If Greece defaults and the European situation begins to spin out of control where will money flow? It would not make sense for market participants to buy Euro's during a default regardless of whether the default it structured or not. In fact, it is more likely that European central banks and businesses would be looking to either hedge their Euro exposure or convert their cash positions to another currency all together.
Some market pundits would argue that gold and silver would likely benefit and I would not necessarily argue with that logic. However, the physical gold and silver markets are not that large and depending on the breadth of the situation, vast sums of money would be looking for a home. The two most logical places for hot money to target in search of safety would be the U.S. Dollar and U.S. Treasury's.
The U.S. Dollar and U.S. Treasury obligations are both large, liquid markets that could facilitate the kid of demand that would be fostered by an economic event taking place in the Eurozone. My contention is that the U.S. Dollar would rally sharply along with U.S. Treasury's and risk assets would likely selloff as the flight to safety would be in full swing.
To illustrate the point that the U.S. Dollar will likely rally on a European crisis, the chart below illustrates the price performance of the Euro compared to the U.S. Dollar Index. The chart speaks for itself:
Clearly the chart above supports my thesis that if the Euro begins to falter, the U.S. Dollar Index will rally sharply. In the long run I am not bullish on the U.S. Dollar, however in the case of a major event coming out of the Eurozone the Dollar will be one of the prettiest assets, among the ugly fiat currencies.
The first leg of the rally in the U.S. Dollar occurred back in late August. I alerted members and we took a call ratio spread on UUP that produced an 81% return based on risk. I am starting to see a similar type of situation setting up that could be an early indication that the U.S. Dollar is setting up to rally sharply higher in the weeks ahead. The daily chart of the U.S. Dollar Index is shown below:
As can be seen from the chart above, the U.S. Dollar Index has tested the key support level where the rally that began in late August transpired. When an underlying asset has a huge breakout it is quite common to see price come back and test the key breakout level in following weeks or months. We are seeing that situation play out during intraday trade on Friday.
We are coming into one of the most important weeks of the year. Several cycle analysts are mentioning the importance of the October 26th – 28th time frame as a possible turning point. I am not a cycle expert, but what I do know is that we should know more about Europe's situation during that time frame. It would not shock me to see the U.S. Dollar come under pressure and risk assets rally into the October 26th – 28th time frame. However, as long as the U.S. Dollar Index can hold above the key breakout area the bulls will not be in complete control.
If I am right about the U.S. Dollar rallying higher, the impact the rally would have on gold and silver could be extreme. While I think gold would show relative strength during that type of economic scenario, I think both metals would be under pressure if the U.S. Dollar started to surge. In fact, if the Dollar really took off to the upside I think both gold and silver could potentially selloff sharply.
As I am keenly aware, anytime I write something negative about gold and silver my inbox fills up with hate mail. However, if my expectations play out there will be some short term pain in the metals, but the selloff may offer the last buying opportunity before gold goes into its final parabolic stage of this bull market. The weekly chart of gold below illustrates the key support levels that may get tested should the Dollar rally.
For quite some time silver has been showing relative weakness to gold. It is important to consider that should the U.S. Dollar rally, silver will likely underperform gold considerably. The weekly chart of silver is illustrated below with key support areas that may get tested should the Dollar rally:
Clearly there is a significant amount of uncertainty surrounding the future of the Eurozone and the Euro currency. While I do not know for sure when the situation in Europe will come to a head, I think the U.S. Dollar will be a great proxy for traders and investors to monitor regarding the ongoing European debacle.
If the Dollar breaks down below the key support level discussed above, gold and silver will likely start the next leg of the precious metals bull market. However, as long as the U.S. Dollar can hold that key level it is quite possible for gold and silver to probe below recent lows.
Both gold and silver have been rallying for quite some time, but the recent pullback is the most severe drawdown so far. It should not be that difficult to surmise that gold and silver may have more downside ahead of them as a function of working off the long term overbought conditions which occurred during the recent precious metals bull market.
Make no mistake, if the Dollar does rally in coming months risk assets will be under significant selling pressure. While the price action will be painful, those prepared and flush with cash will have an amazing buying opportunity in gold, silver, and the mining complex. Right now, risk remains excruciatingly high as the European bureaucrats wag the market's dog.
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Jordan Roy-Byrne, CMT