and the Australian Dollar are likely to be the last to bottom. In fact, the C$, which the following daily chart reveals to be nearing its lows of the past year, could already be close to its ultimate correction low.

Last week's up-move in the Dollar Index stopped just shy of the top of the channel drawn on the following weekly chart, which will undoubtedly give the dollar bears some encouragement. However, we think the odds are strongly in favour of the Dollar Index breaking out of its downward-sloping channel and making significant additional gains over the coming months. There's a reasonable chance that the close proximity of the channel top will prompt some profit taking and short selling, leading to a 1-3 week US$ pullback or period of consolidation, but last week's action was a very clear signal that the dollar's intermediate-term trend has reversed. The one thing that almost always occurs in the early stages of intermediate-term US$ rallies, but had not occurred prior to last week, is a weekly gain by the Dollar Index of at least two points. This formerly-missing piece of the puzzle is now in place. 

Many people will be asking the question: why is the US$ rallying when its fundamentals are so terrible? From our perspective, however, a more reasonable question is: why has it taken so long for the US$ to rally against the euro given that the US$ is extremely under-valued relative to the euro and the euro's fundamentals are just as bad?

The answer, we think, is that the currency market has believed that the US Federal Reserve would be as 'easy' as it needed to be to help the banking system through its crisis, while the ECB would continue to focus on minimising currency depreciation. We think the market was/is right to believe that the Fed will do whatever it takes to maintain the solvency of the major banks, but traders now appear to be coming around to the view that the ECB will also be loosening the monetary reins. Take away the interest-rate 'prop' and the euro suddenly becomes free to fall under the weight of its own over-valuation.

It is also worth mentioning that the recent sharp downturn in the world of commodities has probably had an important effect on perceptions, and hence on relative valuations, within the currency market. The reason is that with the prices of most commodities now in intermediate-term downward trends the decision-makers at the ECB should feel free to pay more attention to the serious economic slowdown currently underway, and less to the inflation problem.

Gold stocks and the US dollar

The Dollar Index will probably trend higher over the next few months. If so, will this prevent gold and gold stocks from rallying?

We don't think so. Why should strength in the US dollar driven by the realisation that other fiat currencies are just as bad as the dollar prevent gold and gold stocks from rallying?

When the US$ strengthens against the euro it creates a psychological headwind for gold-related investments and this psychological effect will usually dominate for a while, but the US dollar's trend relative to other fiat currencies is only one of several drivers of the gold price. Other important considerations are credit spreads (measures of financial market confidence), the yield spread (a measure of financial market liquidity), real interest rates, and money-supply growth trends.

The following chart provides a good example of how the gold sector will sometimes react to an intermediate-term US$ rally. The chart, which compares the performances of the HUI and the Dollar Index during 2005, shows that the HUI tanked during the first part of the Dollar Index's intermediate-term advance and then began to trend upward despite the dollar's continuing strength. Moreover, it shows that in 2005 the bottom of the HUI's correction occurred two days after the Dollar Index broke upward from a basing pattern. This means that we are potentially in exactly the same position today as we were at the May-2005 bottom (the Dollar Index broke upward from its basing pattern on Thursday 7th August 2008).  

It is also worth noting that the best part of the 1973 rally in gold stocks occurred while the US$ was strengthening relative to other fiat currencies.

-- Posted Tuesday, 12 August 2008 | Digg This Article | Source: GoldSeek.com

Regular financial market forecasts and analyses are provided at our web site. We aren’t offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://www.speculative-investor.com/new/freesamples.html

E-mail: Steve Saville

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