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Dollar's contradictions call for caution
Date: 2010/12/27 Click: 988
With the United States¡¯ debt now slightly higher than GDP, long-term market view is getting riskier.

The release of the latest US economic data reveals a significant change in the balance of the economy. The third-quarter figures show a growth of 2.6 percent, and this cheered the Dow Jones to new highs. But a look behind the headline growth shows a more disturbing picture. Calculated on an accrual basis, the level of US debt is now slightly higher than the nation's GDP. In broad terms, this means that the entire annual GDP would be needed to pay off US debt, a debt-to-GDP ratio beside which the European debt problems pale to insignificance.

It creates a contradiction between market behavior and economic analysis. Many analysts, particularly in Europe, believe the high debt-to-GDP ratio should weaken the US dollar. As a result, the market for gold is bullish, with investors turning to it as a currency hedge against fiat currencies. Additionally, the dollar's weakness is bullish for commodity prices, which in turn helps develop inflationary pressures. Add to this mix the US' quantitative easing and injection of printed money into its economy, and some analysts see a recipe for significant problems.

There are many contradictions between the expected price behavior and actual price behavior, and when these appear, caution is suggested.

Commodity prices are rising. Copper is reaching all-time highs. Soft commodities are moving steadily upward and putting inflationary pressure on food prices. Oil has hit new two-year highs and has the potential to move toward $100 a barrel. All of this activity suggests a weaker US dollar.

And here is the most significant contradiction. The US Dollar Index trend shows a strong dollar. The index's downtrend was broken on Nov 15 when it rose above $0.78. The initial reversal had the characteristics of a rally with a fast rise to $0.815. The retreat from $0.815 to $0.795 was an important test of the developing uptrend. The index tested support several times near $0.795 before a successful rebound and continuation of the rising trend.

Full confirmation of the strength of the dollar index's uptrend comes with a successful breakout above resistance near $0.815. This gives an initial upper target near $0.83 - the value of the target is less important than the trend it signals. This behavior confirms strong uptrend pressure on the dollar, the exact opposite of the economic analysis, which concludes the US dollar will weaken.

A strengthening US dollar translates into a weakening gold price. Unlike other commodity markets, the gold price has confirmed the dollar's developing uptrend. The long-term uptrend line on the gold chart was broken on Nov 16, 2010. Over the past six weeks, this uptrend line has acted as a resistance level. There was one successful breakout above the line, but the price spike to $1,420 was a temporary reaction to the tensions on the Korean Peninsula. The gold price moved up to the value of the trend line and then retreated. Gold has tested support in the $1,380 area.

The chart analysis shows the increasing strength of the US dollar is bearish for gold and ultimately for commodity prices.

It is difficult to effectively explain these contradictions in market price behavior. This is something we can leave to later historians to resolve. For investors, it is important to identify the contradictions and develop investment strategies that use a more cautious approach to the opportunities. A strengthening US dollar will eventually take the heat out of commodity market price rises, so protecting profits becomes important. A strengthening US dollar has a negative effect on the underlying uptrend in gold, so investors may start to exit these positions, or develop hedging strategies using short trading.

The year 2010 ends with a high degree of market confusion, as price and trend activity seem counterintuitive. This provides good short term trading opportunities but carries increased risk for those who are committed to long-term investment views of the market direction.

The author is a well-known international financial technical analysis expert.
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