Gold Bulls Back To Square One

Summary

• A revival of dollar strength is capping gold's upside potential.

• Safe-haven demand is still supportive for gold, however.

• Until dollar weakens substantially, expect range-bound gold price.

The bulls have worked hard since August to establish an intermediate-term bottom for gold. While they have largely succeeded in doing so, there is a reason for their failure to take advantage of record short interest and launch gold to higher levels. That reason is the strong U.S. dollar, which continues to plague the yellow metal by undermining its currency component. In today’s comments, we’ll see why the gold bulls once again have their backs to the wall as the dollar is strengthening again. I’ll explain why although gold should continue to benefit from global equity market weakness, the strong dollar will act as a headwind on meaningful gains for the gold price.

In the latest session there was at least some evidence that safety-related demand is still a supporting factor for gold. The gold price firmed on Thursday as weakness in the global equity market stimulated some safety-related buying late in the session. Gold’s latest rally, however, was offset somewhat by a stronger U.S. dollar index. The dollar strengthened after the release of the Federal Reserve’s September policy meeting which indicated that Fed members favor continued interest rate increases in the coming months. Spot gold rose 0.1 percent to close at $1,223, near a 2 ½-month high. December gold futures closed down 0.1 percent at $1,229.

Source: BigCharts

Short covering has also been in evidence as the recent pullback in the dollar index has spooked gold bears. Gold short interest rose to record levels late this summer, and the metal’s refusal to decline further since then is clearly a cause for nervousness among the short sellers. Additional weakness in the dollar, which serves to strengthen gold’s currency component, would almost certainly serve as a catalyst for additional short covering and add to gold’s upside pressure.

There is also some near-term support for gold on the ETF front. Holdings of the SPDR Gold Shares (GLD) have increased more than 2 percent in the last two weeks, according to recent data. After months of net outflows, gold-backed funds are once again seeing demand among retail and institutional investors. On top of the recent increase in safe-haven demand, gold’s plunge this summer to its lowest levels since 2016 has also galvanized value buying among bargain conscious investors. When gold investment demand rises in the wake of high short interest levels, it can become self-fulfilling in terms of pushing prices higher.

Before this set of circumstances works in gold’s favor, however, there is a major obstacle that must be completely removed. That obstacle is of course the stubborn strength of the U.S. dollar index (DXY) which has worked against the gold price for most of this year. Here is what the dollar index looks like as of Thursday. As you can see here, DXY is back above its 15-day moving average on a 2-day closing basis. Assuming DXY doesn’t close Friday’s session below the 95.65 level (the Oct. 17 pivotal high), the dollar index will have confirmed an immediate-term (1-4 week) breakout signal based on the rules of my trading discipline.

Source: BigCharts

The dollar index is also back above its widely followed 50-day moving average, which also carries technical as well as psychological significance. Whenever the dollar index is above the upward-trending 50-day MA, it can’t help but embolden the dollar bulls to make a charge at regaining their control over the dollar’s short-term trend. Their control over the dollar was temporarily surrendered to the dollar bears last month when DXY fell to the 94.00 level and decisively penetrated below the 50-day trend line for the first time in months. As the above graph shows, though, the dollar bulls aren’t ready yet to give up the ghost.

The refusal of the dollar to significantly weaken on a sustained basis will likely keep gold prices range-bound and prevent a major short-covering rally from happening in the immediate term. A break decisively below the 95.00 level in the dollar index - which is DXY’s nearest pivotal low - would give the gold bulls a decided advantage and allow for a gold rally. But as long as DXY remains above 95.00 and the 50-day moving average, the gold bulls will have to be satisfied with just keeping the gold price above the August low.

As I alluded to previously, the reason why gold isn’t manifesting greater weakness right now in the face of a stronger dollar is the extreme weakness in the global equity market. Shown here is the iShares MSCI Emerging Markets ETF (EEM), which is threatening to make a new yearly low. Additional weakness in the world’s major stock markets should at least bolster gold’s safe-haven demand enough to keep the metal’s price above the psychological $1,200 level. It’s questionable, though, that safe-haven demand alone can push gold prices significantly higher while the dollar is strengthening.

Source: BigCharts

In the final analysis, there is still enough evidence to justify a certain level of optimism for gold in the coming months. High short interest levels, increased ETF inflows, and the recently-established higher low and higher high in the gold price itself are all supporting factors for additional gains in the coming weeks. Selling pressure in the U.S. and global equity markets is also favorable for gold’s safety component. However, as long as the U.S. dollar index continues to strengthen, gold’s upside potential will be limited. Therefore, until the dollar shows significant weakness, the gold bulls aren’t justified in assuming substantially higher prices lie ahead for the metal in the immediate term.

On a strategic note, the iShares Gold Trust (IAU), my favorite gold trading vehicle, recently confirmed a technical breakout by closing above the pivotal $11.60 level and is back above its rising 15-day moving average. This put me back on an immediate-term buy signal for IAU, where I remain despite the latest dollar index rally. I suggest watching the $11.37 level (the Aug. 23 closing low) closely from here, as this is my recommended initial stop-loss (intraday basis) for this trading position. A violation of $11.37 would put me back on the sidelines for the immediate term.

Disclosure: I am/we are long IAU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

*********