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June 13, 2006

Staring into the Abyss
by Roland Watson

The parachutist is confident of the large gaping abyss that is open before him. Though he can only see impenetrable darkness ahead, he is prepared to jump. He is confident that all will be well and that exhilaration rather than death will be his experience. Why is he so confident? Because others have gone before him and assured him that a bottom exists and that a soft landing is assured if handled properly.

Are we talking about the current pullback in gold prices or perhaps the disruption in the equity markets? As you may guess from the picture above, I am talking about the US dollar and the abyss that it currently hovers over. Talk about multiple deficits and central banks overweight with dollar reserves are mainstream talk and in no wise can be called contrarian views. In fact, it is expected that the dollar continues its downward motion to rectify the various imbalances that are present in the world economy.

Does that mean we should offer a contrarian call and declare the end of the dollar bear market? Not quite, but we should make clear what the battle lines are. Back in June of 2005 I said this concerning the dollar rally:

"We have just seen a 3.5-year down move; a 6-month rally constitutes 14% of that which doesn't look long enough to me. A look at historically similar moves suggests perhaps twice that which would draw out our rally to the end of this year or early in 2006."

As it happened the US dollar index rallied to the middle of November before commencing its downward motion. The chart below show the entire rally to date and also shows how gold's price action has generally moved in the opposite direction. The question before us is whether this downward move since November commences the next leg of the dollar bear market or is merely part of a greater corrective pattern?

The entire move since December 2004 is actually a sequence of three wave corrective patterns. I could superimpose several Elliott Wave patterns upon this chart, but there is one thing I would rather focus on today.

That thing is what I would call the Maginot Line of the US Dollar Index. For those not familiar with recent European history, the Maginot Line was a series of fortifications built by the French in the 1930s to prevent a direct assault on France's eastern border by Nazi forces. As it happened, Hitler's forces to the north along the Belgian and Dutch borders easily breached the line with France. For this reason, the Line is often seen as a metaphor for resistance that is ultimately futile. However, the Maginot Line that is arrayed against any assault against the US dollar seems to be a different proposition. To date this line has not been breached since 1978, a period of 28 years.

By way of background knowledge, what is the US Dollar Index? It is a geometric weighted average of the change in six foreign currency exchange rates against the US Dollar relative to March 1973. Those six currencies with their weightings are the Euro (57.6%), the Japanese Yen (13.6%), the British Pound (11.9%), the Canadian Dollar (9.1%), the Swedish Krona (4.2%) and the Swiss Franc (3.6%). Clearly the Euro and the Yen can have the greatest influence on the value of this index.

March 1973 was when the world's major trading nations allowed their currencies to float freely against each other and the index measures the dollar's general value relative to this date which is set to 100.00. A current quote of 86.00 means the dollar's value has fallen 14% against these six other currencies since this base period.

With that introduction, we display the value of the US Dollar Index for the last 30 years (chart courtesy of Nick Laird at Sharelynx). In terms of upward motion, the index has been quite volatile hitting highs of 160 and 120. However, it is a different story on the down side. On no less than five occasions since 1978, the line of Maginot support (see channel "support" below) has been challenged and held firm. Those dates were 1978, 1990, 1992, 1995 and 2004. The most successful assault was 1992 when a brief foray into the high 70s was achieved. All other "attacks" have stumbled at the 80 to 83 region.

Now in early 2006 (see first chart), we have seen a sixth assault on the index touch 83 twice in a matter of weeks before retreating once again. With that withdrawal we have also seen gold and silver enter major corrections. Is this a coincidence? I think not.

Despite the other longer-term fundamentals in favor of gold, this is for now a dollar bear market versus gold bull market. In broad terms, when the dollar goes down, gold goes up. But what is the one thing that will stop the gold bull in its tracks? It is this Dollar Maginot Line, if this is not ultimately breached; the gold bull market is halted in its tracks. In that situation, the best gold could hope for is a replay of 1990 to 1995 when this line was tested three times before gold gave up and a new dollar bull market commenced.

As of today, that line has been tested twice, 2004 and early 2006. If the 1990s is anything to go by, it will be three strikes and "You're out!" for gold if the third assault fails.

So what are the prospects for this Maginot line being finally broken? Firstly, what could see the dollar bull win the day? The answer to that is partly dependent on the Federal Reserve. For two years now, the Fed has raised the overnight rate 16 times from 1% to 5% at the last meeting in May. This has made the dollar more attractive to investors seeking decent returns and the rally in the US Dollar Index since December 2004 is a delayed effect of those interest rates hikes feeding into the US economy and beyond.

Just as the cuts in the short-term interest rate from 6% to 1% were bearish for the US dollar between 2000 and 2003, so these recent increases have proven to be bullish. The question is how bullish? Despite adding 4% to the base rate, the dollar has only recouped at most 20% of its losses since the year 2000. The questions that still remain to be answered in this respect are how long will it take for the full effect of these rate hikes to finally be felt? Secondly, is the Fed finished with rate hikes? The consensus is that Bernanke is concerned about the effects of Peak Oil and its increasing inflationary effects. If he enters full firefighting mode against inflation, we can not only expect higher interest rates and a continuing positive real rate of interest but also recession some time in 2007 or 2008. Both are bearish for gold.

The second factor going for a resumed dollar bull is the recession I just mentioned. Here we mention the ongoing trade, current account and federal deficits that are alleged to trouble the dollar. I say "problem" but actually the evidence here is not so convincing. The actual problem is too many dollars being created; these deficits are merely effects of that underlying cause. The reasoning here is that the decreasing liquidity mentioned above will begin to contract the US economy and reduce the consumer demands for imports. Less imports means a shrinking of the trade and current account deficit (assuming exports shrink less) and perceived confidence in the export power of the dollar returns. Once again, this is bearish for gold - at least until the Fed is forced to revive the economy again with interest rate cuts.

In opposition to these ideas, what could be the events that would plunge the US dollar into the darkness that is below our multi-decade Maginot Line? Going back to the composition of our US Dollar Index, we noted that the Euro and Yen are the two largest components. In other words, if this index is going to drop below 80, the Euro and Yen have to appreciate against the US dollar.

In terms of the Yen, this is almost a certainty. If the expected suppression of the Yen by its own government is about to end, the Yen should gain against the dollar. In fact, the Yen has been tracing out a series of higher lows against the dollar since 1998. There is resistance for the Yen at the 100 level, but if the Bank of Japan's Zero Interest Rate Policy is indeed going to end, then this will assuredly be broken to the detriment of the US Dollar Index.

What about the Euro? With over half of the index weighting, the Euro will have the biggest say in this matter. Once again, the signs are bearish for the dollar. The push to trade crude oil in euros instead of dollars has been gaining momentum in Iran, Venezuela as well as Russia. This will obviously increase demand for euros and decrease demand for dollars and send the US Dollar Index down.

Moreover, some of these petroeuros will find their way into the currency reserves of oil exporting countries. The final question is whether other countries will follow suit and diversify out of dollars? We know they are already, will that continue? If Japan is no longer going to keep the Yen down, they won't be needing all those billions of US dollars they got in exchange for selling Yen. Moreover, if China is going to decelerate the expansion of the Yuan money supply (which has been as high as 24% per annum), they will not be exchanging as many Yuan for US dollars. Assuredly, the central banks of the world are top heavy in dollars and that amount is certain to decrease in the years to come.

So, the battle line is firmly drawn. Will the Maginot Line of 80 hold or will the US dollar bounce around that level for a year or two more before resuming a new bull run?

One thing is for sure, the fate of the gold bull market for this decade depends upon it.

Roland Watson is the author of various reports and the investment newsletter The New Era Investor that can be purchased for an annual subscription of $99. To view a sample copy of the newsletter, please go to www.newerainvestor.com and click on the "View Sample Issue Here" link to the right.

Comments are invited by emailing the author at newerainvestor@yahoo.co.uk.

Roland Watson
http://silveranalyst.blogspot.com

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