Dollar Rally to Spur Selloff in Gold

10/26/2011 7:00 am EST

Focus: FOREX

A new flight to safety is likely to see assets flooding into the US dollar and Treasuries, an event that would hit risk assets like gold and silver quite hard, sparking a potentially nasty selloff in the metals.

If Greece defaults and the European situation begins to spin out of control, where will money flow? It would not make sense for market participants to buy euro during a default regardless of whether the default it structured or not.

In fact, it is more likely that European central banks and businesses would be looking to either hedge their euro exposure or convert their cash positions to another currency altogether.

Some market pundits would argue that gold and silver would likely benefit, and I would not necessarily argue with that logic. However, the physical gold and silver markets are not that large, and depending on the breadth of the situation, vast sums of money would be looking for a home.

The two most logical places for hot money to target in search of safety would be the US dollar and US Treasuries.

The US dollar and US Treasury obligations are both large, liquid markets that could facilitate the kind of demand that would be fostered by an economic event taking place in the Eurozone. My contention is that the US dollar would rally sharply along with US Treasuries, and risk assets would likely sell off as the flight to safety would be in full swing.

See related: “Risk-on” and “Risk-off” Currencies

To illustrate the point that the US dollar will likely rally on a European crisis, the chart below illustrates the price performance of the euro compared to the US dollar index. The chart speaks for itself:

chart
Click to Enlarge

Clearly, the chart above supports my thesis that if the euro begins to falter, the US dollar index will rally sharply. In the long run, I am not bullish on the US dollar, however, in the case of a major event coming out of the Eurozone, the dollar will be one of the prettiest assets among the ugly fiat currencies.

See related: Be Ready for Major Euro Event

NEXT: The Early Indication of a Coming US Dollar Rally

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The first leg of the rally in the US dollar occurred back in late August. I took a call ratio spread on the Powershares DB US Dollar Index Bullish Fund (UUP) that produced an 81% return based on risk.

I am starting to see a similar type of situation setting up that could be an early indication that the US dollar is setting up to rally sharply higher in the weeks ahead. The daily chart of the US dollar index is shown below:

chart
Click to Enlarge

As can be seen from the chart above, the US dollar index has tested the key support level where the rally that began in late August transpired. When an underlying asset has a huge breakout, it is quite common to see price come back and test the key breakout level in following weeks or months. We were seeing that situation play out during intraday trading on Friday (Oct. 21).

We are trading in one of the most important weeks of the year. Several cycle analysts are mentioning the importance of the October 26-28 time frame as a possible turning point.

I am not a cycle expert, but what I do know is that we should know more about Europe’s situation during that time frame. It would not shock me to see the US dollar come under pressure and risk assets rally into the October 26-28 time frame. However, as long as the US dollar index can hold above the key breakout area, the bulls will not be in complete control.

If I am right about the US dollar rallying higher, the impact the rally would have on gold and silver could be extreme. While I think gold would show relative strength during that type of economic scenario, I think both metals would be under pressure if the US dollar started to surge. In fact, if the dollar really took off to the upside, I think both gold and silver could potentially sell off sharply.

By JW Jones of Options Trading Signals

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