Gold's strength to dollar increases upside potential

The two great global currencies – the US dollar and gold – have moved in opposite directions for quite sometime, with the precious metal emerging as a clear winner since 2000.

The future contract of gold (YG), which trades on the Chicago Mercantile Exchange, has shown no signs of retreating from its bull run.

The dollar index, on the other hand, fell from 2002 to late 2004 and has since been moving in a range of 70 to 90 ever since. The dollar index measures the US currency against a basket of six major currencies, which include euro, yen, British pound, Canadian dollar, Swiss franc and Swedish krona. The continued rally in gold, despite a range-bound movement in the dollar, shows that the yellow metal carries relative strength.

Gold traders always keep an eye on the dollar as the two have been inversely related. From a fundamental point of view, the value of a currency increases when there is less supply of it. As the US government debases the dollar and resorts to quantitative easing (a politically correct term for printing money), its supply has increased substantially. Gold supply, too, has increased due to mining, but not at the pace of the dollar.

The relatively larger supply of dollar versus gold has led to a rally in the precious metal.

An analysis of the charts shows that the rally in gold continues to be strong. Gold made a high of $1,080 in March 2008, the same time the dollar index made a low of 70.50. A subsequent rally in the dollar led to a sell-off in gold, which clearly showed the inverse relationship of the two currencies in play. Then the dollar peaked near 90 in March 2009, but gold had already begun to rally in October 2008, indicating its relative strength to the greenback. Then comes the interesting part. In November 2009, the dollar bottomed at 74 and rallied without making a new low. Gold, on the other hand, broke out of its previous high of  $1,080, to make a new high.

The subsequent rally in the US currency resulted in a small sell-off in gold, after which the precious metal continued to make new highs. In the recent past, every strong rally in the dollar results in a progressively weaker sell-off in gold. And a sell-off in the dollar leads to a new high in gold.

The strength of the precious metal is clear. However, markets – being markets – can reverse at any time.

Hence, a rally in the dollar index above 92 should give pause to gold bulls. Our price projection tools forecast gold to rally up to $1,370 initially, after which it can go all the way to $1,575.

Remember that, apart from supply and demand, another fundamental factor that drives the value of a currency is trust. The markets understand that it’s very easy to debase a fiat currency like the dollar.

Gold, on the other hand, is beyond the scope of manipulation by the central banks and politicians of the world.

The author is editor of www.capturetrends.com and based in Chicago