Dollar Up and Gold Down

Yesterday, the U.S. dollar rallied hard and gold tumbled. That fall in the yellow metal looks to continue today. Clearly, my short-term outlook for gold –which had been bullish -- is subject to change.

Looking at the charts, you can see that the dollar is now back ABOVE former overhead resistance …

While gold appears to be breaking down, and is testing its recent uptrend right now.

When these things happen a trader has to ask himself where he went wrong. Clearly, I was placing too much emphasis on the problems facing the U.S. dollar – problems that were reemphasized last night with terrible earnings from Washington Mutual. WaMu reported a $3.3 billion quarterly loss Tuesday -- far worse than Wall Street was anticipating -- as it set aside more money for bad loans. And earlier on Tuesday, Wachovia delivered terrible earnings news. My fears about the banking system seem to be playing out. So why isn’t the U.S. dollar going down?

The reason for that lies overseas – in Europe. As my friend and crackerjack currency analyst Boris Schlossberg wrote this morning:

“the latest EZ economic data has been horrid with Industrial Orders dropping a whopping –3.5% versus –1.5% forecast. Demand has clearly fallen off the cliff for the region’s producers and unless it rebounds quickly is likely to translate into weaker labor market data in the near term. Under such conditions that chances of another ECB rate hike this year is practically nil, as the monetary authorities in Frankfurt will come under enormous political pressure to remain stationary and perhaps even entertain a rate cut.”

At the same time, Treasury Secretary Hank Paulson spent Tuesday voicing support for a “strong dollar” while Federal Reserve Bank of Philadelphia president Charles Plosser said that that the U.S. central bank should raise interest rates ``sooner rather than later.''

So, the economic news on Europe weighed on the euro at the same time that Paulson and Plosser whipped up support for the greenback. This was enough to shift the tides on the charts. With the dollar up over overhead resistance, technical analysts rushed to buy the dollar and sell gold.

And THAT’S pretty much why gold swooned yesterday.

You can’t fight Mr. Market (or you’ll become poorer if you do), but I'll point out a few things …

1) Secretary Paulson has been voicing a "strong dollar policy since he was appointed in 2006, and his predecessor John Snow said he backed a strong dollar since George W. Bush's first term. What has happened to the U.S. dollar since then?

Indeed, Secretary Paulson’s support for the strong dollar has become the oft-repeated “check is in the mail” lie of the U.S. financial system.

2) Whatever the problems are in Europe, did the European governments just increase their national debt by 50%? That is in essence what the U.S. government did when Paulson said the “implicit” Federal guarantee of Fannie Mae and Freddie Mac has become an “explicit” guarantee. The two companies own or guarantee $5 trillion in home mortgages. That's just under half of the $12 trillion U.S. mortgage market. In comparison, the total U.S. government public debt totals $9.5 trillion. (In addition, Fannie Mae and Freddie Mac have $831 billion and $644 billion. respectively, in bonds outstanding.)

3) Why anyone is listening to Plosser now is beyond me. He argued against cuts in two Fed decisions this year, and no one listened to him then. And if anything, the U.S. economy is weaker now than it was then.

Nonetheless, while I consider the bullish dollar case weak, obviously Mr. Market has other ideas. Now, looking forward, what could weaken the dollar and strengthen gold?

Well, the U.S. Beige Book comes out at 2 pm today. This report on economic conditions is used at FOMC meetings, where the Fed sets interest rate policy. If the Beige Book shows recessionary conditions, the Fed may see the need to lower interest rates in order to stimulate activity.

The extent of the US slowdown will be reported in today’s Beige Book due out at 1600 GMT. Traders will be watching for any reports of particular weakness from the Fed districts across the US and the greenback may come under pressure later in the day should the news prove overly bearish. In the meantime the market remains very constructive for dollar longs as the unwind of the oil trade causes further euro selling. If today’s oil inventories figure pushes crude below 125/bbl then EURUSD could tumble below 1.5700 in sympathy.

I’m going to go out on a limb here and say the Beige Book will show both recessionary AND inflationary conditions. That puts the Fed in a pickle. But with sentiment on the dollar now bullish, bearish news on the economy could put the greenback under pressure.

On the other hand, if today’s oil inventory numbers (out at 10:30 am) push the price of oil down, the greenback could get another boost from that.

Does this short-term strength in the dollar and weakness in gold change my long-term outlook? Not a bit. Paulson may talk a good game, but the U.S. financial system and the U.S. dollar are in serious trouble. This pains me, because I love my country and like anyone with dollars in his wallet, I get hurt along with everyone else when the dollar goes down. But I think it’s prudent to use short-term pullbacks in gold to take longer-term bullish positions in gold AND silver. They will pay off down the road when the chickens come home to roost for the greenback. My intermediate term target on gold remains $1,210 an ounce.

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