After starting the year strong and rallying to trade above $2,100 in early May, the price of gold has been slowly falling. Why has gold been weak over the past four months, and how long can we expect this decline to continue?
Gold is currently trapped in a bear channel (parallel lines), as the yellow metal made a fresh lower-high (LH) last week. Gold recently fell below its key 50-day (blue) and 200-day (red) moving averages, also a bearish signal.
To understand why gold is soft, we need to look at the U.S. dollar. The U.S. Dollar Index ($DXY) has gained about 5% since mid-July, and in the world of currencies, that's a pretty big move.
This week, the dollar index, which measures the U.S. currency vs. a basket that includes the euro, British pound, and Japanese yen, reached its highest level in six months after breaking above its June highs (black dotted line).
Images via TradeStation
It's interesting that just as gold has fallen below its key moving averages, the U.S. Dollar Index has climbed above its 50-day (blue) and 200-day (red) moving averages). This suggests an inverse relationship between the dollar and gold.
Why is the dollar so strong? It's not because the U.S. economy is in great shape; it's because China and Europe are considerably worse.
In June, the People's Bank of China cut two key interest rates by 10-basis points each. In August, one of those rates was cut by an additional 10-basis points.
While the European Central Bank hasn't yet reduced rates, it might have to in the near future. At least that's the impression I get from Europe's recent PMI (purchasing manager index) reports.
In a PMI report, any reading below 50 indicates contraction. Here is the most recent set of manufacturing PMI results from Europe:
That German manufacturing PMI reading of 39.1 is particularly disturbing, since that country has the largest economy in Europe. German manufacturing is critical to its export economy, producing automobiles (Volkswagen, BMW, Mercedes-Benz) and high-end medical devices (Siemens).
Europe's services PMI reports were better, but still indicated contraction:
You might be wondering, what's the bright side to this equation?
First, gold should find solid support around $1,915. So, while a deeper pullback is likely, there is technical support nearby.
Second, the U.S. dollar rally will eventually become a victim of its own success.
As the dollar rises, U.S. products become less attractive to overseas buyers, pushing them toward companies in Europe and China. As a result, U.S. exporters will see fewer orders, causing the dollar to soften. When that happens, gold should rally.
