Several weeks ago I dwelled on the relative merits of four musketeers – perceived safe havens in the times of market plague. The plague has since spread further, underlying the brittle state of market confidence, easily shaken up by anything from a takeover of a Spanish ‘caja’, to a Korean torpedo, to another regulatory rumor emanating from Berlin or Washington. The Japanese Yen, the German Bund, the US dollar and gold have all benefited from increases in risk aversion. In Yen’s case, this is a story of capital repatriation. The Bund’s triumph is a death toll to the decade of Euro-wide credit enhancement. The dollar and the dollar denominated fixed income market (with the exception of the completely vanished corporate issuance) remain the ‘lato sensu’ greatest pool of liquidity for small and big fish alike.

And gold? Gold’s shine has now adapted to a new reality in the currency market. It is a brand new world of carry trades which increasingly use the Euro – rather than the Yen and the dollar – as the funding currency. To be sure, this was an unlikely scenario until December last year when the Mediterranean ripples reached the shores of financial markets. After all, the Euro’s short term rates remain at 1% – several magnitudes above the Japanese Yen. But with the non-European demand for European bonds slowing to a trickle, the support for the currency has largely evaporated. It did not help that China’s trade surplus dissipated in the first quarter on the massive restocking of soybeans and iron ore. Suddenly, there was no dollar surplus to be redeployed into the Euro. Now, the conservative Japanese investors are beginning to vote down Euro exposure in their fixed income portfolios.

Despite the less attractive yield differential, the Euro’s fall from grace offers more stable returns for carry trades on a volatility-adjusted basis. Sudden spikes in risk aversion are unlikely to force non-European capital into the embrace of the Euro area. The combination of these forces and the continued attractiveness of the dollar and the yen indicate that Euro will remain weak for longer. But it is remarkable how well the gold market has adjusted to this paradigm shift.

When gold scored an all-time high in December 2009, its correlation to Euro – dollar pair was at 0.9. This was a close of a year in which trade-weighted dollar suffered enormously, but budged only marginally against the Euro (around 4%). Fast forward five months and, remarkably, the recent highs in the gold price have been registered at a NEGATIVE correlation to Euro of 0.8. The last time we saw such levels was December 2005, a period of heightened geopolitical risk in the Middle East.

To understand the differences between the December and May highs ($1216/$1239 and EUR808/EUR993, respectively), it is worth digging into the technical analysis. The Bollinger charts show that the bandwidth in USD was below 20 in December, but failed to reach even 11 in May. By contrast, in EUR terms, gold bandwidth was 18 in December and a whopping 23 in May. Such high volatility in Euro-gold means that there is little probability of a sharp breakout from the current levels. There is nothing in the candlestick charts that would undermine this hypothesis.

A 14-day relative strength index (RSI) has sent correct sell signals post the new highs (in both the dollar and the Euro), and the commodity channel index (CMCI) has always registered divergence around the highs. No surprises there and not much difference between the gold investors operating out of these two currencies.

The differences between euro-gold and dollar-gold reappear when we focus on 14-day directional movement (DMI). Here, post the December high, dollar gold was in the negative territory for the whole month and in Euro terms for only 5 days. Remarkably, the pullback last week did not trigger a dominance of negative directional indicator (in either currency).

The most fruitful lessons for the short term are to be gleaned from the stochastics. Such leading indicators perform best in sideways markets. Since December, dollar-gold sent 4 ‘buy signals’ and the first weak ‘buy signal’ appeared already within 12 calendar days of the previous high. In May, this period has been even shorter. However, in Euro terms, stochastics remain in overbought territory. What it could mean is that for all the drama surrounding the Spanish cajas, German short-selling curbs, and the fears that foreign reserve managers begin to scowl at the common currency, Euro could probably offer a strong support above 1.10 level. If this was the case (and keeping in mind Bollinger lessons on the unlikely Euro-gold breakout), it is smarter now for dollar-wealthy investors to start accumulating gold positions through the summer, regardless of what the Euro does. Any sign of inflation or ‘old’ correlation returning would come as a huge surprise from the current levels and gold would offer far more than mere ‘capital preservation’.

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Tags: dollar-gold, Euro carry trade, euro gold, gold technical analysis, stochastics