Gold looks vulnerable

I am of the view that the bull market in gold is far from over. To me, it’s obvious that so long as the fiscal and monetary frameworks that support the $US are in chaos, then gold fundamentals are strong. Arguments over the value of the metal are irrelevant. You can’t price chaos.

This is the point missed by that those who describe the gold price as a bubble. It will no doubt become a bubble at some point, when those fundamentals weaken, and the price continues to rise only because it has already risen. But so far there is no sign of stabilisation in the fiscal and monetary frameworks that support the $US.

That is not to say that gold will not drop precipitously at some points within the larger uptrend. When the $US rallies during large risk-off events, gold will likely correct, perhaps significantly. The 30% selloff following the Lehman Brothers collapse in 2008 is a case in point.

We may be approaching another of those points. As Delusional Economics has so studiously documented, Europe is beginning to fragment. According to Deus Forex Machina that has finally knocked the stuffing out of the euro and it is set to fall, probably substantially. As I have explained before, when the euro falls the entire reflation dynamic of the world economy get’s wiped. That’s because, coming out of the the great global imbalances of the Bretton Woods II era, the US can only grow through stimulating external demand. It does this by weakening its currency. But with a falling euro, there is always a corresponding rise in the $US. And we are seeing that now. From Bespoke overnight:

Moreover, the weakness in Europe that is causing the macroeconomic shift from the euro to the $US is exacerbated by the $US funding needs of the European banks. We have known for some weeks that European banks have been struggling to raise $US funding as US-based money markets froze them out. Now from the FT comes the following:

European banks are facing increasing strains on their balance sheets because of the dramatic jump in the cost to borrow dollars, essential for some institutions as they need to repay loans in US currency.

The cost for European banks to swap euros into dollars has jumped fivefold since June, hitting the highest levels since December 2008, and raising the risk of insolvency in the region’s financial sector.

Strategists estimate European banks face a $500bn dollar funding gap – the sum they need to repay loans and obligations in the US currency over the coming months. The extra cost to swap euros into dollars, therefore, could make the difference between survival and bankruptcy for some institutions, strategists warn.

So, there’s a develpoing need for $USs, which is a parallel with the credit squeeze of 2008, even if it so far remains well below those panic levels. As Delusional Economics points out this morning, these tensions are only likely to increase as French banks face downgrade action from Moody’s.

So, with this setting of a developing run to the $US, I asked The Prince to take a look at the gold charts. Here is his take:

Technically, the current medium term uptrend in gold began in October 2008, as this weekly price chart below shows:

Corrections since then have averaged 8-10%, but have reduced in magnitude from the end of each subsequent round of Fed QE programs. Some were purely reversion to the mean corrections (marked as KC Signals or “too fast”) as traders pushed the price of gold back to its trendline:

Using an oversold/overbought indicator below the main chart and a trend channel, these overbought or too fast rallies are clearly evident, whilst the current price action most resembles the blowoff in November 2009:

A reversion to the lower end of this price channel implies a correction to approx. $1600-1650 USD per ounce over the next 2-3 months. The short term price action is a double top formation, with a closing break below $1800 an ounce indicating the start of a correction.

So, gold looks vulnerable on the back of a run to the $US. Does that spell the end of the bull market? You can expect the usual suspects to pile in and tell you so, even though they’ve been wrong for a decade. But no, it won’t be over. What will follow, or accompany, the fragmentation of Europe will be QE3 (4,5,6 etc). At the same time, if QE3 were to come sooner rather than later it would threaten this forecast.

Anyway, whenever it does come, gold will resume its climb. How high? As high as the monetary and fiscal chaos is long. Much higher, I suspect, than we see it today.