Euro Gold Challenges E350

By: Adam Hamilton | Fri, Apr 2, 2004
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With the European Central Bank meeting this week, Europe was very much in the financial-news spotlight. The ECB's decision to sit tight on interest rates at 2% for the tenth straight month proved to be a bit anticlimactic, but it is still always interesting from an American perspective to hear financial tidings from Europe.

While it can be amusing watching central bankers agonize about just how much to actively manipulate short rates, like they are the wizards of Oz, a far more important financial event was unfolding in Europe behind the headlines. Euro gold, gold denominated in the euro currency, is on the verge of breaking out to new all-time highs!

Having been born and raised in the States myself, I have always deeply admired the strong cultural European affinity for the Ancient Metal of Kings. Unlike Americans who tend to believe that governments and paper money last forever, the Europeans remember enough history to know that governments and empires are short-lived in the grand scheme of things and paper money always eventually returns to its intrinsic value, zero.

I realize that many younger Europeans know as little about gold as your average young American, basically nothing beyond its use in nose rings and wedding bands, but the savvy European investors with more than a few decades under their belts never lost their strong affection for the noble metal. As such, I have long waited for the glorious day when European investors join our young gold bull en masse, bringing their enormous pool of capital to the table.

The primary stumbling stone that has been troubling Europeans on gold, as I discussed late last year in "Gold in Euros and Yen 2", is the fact that gold in euros has not really been in a bull market at all. Europeans know exactly what I am talking about, but most Americans who hear this are quite puzzled. We Americans have grown up in a dollar-dominated world and scarcely have the ability to think outside the dollar box.

In the usual dollar terms, the gold bull has soared from around $257 in April 2001 to $427 today, an incredibly impressive 66% bull-to-date gain! We are all very familiar with the long-term dollar gold charts highlighting the greatest gold bull in decades. But what we Americans tend to forget is that much of this gold bull has been driven by a bear market in the fiat dollar.

As the long-term dollar charts reveal, the mirror-image foundation undergirding the gold strength has been dollar weakness. While certainly not perfectly negatively correlated on a day-to-day basis, the major uptrend in gold and the primary downtrend in the dollar rhyme remarkably well on a strategic scale.

The same chart we Americans proudly call a gold bull can just as easily be called a dollar bear. Gold is the ultimate form of money, steadfastly immune to all but the very shortest term machinations by central bankers. Unlike paper money, central banks cannot create gold out of thin air, nor can they achieve an international monopoly in issuing it like some random national currency.

Indeed, any local-currency gold price is nothing more than the exchange rate between that currency and gold. If it takes $425 to buy an ounce of gold this afternoon, this is the dollar/gold forex rate. This exchange rate fluctuates based on supply and demand trends in both the fiat dollar and gold itself.

While the local-currency exchange rate for gold has been rising in the States, in Europe the euro/gold forex rate has been radically different from what we have seen in the dollar. As our first chart this week illustrates, euro gold has been trapped in a massive trading range for years now, meandering between €300 support and €350 resistance.

It is no wonder that European investors see the gold bull vastly different than we Americans. While we view it as the value of gold increasing over time, Europeans view it as the value of the dollar decreasing over time. In the New World we concentrate on the gold denominator of the dollar/gold exchange rate, while in the Old World the focus remains on the devaluing numerator. Two sides of the same gold coin.

The gold bull to date viewed through the eyes of Europeans certainly does not look very impressive. Euro gold first challenged €350 in February 2002, over two years ago, and has tried several times since to break out to new highs. All have been unsuccessful so far. While Americans revel in a fantastic dollar gold bull, the Europeans remain rightfully skeptical as all they see is a lackluster trading range.

Euro gold has meandered between €300 on the low end and €350 on the high end for years now, like a lazy river. As the black 200-day moving average shows above, the euro gold trend has been modestly higher, but running at an almost imperceptible snail's pace. Until the heavy overhead resistance line at €350 decisively falls, European investors are going to continue to view the gold bull as little more than a dollar bear.

To Americanize what a boring chart like this actually feels like psychologically and intellectually to a European gold investor, we can roughly convert this into dollar terms. Way back in early 2002 when euro gold first challenged €350, dollar gold had just broken above $300 for the first time in this bull market. This was a darned exciting time for American gold investors, as it provided some of the earliest clues that the Great Bear in gold was over!

But, how excited would we American investors feel today, 26 months later, if gold had never closed more than a percent or so higher than $300? What if instead of challenging $425 today, dollar gold was now making its sixth attempt at breaking decisively above $300? I have a sneaking suspicion that there would be far fewer gold investors today and those diehards still chasing gold would be seen as raving lunatics by everyone else.

If you can imagine 26 endless months where gold failed five times in a row to break above $300, you can start to understand how most European gold investors feel. A bull market with no new highs in 26 months is not really a bull market. Yes, its 200dma has a modest upslope, but a bull market needs occasional higher highs to win popular acclaim and prove to the players that it is the real deal.

The culprit in the euro gold lethargy is the dollar/euro exchange rate, drawn in red in these graphs. Back in early 2002 when €350 was first challenged, it only cost about $0.87 to buy one euro. It is kind of funny reminiscing, as at the time, as usual on the verge of major trend changes, most Americans involved in the markets thought the dollar would be strong forever. The euro was widely hailed as the "zero" and you had to be one heck of a belligerent contrarian to believe that a dollar slide was coming.

My how markets change! Today it costs around $1.23 to buy one euro. The euro is up, or the dollar is down depending on how you want to look at it, by about 41% since €350 was first challenged so long ago! This massive fluctuation in dollar/euro exchange rates is the force that has wreaked havoc with the euro gold market. It is no surprise that the red dollar/euro exchange rate line closely parallels the dollar gold bull.

One of the peculiarities of the world gold markets is they are still primarily denominated in dollars, a hold out from the pre-1971 days when the US dollar was actually backed by gold from a foreign perspective. With the United States still the world's premier military and economic power, it still makes some sense that gold is priced in dollars worldwide today. What was that old proverb? He who has the guns makes the rules?

Because of this dollar domination, the local-currency price of gold anywhere on the planet is a direct function of the dollar/local-currency exchange rate. If you know the dollar gold price, and you know the exchange rate between the dollar and the local currency, you can estimate the local gold price with a very high degree of accuracy.

In European terms, the global markets see an ounce of gold being worth $425 or so today. Each US dollar, however, is only worth about €0.81. So $425 gold translates into €344 or so in euro gold terms. The euro gold price is almost exclusively a function of the dollar gold price and the dollar euro exchange rate.

If you think about this long enough, it is kind of like a three-dimensional chess game that can make your head spin. The future direction of euro gold not only depends on global gold supply and demand like dollar gold, but it is also heavily dependent on the strength or weakness of the dollar relative to the euro.

Several quasi-independent variables including gold's real free-market commodity and currency supply and demand value, gold's dollar price, and the dollar's euro price somehow manage to meld harmoniously together to set euro gold prices each trading day!

Whenever I am pondering any gold price, dollar gold, euro gold, yen gold, whatever, it helps me a great deal to keep the fact in clear focus that gold is the ultimate form of money. Gold is truly far more than just a garden-variety commodity, as six millennia of human history have undisputedly proven that it is the king of currencies.

Rather than thinking of the gold price as being a pure commodity price like a wheat price for example, think of any gold price as an exchange rate. The price of gold is truly the exchange rate between the real and the fictional, a timeless tangible metal with intrinsic value that stands on its own versus fleeting intangible paper backed by nothing but faith in or fear of ephemeral and flawed human governments.

And as the European culture collectively understands more than we Americans ever will, gold's value will remain rock solid over centuries while nations and paper currencies rise and fall. Physical gold is the most timeless of all investments, and the lowest risk and safest. I have personally never met any European investors who dispute the importance of a solid gold foundation for every investment portfolio.

But today back in the now, there is very little incentive for European investors to expand their gold holdings beyond a portfolio base. €350 gold is about as exciting to Europeans as $300 gold would be to Americans today. What is going to entice European investors to add to their gold positions and European speculators to start gaming their own gold bull?

Speaking as an American gold investor and speculator, the prospect of the Europeans chasing gold is immensely exciting. European investors control vast pools of capital and even a shift of a small fraction of these funds out of conventional stocks, bonds, and national currencies into gold-related investments could have an enormous global impact. Worldwide gold demand would climb dramatically on broader European participation in the gold markets!

What will the catalyst for such a bullish event be? In my opinion there can be only one, the decisive fall of the long-vexing €350 resistance line. There is nothing that so effectively wins over hearts and minds to finally perceiving a bull market's opportunities like rising prices achieving a series of new highs. The fall of €350 is the necessary next step to capture the collective attention and imagination of the European investors. There is no rush like a gold rush, and euro gold will have to fly above €350 to trigger one across the pond.

Zooming in to our second chart, it is wonderful to see that the fabled €350 graveyard in the sky is within spitting distance for euro gold today. Is the long-awaited €350 euro gold breakout finally imminent?

From a tactical perspective, euro gold is the closest it has been to breaking above €350 since early 2003 before Washington annexed Iraq. Euro gold entered March like a lamb, drifting lazily near €317, but it sure left March like a lion near €346. Gold investors and speculators worldwide, regardless of where they are domiciled, need to closely watch euro gold in the weeks ahead.

One of the really intriguing things about this latest attempt to burst free from the €350 shackles is the relatively constant dollar/euro exchange rate in March. As you can see above, even while euro gold soared there was no corresponding movement in the dollar/euro exchange rate. A euro cost about $1.24 as March arrived and about $1.23 as March left, certainly not a notable fluctuation.

This particular euro gold spike was driven up by a decoupling in the dollar and dollar gold trends. While the US Dollar Index was up 0.4% last month, gold soared by a very impressive 7.7%. So each ounce of gold cost 7.7% more dollars to buy, but each dollar commanded roughly the same amount of euros! The net effect of these interacting exchange rates when the dust cleared was a huge 9.2% monthly gain in euro gold.

Now there is absolutely no doubt in my mind that €350 will fall eventually, as we are in a massive long-term secular commodities bull. I am not sure if this attempt will prove successful though. In order for euro gold to continue higher in the immediate weeks ahead, the current decoupling of the US dollar and dollar gold will have to continue.

If the dollar starts to weaken against the euro then dollar gold will rise, but euro gold probably won't. This would bring us right back to the same old story of the last few years, where the vast majority of dollar gold's gains are bled off for foreign investors by the dollar's weakness. Unless dollar gold's gains continue to outpace the dollar's forex decline, it will be very difficult for €350 to fall this time around.

There are a couple technical concerns too, totally independent of the interaction of the various exchange rates. As you can see above, euro gold has generally been in a downtrend since early September. It didn't bounce in February until it hit its major support line rising up from the spring 2003 euro gold lows. Today this support line, rendered above, runs through €320 or so.

Due to the way major breakouts typically unfold, the considerable distance between the €320 support and the €350 breakout zone is a concern at this point. Generally, because major resistance becomes so firmly entrenched in the popular speculator psyche, these intimidating levels are usually only broken when support approaches them. As the lower support line rises to converge with the top resistance line, an increasingly tighter wedge is formed that eventually leads to the upside breakout.

For example, in American terms $325 gold was an enormously potent resistance line a couple years ago much like €350 is for the Europeans today. The $325 Maginot Line in the States did not fall on a massive spike high above support like the one above, but it waited until support grinded up very close to the overhead resistance line before launching its fateful successful assault.

In the chart above the €320 major support is about 9.4% under the €350 major resistance. When the $325 resistance finally fell in dollar gold in December 2002, gold's major support was running near $315 or so. This $10 distance represents only a 3.2% technical gap, or merely a third as much.

Dollar gold did not manage to finally break out until the technical triangle trapping its price between major support and major resistance was much tighter than that of euro gold today. A similar tightening won't occur in euro gold until its support migrates up to E339 or so, which is still some months out based on the current modest upslope of euro gold support.

Second on the technical front, the vertical spike in euro gold in March has been hugging its upper Bollinger Band for weeks now, rendered in yellow. This is a sign of a rally probably past its prime.

Since Bollinger Bands define an envelope 2.5 standard deviations away from the current 50-day moving average, the longer a price stays 2.5+ SDs away from its 50dma the lower the probability that the extreme will persist. These declining probabilities are similar to flipping a coin over and over again. The more times in a row you get heads, the less likely the next flip is going to be heads too (when considered as a sequential series). Markets abhor extremes.

A euro gold spike will have a much higher chance of bursting through €350 if it is not already crowding its upper Bollinger Band when it first slams into the €350 major resistance. In that case the spike of destiny will not be as mature and will have more time to run ahead and consolidate above €350 before it retreats.

Now a change in fundamentals can certainly trump technicals any day, like the dollar/gold decoupling continuing, but the technicals are still worthy of consideration. Technically, euro-gold's current price spike looks both a bit overextended in terms of distance above its major support and a bit mature in terms of its time on target crowding its upper Bollinger Band. Technically, I don't think the odds are favorable that this particular rally will prove to be the glorious spike of destiny that decisively breaks €350, but only time will tell.

If you are interested in the current dollar gold situation as well as the recent decoupling of these two competing currencies, I do discuss it in the hot-off-the-presses April issue of our acclaimed Zeal Intelligence monthly newsletter. I also weigh the probabilities that the gold and gold-stock corrections are or are not over, as well as offer specific investment and speculation strategies going forward. Please consider subscribing today and helping to support our research work! Thank you!

Whether €350 falls in a few days or a few months, it will fall sooner or later. And when it does, all of a sudden the European investors and speculators out there can once again get excited about gold on its own wonderful merits. Today there are some Europeans playing American gold stocks, since the gains have been far greater than currency losses, but in general they are not very excited about gold itself. They will be.

The long-anticipated euro gold break above €350 will light a lot of fires and rekindle that centuries-old European love affair with the Ancient Metal of Kings. To see European capital once again chasing gold in earnest would do wonders for gold prices in all currencies too, as it would dramatically increase global gold investment demand. I can't wait!


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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