Historically, when the market is concerned about inflationary pressures, money is moved away from most investing instruments and toward gold. This pattern of behavior was apparent during the hyper-inflationary times of the 1970s when gold prices went from $35 per ounce to nearly $700 per ounce, nearly a 2,000% increase in one decade. The dollar index during this same time period saw a decline of approximately 11%, not nearly as dramatic as the climb in gold prices. The dollar index used during this time period was discontinued in 1998. The move to gold reflected the concern and impact of inflation on all markets, not solely the dollar. In periods of deflation, commodities, including gold, receive the brunt of the sell-off where the value or purchasing power of the dollar relative to goods and services is growing. Deflation was seen between mid 1980 and 1983 where the dollar index grew by nearly 40% and gold saw a similar drop of just over 40%.

If investors move money toward gold during times of inflation and toward the dollar and away from gold during times of deflation, why would both gold and the U.S. dollar be strengthening at the same time and what is the opportunity it represents?

The answer to the first of these questions is fear. Fear or uncertainty is what will drive money to perceived safety. As is evident from the VIX, there is a higher level of volatility and uncertainty in the equities markets. As investment money has looked for a safe haven, money has been moved toward gold, fixed income, and cash positions. Both cash positions and fixed income increase the demand for the U.S. dollar and in turn, strengthen the dollar. Looking at the continuous futures contract for gold and the CME continuous dollar index, it is evident both have strengthened over the past three months. The gold and dollar bullish moves have been simultaneous with the fear and uncertainty which have plagued the investment markets.

Gold Continuous Contract (GC1700) Rising Over the Past 3 Months

U.S. Dollar Continuous Contract (USX1700) Rising Over the Past 3 Months

The opportunity lies in both trend-trading as well as watching for one of these two, normally opposing instruments to reverse direction. As uncertainty continues with no direct signs of inflation from Consumer Price Index (CPI) or Producer Price Index (PPI), trading gold and the dollar in the direction of the bullish trends is supported by both price and fundamental pressures. Trading gold positions can be accomplished by trading gold futures contracts, the gold ETF (GLD) and even by trading gold mining stocks. The U.S. dollar can be traded by trading dollar futures or by trading the spot markets.

If the probability of immediate inflation concerns in the U.S. remains low, trading the dollar against a country that has a higher probability of inflation increases the odds of success. Standard & Poor's downgraded Spain's credit rating from AAA to A this week. As can be imagined, it is not a common occurrence for an entire country's credit rating to be downgraded. The last time this occurred was during the "Asian Flu Crisis" in the 90s. This recent credit rating downgrade will impact the ability of Spain to sell off debt and will, consequently, directly impact the strength of the Euro. In addition to the demand of the Euro potentially decreasing, the Euro Zone CPI is higher than the U.S. CPI. Comparing the recent trends and last month's CPI reports, inflation will likely hit the Euro before the dollar. As can be seen from the EUR/USD chart, the pair has favored the dollar as price action has dropped nearly 3,000 pips since July of 2008 and has fallen nearly 1,500 from the three-month highs. The recent support area near 1.25 may come into play and swing traders may find the a bearish move an appealing target. From a fundamental and longer-term view, rising inflation in the Euro Zone could drive the pair further, closer to parity over the next year. A position trade such as this could take multiple months, while volatile price changes in the shorter term may be seen.

The EUR/USD Pair in a Down-trend, favoring the U.S. Dollar

A bullish Dollar, bearish Euro trade can be exacted on numerous trade instruments including the currencyshares ETF (FXE), CME Euro FX Futures, currency options provided by ISE and PHLX, and the Forex spot market (EUR/USD). The key to longer term, fundamental trades is to watch for shifts that would disrupt the fundamentals. Fortunately, there are weekly and monthly reports reflecting inflation data. As mentioned before, if the CPI and PPI indicate inflation (positive percentage numbers) in Europe while less so in the United States, the bearish trend could continue for some time. If, however, the U.S. shows inflationary pressures, reconsidering the long-term view would be appropriate.

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