Are Correlations Between Currencies and Precious Metals Returning to Normalcy?

By Przemyslaw Radomski, CFA  FEB 26, 2013 1:30 PM

Currency market implications appear quite bullish for the precious metals sector in the weeks ahead. Here's why.

 


We have been witnessing the abnormal situation in the intermarket correlations for quite some time now, i.e. positive correlation between dollar and gold and silver (or virtually no correlation at all), and negative one between the general stock market and precious metals sector. Such a setup is not the best from the precious metals perspective, as the overall medium-term outlook is bullish for stocks and bearish for the dollar. But last week seems to have brought some important changes to the structure of correlations. Before we analyze them, let’s see what happened in the currency market last week – we’ll focus on the USD Index (charts courtesy of http://stockcharts.com).

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On the very long-term chart we see a move above the declining long-term resistance line which normally would be a big deal. However, in the middle of last year when this happened, it was followed by an invalidation of the breakout and a subsequent decline. I expect to see the same thing here once again. Keep in mind that we have not seen a weekly close above this resistance line and really need to see several before stating that the breakout is truly confirmed.

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Let us see how the medium-term perspective looks like.
 

 
I am including this chart in today’s article so that I could make some points about the head-and-shoulders pattern. We see that it is no longer perfectly symmetrical, but this does not invalidate the pattern. It could still be the case that a double right shoulder is forming. If the index declines below the 79 level, the pattern and the outlook will once again be just as bearish as if the breakdown took place last month.
 
Finally, let us take a looka at the short-term picture.
 

 
In the short-term USD Index chart, we see the index right at its cyclical turning point. The sharp rally this month brought the index to its November 2012 high and the last part of this rally severely exacerbated the decline of gold.

(More from Minyanville: Gold Is Declining, and the 'Buying Stampede' Is Continuing)
 
With the index at its November 2012 high, at a cyclical turning point, and with RSI levels above 70, a decline here is quite likely very soon if not immediately.
 
Let us take a look at gold and silver correlations to see how such a decline in the US dollar could translate into precious metals prices.
 

 
The Correlation Matrix is a tool that my firm has developed to analyze the impact of the currency markets and the general stock market upon the precious metals sector (namely: gold & silver correlations). We continue to see some return to normalcy between the precious metals and the USD Index. Unfortunately the reason is that precious metals declined as the USD Index rallied. Of course, this must be considered a better scenario than if the metals had declined in price for no apparent reason. The indications are that when the USD Index reverses, the precious metals will do the same. With the USD Index at a cyclical turning point therefore, we could very well see higher prices for precious metals and mining stocks in the coming weeks.
 
I have mentioned the importance of cyclical turning points in the analysis of the currency markets and I would like to address one of my reader's questions regarding that matter, as this technique seems to raise doubts.
 
Question: I was wondering if sometimes cyclical turning points just don't happen at all. For example, we've been waiting for a cyclical turning point in the USD but it just hasn't happened. And it now seems to be forming a right shoulder of a head-and-shoulders pattern. Is there a variable or certain rule about cyclical turning points that I don't know about?
 
Yes, sometimes cyclical turning points just don't happen -- just like any technical tool. Good tools work most of the time and excellent tools can be expected to work 80% of the time or so (and it can be the case that something doesn't work a few times in a row only to then work 20 times in a row). Expecting anything more than 80% is not really realistic and thus cyclical turning points also have to not happen at times. It still seems that they will work this time, though.
 
Summing up, the outlook remains bearish for the dollar. The implications from the currency markets appear quite bullish for the precious metals sector in the weeks ahead.

For the full version of this essay and more, visit Sunshine Profits' website.

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