GOLD AND DEFLATION ... Some readers questioned my reference to gold as a hedge against deflation. You might want to reread my December 16 Market Message which explains how various markets act in a deflationary environment. Quoting from that earlier piece: "One possible beneficiary of those (deflationary) trends is gold which usually thrives in an environment of lower interest rates, a lower dollar, and weak global equities...during the depressionary years from 1929 to 1932, the only two assets that rose were Treasury bonds and gold stocks (bullion was set at a fixed price). The green line in Chart 2 is the 10-Year T-Note yield which plunged during the fourth quarter of 2008. One of the reasons for the plunge in bond yields (and the surge in Treasury prices) was fear of deflation resulting from falling stocks and commodities. Notice that the upturn in gold started in mid-November just as bond yields started to tumble. In the months since then, the two biggest winners have been Treasuries and gold -- not unlike the situation from 1929 to 1932.
ARE GOLD AND THE DOLLAR DECOUPLING ... One thing missing in the bullish case for gold is a falling dollar. Normally both markets trend in opposite directions. Chart 3 shows them doing that throughout 2008. The July gold peak coincided with a dollar bottom, while the November gold bottom coincided with a dollar peak. Both markets have been rising together, however, since the start of 2009. I doubt that will continue much lower. I strongly suspect that the recent upturn in gold is hinting that the dollar rally is overdone and could start to weaken. Chart 4 shows the Power Shares US Dollar Dollar Fund (UUP) gapping down yesterday and forming a bearish "island reversal" pattern (see circle). [An island reversal occurs when an upside gap is followed a few days later by a downside gap]. Only time will tell which of the two markets will continue its recent uptrend. I doubt that both will do it together.
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