The New Gold/US Dollar Relationship

09/22/2011 6:00 am EST

Focus: FOREX

It remains to be seen whether gold can reverse recent weakness in the face of new dollar strength, and the reaction to the latest Fed announcement is likely to play a factor as well.

As many readers may already know, I expected the dollar index to put in a major three-year cycle low sometime this year. The normal timing band would have been for a bottom in the spring. The recent breakout and move to new highs has confirmed that the May bottom did in fact mark the three-year cycle low.

As expected, that also marked the top of the cyclical bull market in stocks.

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It was widely expected that the Fed would announce “Operation Twist” at yesterday’s Federal Open Market Committee (FOMC) meeting. Obviously, if printing several trillion dollars didn’t save the economy, then rotating the Fed’s balance sheet from short-term interest rates to long term in the attempt to hold down the long end of the yield curve isn’t going to have any effect at all as the approaching recession intensifies. Interest rates are already at historic lows. 

Interest rates aren’t the reason why people are not borrowing. With continued high unemployment, there simply isn’t enough demand for businesses to expand their operations. The American consumer is so deeply in debt that he can’t service it. Unfortunately, consumers can’t print money like the US government so it doesn’t help us to go deeper into debt. The US consumer will not be borrowing money anytime soon.

The bottom line is that Operation Twist will be a miserable failure just like QE1 and QE2.

NEXT: New Cycle Lows Ahead for Gold and Stocks

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The stock market and gold are now moving into the timing band for the next daily cycle low (selling event). The only question now is whether the announcement of Operation Twist yesterday afternoon will initiate a short-term knee-jerk reaction higher, or whether the market will immediately continue to sell off into that next cycle low that is due to bottom sometime in the next 11 days.

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I expect gold to bottom a little sooner, as its daily cycle tends to be slightly shorter.

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But gold also is at a critical stage. It must hold above the prior daily cycle low of $1705. If it fails to do so, it will signal that an intermediate-degree decline has begun. It would also signal a left-translated intermediate cycle, which would have high odds of moving below the prior intermediate degree bottom of $1478.

As you can see in the chart below, gold began to struggle just as soon as the aggressive stage of the dollar rally began.

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As the stock market moves down into the next daily cycle low and the selling pressure intensifies, this should drive the dollar index much higher. It remains to be seen if gold can reverse this pattern of weakness in the face of dollar strength, especially since the dollar will almost certainly be rallying violently during the intense selling pressure that is coming in the stock market.

All we can do now is wait to see what the initial reaction to Operation Twist will be in the next few days. Will there be a temporary knee-jerk rally that quickly fails, or will the market just continue down after a shaky week? We shall see.

By Toby Connor of Gold Scents

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