Is gold heading for a major correction before it climbs higher?

From a chartist's perspective the reality could be that we have now seen a double-bottom for the US dollar and a double-top for gold and precious metals.

It is not hard to see why the twin deficits could push the US dollar lower still. But surely the European Central Bank will not stand by much longer and watch the euro become even more overvalued.

In any case, as the 20th anniversary of the 1987 Wall Street Crash approaches this week, are we not overdue for a correction in equities? Is it not rather ridiculous that Wall Street has just posted a fresh all-time high when the US economy looks to be facing considerable problems, in particular a house price crash and credit crunch?

Dollar rally

Now we know from recent experience of mini-corrections, and from distant experience of major crashes, what the likely impact of an equity event will be on the US currency.

The US dollar will rally in a sell-off as equities will be sold in favour of cash deposits, and this upwardly revalues money due to increased demand for cash against a relatively limited supply. Now another axiom of investing is that the US dollar and gold are inversely related.

That means that if the US dollar goes up in value then the gold price will go down. There is a good market rationale for this in an equity sell-off. Namely speculators who hold gold find that they have to liquidate all their assets to cover their margin positions.

It is the old story of 'good' investments suffering alongside 'bad' investments in a real crash. And again gold will be liquidated in favour of cash, adding to the upward pressure on the value of the US dollar in which it happens to be priced.

Therefore, to hold gold in the present environment as a safe haven asset or a hedge against inflation may be a little premature and even hazardous. One famous chartist believes that gold could correct to $560 an ounce under such circumstances and the dollar rally quite strongly.

Fed action

Of course, we can also make a good guess at the most likely scenario after that. The Federal Reserve would surely survey the damage to the financial system and cut the base rate again, but it might not do so until some of the moral hazard of the Greenspan put was eliminated.

Then the currency market would surely start to price in a round of confidence restoring interest rate cuts and the dollar would weaken, both against other major trading currencies and gold.

However, to try to anticipate the future strength of gold now by stocking up on the yellow metal might prove premature as a better window of opportunity will soon occur, ensuring an even bigger bonus in the likely strong performance of precious metals in an inflationary economic bailout.

See also:
Marc Faber: Considerations for gold investors, tech stocks and emerging markets
Gold: is the sky the limit?
How will the gold price react to the global credit crunch?