Dollar Gravity On Precious Metals

Earlier today I decided to exit a long campaign on gold which I only had initiated late last week, and which on the surface looked like a perfectly good reversal candidate. As you know I rarely interfere with open campaigns and I’d like to share my reasons.Technically speaking we are sitting on prospective long term support levels, so what gives?

First of all there are short term considerations: Momentum is lacking after a considerable drop to the downside and realized volatility is still in the process of normalizing. The odds of a jump here and now ahead of the contract roll over is pretty slim given that we are heading into the Thanksgiving weekend. So I could just exit here and then enter long again next week once we rolled into the February contract, right?

Well, not really. Let’s talk about Dollar gravity, which is a factor more apparent on the Forex side but obviously it does play a significant role across all market verticals and in particular on the future side. As you can see above the Dollar just completed a series of 10 consecutive higher closes and only yesterday dropped back after touching the 101.4 mark. It would be fool hearted to proclaim an immediate top here and now as currencies often exhibit excess kurtosis which is a fancy way of saying that they have a tendency to run far beyond your most conservative stops and then some.

Now with that in mind let’s talk about Dollar gravity which I have attempted to visualize by showing you a GOLD:USD ratio (in blue) on top of just the continuous gold futures contract (in green). What you may notice is that the ratio has been dropping below gold over the past few years which means that gold in relation to Dollar strength is weaker than gold on its own.

I know this can be a bit confusing as futures contracts after all are quoted in Dollars, right? But recall that the Dollar index represents the strength of the Dollar in relation to other currencies. And if the Dollar strengthens then it obviously will impose a drag on commodities (as well as stocks) as you require less Dollars to buy the same amount.

What I find interesting is that the ratio and the futures seem to have been in relative sync during the heydays of the goldbugs, which means from about 2005 into mid 2011. After that the Dollar goes through quite a few cycles as you may recall but apparently the ratio continues to trade below the futures price ever since. And starting about in late 2014 we are seeing an expansion of that delta as the Dollar gains in strength. Thus it seems that until the futures contract catches up with ratio gold is going to continue being difficult to trade on the long side, and in especially right now.

Clearly correlation charts are difficult to interpret as it always depends on the baseline, meaning where you start correlating the two. But even if you shift the two series against each other it seems clear that Dollar gravity does seem to affect gold on a long term basis.

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