The good professor puts forth a few points that supports the theory that the USD is entering a much more pronounced downleg.

Its a shame - VHF

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The Beginning of a Currency Crisis?

Lance Lewis

October 21, 2009 11:20 am

The “race to debase” went into high gear yesterday. First, Brazil imposed a tax on foreign investment to try and stem the real’s climb. Second, the Bank of Canada warned that the strong Loonie could offset the favorable economic developments since July. Third, the EU whined about the strong euro and complained that the US was “flooding the world” with dollars and creating dollar weakness that was “unbearable.”

So, basically we’re seeing the dollar’s weakness begin to turn from a global positive to more of a concern -- or to put it differently, the “dollar crisis” may slowly be getting recognized for what it is.

Unfortunately, much like the 2008 collapse of the US financial system, there’s not a whole lot that anyone can do about that dollar weakness. And as other central banks are eventually forced to try to intervene and print their own currency or raise capital barriers (like Brazil), it’s going to favor gold more and more in all currencies regardless of what the dollar is doing.

With that said, the action in the gold stocks versus both gold and silver was a little odd yesterday. The dollar was firmer, which had both gold and gold stocks under pressure, but the gold stocks were far heavier, with the GDX actually making a new low for the move since the recent peak on October 14.

We’ve seen this action before though. In fact, we’ve seen it a couple times over the past two months where the gold stocks appeared to be far heavier than the metal on days that the dollar bounced. In each instance, a substantial rally then kicked off within a day or two (see the following chart of the dollar index, the GDX, and gold).


Click to enlarge

The most recent instance of this action in early October also interestingly produced a divergence exactly like yesterday’s in which the GDX took out its lows for the recent correction while gold didn't (see the chart).

In years past, this sort of divergence typically would have been bearish, but increasingly of late, I’ve found that it ironically kicks off rallies.

We obviously can’t really know what exactly is going on here, but my suspicion is that we’re seeing shorts in the gold stocks (which we know are already pretty heavily positioned in the gold stocks given the record short interest in the GDX) reacting to the moves in the dollar even though gold is increasingly shaking off those bounces in the dollar.

Instead, gold is tending to rally more and more in all currencies, regardless of the dollar’s day-to-day motion. When gold then rallies sharply a day or two later, these shorts in the gold stocks are caught off guard and are being squeezed (not to mention the fact that the dollar index tends to slide to new lows shortly thereafter as well).

Will this pattern repeat again and lead to a rally in the next couple days? We obviously can’t know one way or the other, but the downside at present in gold and the gold stocks seems pretty small even if this pattern doesn’t repeat.

With gold being not all that extended in the short-term on the charts, it’s difficult to see any potential pullback going much below the old all-time high of $1033, especially when there are so many buyers underneath hoping to buy a dip (such as ABX, the Indians, and investors in general that got left behind in by the speed of the rally since September).

The GDX probably doesn’t have much downside risk beyond filling its gap from early October and sliding to around 45.

Thus, the “risk” in my mind clearly remains to the upside and not to the downside in the gold complex, especially if we're now moving on to a whole new leg of the “dollar crisis” in which all fiat currencies become more and more suspect in investors’ eyes. Obviously, such an environment would clearly favor gold as the ultimate refuge during such a currency crisis.

Putting the day-to-day chart machinations aside, yesterday may have been important from a much larger perspective given the rhetoric out of the EU and the BOC, and especially the fact that Brazil imposed capital controls.

It suggests that the dollar’s decline may be entering a whole new phase that's increasingly less and less of a gentle glide and more and more of a potential crashette.

If so, then other central banks are going to increasingly feel pressure to try and weaken their own currencies in an attempt to stabilize the dollar, and that means other fiat currencies are going to become increasingly suspect, too, versus gold and many commodities.

After all, what we're watching isn't a “weak dollar trade” anymore than “short financials” was just a trade in 2008. This is the beginning of a currency crisis, and the dollar is at the center of the storm.