How to Play Gold & the US Dollar

The staff at DailyForex.com outlines how to play the uncertainty playing out across the global stage in the months ahead.

When talking to market practitioners, gold is treated as a currency. While it is not the currency of any specific country or political/economic union, gold has always been a safe-haven to which investors resort in times of crises. Alongside United States Treasury Bonds, and the Swiss franc, gold has traditionally benefitted from unrest in the markets.

The perception that physical ownership of gold will somehow preserve wealth even when other assets lose a lot their value has made it a metal whose price is not derived solely (or even, mainly) from supply and demand, both for the metal’s actual uses as a precious metal and for industrial purposes. Specifically, gold is sort of the anti-dollar currency and XAU/USD (the currency pair symbol for Gold vs. Dollar) tends to go down whenever the USD weakens.

A few more words about safe-haven assets. Since 2010, when the crisis in Europe began to unfold, the Swiss Franc has steadily appreciated against the EUR. This strengthening of the CHF has had negative effect on the Swiss economy as it made exported Swiss goods more expensive and also burdened the tourism industry. In response to that, the Swiss National Bank (SNB) decided in September of 2011 to artificially devalue its own currency. The SNB sold francs in a quantity that brought the EUR/CHF to a level of 1.20 and pledged to step in and intervene in the markets to maintain this floor. More than a year later, the EUR is not much safer or attractive, yet the CHF is at around the same level. That commitment by the SNB effectively canceled the CHF’s status as a safe-haven for investors to park their money in, when uncertainly prevails.

About a month before the SNB action, Standard & Poor’s downgraded the US Treasuries to AA+, a notch shy of the perfect AAA assigned to US debt since, well, practically ever. Although the markets didn’t really respond to the downgrade with the same panic that followed other sudden downgrades like that, the signal was clear—no sovereign debt is immune.

After the CHF and US Treasuries lost their safe-haven status like that, the gold rallied. From below $1,400 per ounce, it reached just over $1,900 in less than a year. However, since its peak in August of last year, XAU has been very volatile. Specifically from the beginning of 2012, or more precisely, since a deal was reached on Greek debt, gold has become the worst performing precious metal.

Why is that? Why isn’t gold responding to all the bad news from Europe? How come we see little in the way of a permanent and decisive solution for the European crisis (as well as subdued growth in many other places in the world), and yet gold is stagnating?

NEXT PAGE: How Play the Global Uncertainty Card |pagebreak|

We will divide the answer to two parts: Europe and the US.

In Europe, as time passes and a catastrophe is avoided, policy makers and gradually, market participants as well, grow to believe in their ability to resolve the crisis with relatively few casualties. If a year ago a mass departure of a few problematic states from the Eurozone seemed like a valid, if not probable scenario, then today this seems like a distant possibility. So distant, that the market assigns a negligible probability to such a scenario, especially when talking about a large member state (Spain or Italy, as opposed to Cyprus or even Portugal).

Recently, the European Central Bank (ECB) announced a plan to buy sovereign debt in the open market. The states whose debt will be purchased (and thereby artificially elevate their prices and reduce their risk premiums) have to actively apply for that, and in return commit to structural reforms and budget cuts. Now all eyes are on Spain, as Spain is in the worst situation of all member states (Greece and Cyprus aside), and is the closest to default should it not receive any aid.

In the US on the other hand, things seem to be improving in the last few quarters. Activity is up and unemployment is down. Lately, the Federal Reserve (the Fed) announced a Quantitative Easing (QE)—a program to inject money into the market by purchasing mortgage-backed securities. Together with other measures the Fed has taken and its statements, and relative to the rest of the world, the USD seems stronger.

A look at the gold chart since 2010, before the European crisis

Click to Enlarge

Gold chart after 2012

Click to Enlarge

What We Expect to Happen
We expect Spain to ask for aid as soon as the European summit takes place later this month and that the data coming out of the US will remain positive. This means that gold should remain less attractive.

However, we don’t believe XAU/USD has all negative surprises priced-in:

• The Spanish government has presented a rather thin budget, together with an optimistic growth estimate. Also, the ECB’s pledge to step in and buy its bonds (if asked) discouraged many investors from selling them, thus supporting their price without any actual intervention. This can encourage Spain not to ask or to delay asking for help.


• The situation in Greece is not totally resolved yet and it, too, should be discussed at the next Eurogroup, Ecofin and summit meetings.


• Data in the US can still surprise to the downside. A sub-100K Non-Farm Payrolls number can signal that the optimism surrounding the American economy is misplaced.

All these can immediately elevate uncertainty in the market and ignite a flight to quality that will be very favorable for gold. Moreover, bad news out of the US will also mean a weaker dollar, which is just the more reason to buy gold.

Trade:
Buy XAU/USD and hold until as late as February of 2013.
We predict XAU/USD to top $1,800 before year-end and add another $20-50 by February.

By the Staff at DailyForex.com.