Gold, the Dollar, and the Euro

Written By Brian Hicks

Posted May 18, 2010

So much for the “shock and awe” of the $1 trillion European bailout….

A mere eight trading sessions removed from the “flash crash,” the markets are as volatile as ever as the euro tanks, the dollar screams higher, and gold reaches new highs.

In fact after posting a 1165-point relief rally off of the May 6th lows, the markets have quickly reached a moment of truth where the next few sessions will be absolutely critical as to where we head from here.

The same could be said for the European Union…

Faced with the economic equivalent of WWIII, the EU is on the brink of unraveling completely as its monetary Maginot Line fails to inspire confidence… and with it, the euro shrivels like so many raisins in the sun.

And while most market pundits would like to be able to tell you with certainty which side of the net the EU itself will land, the truth of the matter is that the ball is still in the air — for now, at least.

Even European Central Bank (ECB) head Jean-Claude Trichet admits, “We’ve bought time, nothing more” as “extreme tensions” rock the Eurozone.

The Euro and the Price of Gold

The latest market action carries with it a growing sense of unease along with a certain feeling of familiarity.

Not long ago it was the U.S. dollar that was deemed “worthless” — today that’s what’s being said about the euro, as Greece burns and other member states begin to wonder why they signed up for this gig.

That has put unrelenting pressure on the currency driving it beyond levels last seen during “The 2008 Crash.”

Take a look:

Meanwhile, the flip side of that trade has been three-fold thus far.

One is a bounce in the price of gold and other precious metals that my pal Adam Sharp discussed yesterday. Due to the failing confidence in the euro, Adam believes the case for gold is getting stronger every day.

What’s more, he says, “Gold is not close to done yet. If this were a baseball game, I’d say we’re in the third inning.”

That leaves plenty of upside from here — especially since the next stop for the euro could be as low as $1.14 after falling through resistance yesterday at $1.24.

Absent gold, going long the ProShares UltraShort Euro (NYSE: EUO) is another way to play it while speculating on even more tension in the Eurozone.

The Chinese Piece of the Euro Puzzle

The second piece of the falling euro puzzle is the benefit it provides to the U.S. Dollar Index. As the euro plummets, the greenback rockets higher, since the euro makes up 57.6% of the weighted index.

The “flight to safety” affect only adds to these gains, making the dollar stronger with every drop.

And while that is good news for dollar bulls (NYSE: UUP), there is a third effect with consequences for Chinese markets, since the yuan is still pegged to the greenback.

As the dollar rises, so does the yuan — making Chinese goods less competitive in Europe, their largest export market.

In fact the yuan has risen about 14.5% versus the euro over the last four months. This in turn prompted the Commerce Ministry to warn Monday that China’s exports could be threatened.

Unfortunately, this all comes at a time when the Chinese property bubble is about ready to burst, and rumors of aggressive Chinese monetary measures are a daily occurrence.

As a result, the Shanghai Composite has slipped even further into bear-market territory, losing a 5.1% in big sell-off just yesterday.

This marked the biggest drop since August and the lowest close in more than a year; only 18 of the 911 stocks in the index rose.

Prior to the drop, the Shanghai Composite had been up over 80% for the year. Sound familiar?

Take a look:

This all has left U.S. investors with an increasingly dicey situation — especially since the technicals on the Shanghai point to a 2100 target if the current head-and-shoulders pattern plays out…

That’s the other side of the coin where both of them are bad — unless you’re long the ProShares UltraShort FTSE/ Xinhia China (NYSE: FXP). Its share price goes up as Chinese markets go down.

Either way, both of these falling markets are at work, adding new volatility to the American exchanges — Europe on one side and China on the other.

After all, markets thrive on stability — not gigantic question marks.

So, as I wrote earlier, we are at the make-or-break point here, but now leaning bearish as we keep our eye on Dow 10,400 at first followed after that by the 10,000 mark.

Those are the levels that need to hold over the course of the next few weeks…. Otherwise, it’s headed lower from here.

The bottom line is that investors need to take a cautious approach these days. As I said in my 2010 Stock Market Outlook, the first half was likely going to be much better than the second.

With June just around the corner and the EU fading fast, things have suddenly gotten interesting again — especially when it comes to gold.

Your bargain-hunting analyst,

steve sig

Steve Christ
Editor, Wealth Daily

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