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Will the Rising U.S. Dollar Derail the Rally in Gold? (GLD)

All signs point to continued dollar strength - which is bad news for gold

gold prices gld u.s. dollar

Investors in gold and gold stocks finally have something to cheer about. After suffering horrific performance in 2013, both categories have bounced back strongly on a year-to-date basis.

Still, this is no time to be complacent. The U.S. dollar is rallying, and the fundamentals indicate that this move can continue. If it does, the rally in gold prices could prove to be yet another head-fake.

Already, the recent strength in the dollar has begun to take a toll. Through the first six months of the year, the modest downtrend in the greenback provided a nice tailwind for gold. Based on the performance of the PowerShares DB US Dollar Index Bullish Fund (UUP) — which tracks the performance of the U.S. dollar against a basket of six developed-market currencies — the dollar slipped 1.2% in the first half of 2014. During that same interval, the SPDR Gold Shares (GLD) gained 10.3%, while the Market Vectors Gold Miners ETF (GDX) rose 25.2%.

In July, however, it has been a much different story.

The dollar has rallied behind signs of slower European growth, propelling UUP to a gain of 1.9% — a substantial move for a major currency in such a short period of time. Not coincidentally, the rally in gold has stalled. GLD has fallen 2.2% month-to-date through July 29. GDX, for its part, has still managed a gain of 1.2%, but the movement has largely been sideways after a strong gain of nearly 7% in June.

GLD, GDX, and UUP Year-to-Date

GLD, GDX and UUP year-to-date chart

This type of negative correlation is nothing new. Since gold is priced in U.S. dollars, a rising dollar makes the yellow metal less expensive for foreign buyers, and vice versa. This is reflected in the numbers: In the past seven years, UUP and GLD have a strong negative correlation of -0.65.

Keep in mind, correlation runs on a scale from -1.0 (perfectly negative correlation) to 1.0 (perfectly positive). In an era of higher correlations among asset classes, this -0.65 number stands out.

None of this matters, of course, if the recent strength in the U.S. dollar proves short-lived. And the greenback might indeed be due for a breather after such a strong month.

However, there are two reasons to believe that the July rally could be just the beginning of a longer-term uptrend.

First, U.S. growth — while certainly nothing to write home about — remains superior to that of both Japan and continental Europe. The shift of European growth trends into positive territory late last year fueled a great deal of optimism that the recession was over, sparking a rally in stocks, bonds and the euro alike.

More recently, a string of worse-than-expected economic data has led investors to sober up and realize that the region’s structural issues remain a massive impediment to growth. If Europe continues to disappoint — and there’s no reason to believe that it won’t — the U.S. dollar should retain its upward bias against the euro.

The chart of the CurrencyShares Euro Trust ETF (FXE) below shows that the recent weakness in the common currency has already caused it to break below a two-year trendline.

FXE, 3-Year Chart

FXE, three-year chart

Second, the U.S. is tightening monetary policy via tapering and the start of rate increases in 2015. Conversely, both Europe and Japan are ramping up monetary stimulus. This wide gap in the direction of monetary policy among the three major regions hasn’t fed through to the currency markets just yet, but it represents an important, longer-term pillar of support for the U.S. dollar.

Investors in GLD and gold stocks should take note. It has already been a strong year for this formerly downtrodden market segment, but the dollar rally of the past month shows that the tide may be turning once again.

Stay focused on the currency markets, and be ready to take profits if GLD slips much further from here.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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