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Written by Sumit Roy  |

December 13, 2011

Precious Metals Monitor: US Dollar On Cusp Of Bullish Spike: What It Means For Gold

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Upside momentum is picking up in U.S. dollar, as it hits an 11-month high. What are the implications for gold?

It was a negative week for gold, as the metal plunged back below $1700, falling into the mid-$1600s area, which puts it at the lowest levels since October. Prices now have a clear path toward the $1600 level, where the first key level of support lies.

Unsurprisingly, the eurozone sovereign debt crisis continues to simmer in the background. While last Friday's EU Summit was a victory for the likes of Germany —a key advocate for stronger fiscal integration between member countries — it did little to address the immediate default fears that have been spooking markets.

Of the 27 countries in the European Union, 23 have agreed to a new treaty that calls for stricter budget discipline from members. All 17 countries that use the euro currency (the eurozone) signed onto the deal.

The new treaty will require mandatory balanced budgets from member countries. Members that have deficits exceeding 3 percent will be hit with sanctions.

Additionally, each country must submit its national budget to the European Commission. The intergovernmental body will have the power to request revisions to budgets, but cannot outright reject them.

While Germany and France succeeded in accomplishing much of what they wanted to achieve at this latest summit, it was far from a grand solution to the eurozone sovereign debt crisis. The new treaty won't be officially written for months, and it will take even more months for each individual country to ratify it.

The immediate concern remains the risk of default in Italy and Spain. Markets are thus hoping for aid from either the European Central Bank or the International Monetary Fund.

To that end, European nations will lend the IMF €200 billion ($261 billion) — significantly enhancing the fund's $390 billion of currently available capital — so the IMF can better provide support for struggling eurozone nations.

Critically, however, the ECB downplayed speculation that it would purchase sovereign bonds more aggressively than it has. Disappointed by the lack of action from the central bank, Italian and Spanish interest rates bounced aggressively off recent lows.

Italian and Spanish 10-year bond yields were last trading near 6.69 percent and 5.7 percent, respectively. However, that still leaves them below the respective euro-era records of 7.47 percent and 6.78 percent that were set just weeks ago.

Interestingly, the ECB only purchased €635 million worth of sovereign bonds last week — the smallest amount by far since it resumed its securities market purchase program back in August.

Perhaps the central bank wanted to send a clear message to markets that it was not planning on upping its purchases dramatically.

The lack of action from the ECB has been interpreted as bearish for gold in the short term. Some speculated that the central bank would unveil a quantitative easing program like those in the U.S. and U.K., but those hopes have been dashed following ECB President Mario Draghi’s latest comments.

The other significant development over the past week was the U.S. dollar, particularly the exchange rate between the greenback and the euro currency.

We now see the U.S. Dollar Index above 80 and at the highest levels in 11 months. Similarly, the EUR/USD — the largest component of the index — is just above 1.30, putting it at the lowest levels in 11 months.

The 1.30 level is a key support level for the exchange rate, with a break exposing much lower levels, such as the 1.1877 level hit in June 2010, when the woes of Greece first caught the attention of markets.

Though there have been exceptions, strength in the U.S. dollar has usually been bearish for gold. Currently, we are in a period where the exception is not the rule. Indeed, the correlation between gold and the U.S. Dollar Index has been -0.72 over the past month and -0.94 over the past two weeks. Both are strong negative correlations, indicating that gold has been falling when the dollar has been rising (and vice versa).