That trigger was pulled by a surprisingly positive November payrolls report (which raised the possibility of U.S. rate hikes) and by credit downgrades for Greece, Portugal and Spain (which lowered the chances for rate hikes in Europe). These developments, in combination with credit troubles in Dubai, were enough to halt the slide in the U.S. dollar.

It’s not that the prospects for the dollar are great. It’s just that the prospects for the rest of the world were suddenly judged much worse in comparison.

The result, as I write this, has been a fall of about 10 percent from gold’s high-water mark in the rally.

The return of risk aversion to the global markets is certainly not bullish for gold. That may sound strange to those steeped in the lore of gold as the safest of safe havens. But in this day and age, when massive speculative positions are built like houses of cards on foundations of cheap money and margin, reversals of such trades mean that accounts must be settled in currency. And that currency is usually the U.S. dollar.

Thus, exiting speculations means a search for liquidity. And gold, as the ultimate source of liquidity, is often the piggy bank that is robbed when speculators need cash.

Even in these situations, the metal can serve as a financial life preserver—it didn’t do nearly as badly as other assets during the financial crisis of 2008. But there’s no denying that a global stampede to liquidity seriously hurts gold and gold investors.

The current situation has not devolved into a stampede just yet. But you can bet that there will be more credit-agency downgrades of U.S. states, and countries, as well as other assorted crises, in the days ahead. So caution is advised.

With that said there is certainly no reason to be bullish on the dollar for the long term. If the trillions in debt and new currency created over the past year weren’t already enough to dissuade one from relying on the future value of the greenback, President Obama’s decision to “spend our way out of this recession” by applying funds from the Troubled Assets Relief Program (TARP) to another round of supposed stimulus only makes the upcoming monetary inflation more certain and menacing.

This scenario is, obviously, very bullish for gold. But an even more positive outcome, like a significant economic rebound, would help gold’s cause by unleashing pent-up excess banking reserves that are currently overhanging the economy. So, over the longer term, gold wins either way.

But what about the short term? On an economic basis, as I noted, I expect more bad news from overseas. But I also expect the bloom to come off of the rose in the U.S. as well. For example, the November payrolls report that everyone went crazy over could be reversed as soon as the next report is released.

As John Williams of Shadow Government Statistics (shadowstats.com) notes, the November report was victimized by highly variable seasonal adjustments, which are themselves the result of the wildly volatile economic environment of last year. He expects the positive November surprise to be reversed, with an equally surprising upturn in the unemployment rate, with December’s reporting.

As John puts it, “The short-term reporting of payroll data is misleading—virtually worthless—at the moment.”

As far as gold itself, we were waiting for, even hoping for, some break in the metal’s dizzying ascent. But as Mencken warned, we should’ve been careful what we asked for. We wanted a healthy little correction or brief respite. What we got was a pretty vicious sell-off.

Still, this should be good for the market. The speculators were overloaded on the long end, and the commercials were oversold on the short end. Just as the speculators jumped ship, we should begin to see short covering from the commercials come in to support the market.

More importantly, we should also see physical demand return in force upon the first signs that the price has bottomed.

This brings up the argument that, until recently, was raging amongst gold bugs and bulls. Some maintained that it was physical demand driving gold higher, while others held that a weakening dollar was behind the big rally.

In truth, it was a bit of both—and for gold to continue its rally, we will need both factors to contribute going forward. The good news is that both seem likely to remain in effect for some time.

Physical demand will remain robust as the global economy recovers and grows and, as I’ve noted, there is little reason to expect sustained strength in the U.S. greenback.

A Buying Opportunity
If this rally was to play out like the similar breakouts in 2005 and 2007, I was forecasting a gold price in the $1,350-$1,500 range by March or April. Yet gold’s recent trajectory had left me wondering if the metal was going to hit that mark much sooner… or overshoot it on the upside.

As it turns out, the sell-off put a much-needed squiggle in the price trend, and leaves gold back on track to hit our previous targets.

So is this a buying opportunity? I think so. We may see further weakness if there are further credit downgrades overseas, or if some other potential crisis frightens the market and sends investors running for cash. And the thin holiday markets can bring nerve wracking volatility—to both the upside and downside.

But when it’s all said and done I expect short-covering and physical demand to stabilize the gold price and set us up for a renewed ascent this year.

—Brien Lundin

To answer this question, we need to recognize that there are still reasons to be cautious, in the near-term, for gold. The market really had gotten overbought, and the correction of late October probably didn’t release much of this pressure.

In addition, the greenback’s fall had gotten to the point where our trading partners were beginning to scream bloody murder. With a growing international consensus forming to abandon the dollar as a reserve currency, even the Obama administration must have been forced to pay it a bit of attention. So, despite the fact that a lower dollar is desirable in Washington (both as a supposed lubricant for the economy and as a payoff to various political constituencies), I wouldn’t doubt that the October respite in the dollar’s decline was orchestrated by official sources.

If so, the current dollar nosedive could lead to some sort of intervention—even mere jawboning—that might breathe some life back into the greenback and send gold tumbling.

And it wouldn’t take much movement in the dollar to knock the snot out of gold, because the yellow metal not only responds inversely to the dollar’s moves, it leverages those moves in the opposite direction. That’s why a very mild rally in the dollar in October led to a much greater decline in gold, on a percentage basis.

The new Kitco Gold Index, featured near the top of their home page, is a great tool for illustrating this effect. For any change in the gold price upwards or downwards, it shows the amount of change that relates to the percentage change in the U.S. dollar index. The balance of the change in gold is due to, as Kitco calls it, “predominant buying” (or “selling”).

This tool also shows how the leverage cuts both ways. On some recent days a fall in the dollar index of around a half of a percent would vault gold up nearly 2 percent.

The bottom line, both in the short and long term, is that the dollar will continue to drive gold, as well as the U.S. stock market. And, as a corollary to this, any positive economic news for the American economy will send the dollar tumbling… and those other two asset classes soaring.

Why? Because, as I’ve noted recently, there is a huge flood of liquidity, in the form of credit, currency and excess bank reserves, overhanging the economy, waiting to be put into effect.

Think of it as the contents of the Pacific Ocean, suspended above us in an enormous balloon. Any sign of sustained economic growth—growth that can unlock the still-frozen credit markets—will serve as the pin that pricks this balloon.

When that happens, all this newly authorized money that has been hidden behind the scenes will suddenly pop into existence as new dollars and new liquidity. The end result, which the market clearly sees, is that the value of all currently existing dollars will be substantially diluted.

So, at least over the long term, any view of gold’s future must be intimately tied to the prospects for the U.S. dollar.

And, given the trillions in new deficits and debt… the prospects for an unleashing of unprecedented, pent-up liquidity… and the clear intent of the regime in Washington to continue expanding the role and expense of the Federal government, is there anyone who can be bullish on the dollar?

The Past Points To The Future
Assuming, as we clearly must, that the long-term trend for the dollar is down, where can that scenario put gold in terms of price?

The past may help guide us. As I noted in my speech at the recent New
Orleans Investment Conference, gold’s impressive breakout over $1,000 appeared to be very similar to previous rallies in 2005 and 2007. Both of those previous breakouts occurred after significant corrections marked by very similar patterns in their price trend lines and moving averages.

Most importantly, as you can see from the accompanying “analog” chart produced by our good friend Ron Griess of Thechartstore.com, the 2005 and 2007 rallies took the gold price up 75 percent and 57 percent, respectively. In 2005, the rally lasted about 240 trading days, while the run in 2007 was shorter, at about 180 trading days.

If you mark the beginning of all three rallies to the day each broke out of their consolidation triangles, then the current run in gold is about 90 trading days old, from its breakout on Aug. 17.

Again, assuming that the future will at least rhyme with the past, if not repeat it, then gold would have from 90 to 150 trading days left in its current rally. If the rallies are growing shorter, as our two-datapoint trend might indicate, then the rally may be of even shorter duration.

As to the degree of the rally, let’s project that it could take gold from 40 percent to 75 percent higher (again, assuming we see a performance similar to the 2005 and 2007 breakouts). From the Aug. 17 close of $937.30, that would translate to a gold price in the range of $1,312 to $1,640.

For this to happen, however, I’m convinced we would need an associated fall in the dollar. But, given gold’s leverage to the greenback, a fall of only 10 percent to 15 percent in the dollar index would likely yield the types of gains we’re talking about for gold.

So, a fun little exercise in math. Let’s hope it works out. In the meantime, suffice to say that I’m bullish on gold for the next few months, but a bit concerned about volatility along the way.

So why does a weaker dollar translate to strength in gold and equities? Because, on balance, a weaker dollar is a lubricant for a U.S. economy saddled with debt and low growth. It eats away at debts; it helps boost trade, and generally makes for a more ebullient economic environment.

But I believe that one of the primary reasons behind this relationship has escaped most analysts. Namely, the fact that economic growth will help burst open the dam holding back enormous U.S. bank reserves.

Investors are watching closely for any signs of an economic recovery because such a recovery could unlock the U.S. credit market… and unleash a flood of liquidity that—so far—remains safely dammed.

U.S. bank excess reserves have skyrocketed to truly unprecedented levels. (Essentially, excess bank reserves are reserves on deposit with the Fed over and above what the bank needs to meet its reserve requirements.)

Now, these reserves don’t impact the money supply—as long as they aren’t loaned out by the banks and thereby put into commerce. And these funds by and large have not yet been put into commerce, and therefore have had no effect on the supply of money or the prices of goods and services.

That may not last for long, however, as economic growth in the U.S. would, eventually, lead banks that are now risk-averse to begin lending. This, in turn, could quickly burst the dam holding back the enormous excess reserves of the U.S. banking system.

Some argue that the Fed’s newly gained power to pay interest on banks’ reserves will forestall any unwanted increase in lending. In practice, however, this will have little effect, unless the Fed is willing to pay interest at rates far above the Fed funds target rate.

As Frank Shostak, chief economist of M.F. Global, notes, “We… suggest that paying interest on bank reserves is not going to stop banks from expanding credit… After all, there are always opportunities to lend money at much higher interest rates than the federal-funds rate.

“We can thus conclude that the massive increase in banks’ excess reserves is a potential threat for an explosive credit creation some time in the future. Contrary to popular thinking, we suggest that the new setup, which gives the Fed total freedom to pump money, can only destabilize the financial system and the economy.”

Of course, this isn’t the last word. Only time will tell how we exit the precarious monetary situation that the crisis, and the Fed’s response to it, have created.

But those who argue that the Fed will be able to mop up the massive liquidity they’ve poured onto the economy ignore the fact that this institution, and governments in general, have never been able to escape from a monetary expansion without significant inflationary after-effects.

And because the Fed is now treading new ground in many ways, they cannot rely on past experiences to clearly guide them.

If we pull back from the economic intricacies and simply look at the big picture, does it seem remotely feasible that the U.S. and the world can employ such monetary and debt expansion without considerable inflationary consequences?

While I have many reasons to be doubtful that we’ll see 70s-era price inflation as measured by the consumer price index (CPI), I am absolutely confident that we will see price inflation in commodities and other assets.

And that will be good news for investors in gold and resource stocks.

Fed Admits Hiding Gold Swap Arrangements
Our friends at the Gold Anti-Trust Action Committee (GATA) have scored another huge coup. In response to a freedom-of-information (FOI) request, the Fed has essentially admitted that it has gold swap agreements with foreign banks that it doesn’t want publically acknowledged.

GATA had requested from the Fed any information or correspondence on gold swaps, which are transactions in which monetary gold is temporarily exchanged between central banks or between central banks and bullion banks.

But GATA’s request was denied, and the organization’s appeal was answered by a Sept. 17 letter from Federal Reserve Board member Kevin M. Warsh, who was formerly a member of the President’s Working Group on Financial Markets.

Warsh wrote that, “In connection with your appeal, I have confirmed that the information withheld under Exemption 4 consists of confidential commercial or financial information relating to the operations of the Federal Reserve Banks that was obtained within the meaning of Exemption 4. This includes information relating to swap arrangements with foreign banks on behalf of the Federal Reserve System and is not the type of information that is customarily disclosed to the public. This information was properly withheld from you.”

As GATA secretary and cofounder Chris Powell notes, “The disclosure contradicts denials provided by the Fed to GATA in 2001 and suggests that the Fed is indeed very much involved in the surreptitious international central bank manipulation of the gold price particularly and the currency markets generally.”

GATA has the right to further appeal through the legal system, and plans to do exactly that. A federal lawsuit will be quite expensive, but well worth it for gold investors who need market transparency to unlock gold’s true value in today’s uncertain world.

As you may know, I’ve never been a big believer in day-to-day manipulation of the gold market by the “powers that be.” But I do believe that governments have and are acting over the long term to keep gold in chains. They’ve done it before, both covertly and openly. And they currently manipulate every other investment market. So why wouldn’t they also do it in gold, the very measuring gauge of their performance?

So I urge all serious gold and resource stock investors to help GATA out. It’s not just their cause—it’s a cause for all of us. GATA is recognized by the U.S. Internal Revenue Service (IRS) as a nonprofit educational and civil rights organization and contributions to it are federally tax-exempt in the United States.

Just as important, you can help by bringing this issue to the attention of news organizations and other investors. With the U.S. dollar at a crucial turning point, and with the International Monetary Fund (IMF) and other official organs needing to keep the gold price suppressed, it has never been more important to make the gold market open, transparent and honest again. To learn more about GATA, this issue and how to donate, visit www.gata.org.

—Brien Lundin

They weren’t alone. Investors and analysts were similarly surprised by the power and persistence of the rally in the broad U.S. equity market, and were left grasping for excuses.

The common denominator behind both bull moves: a declining dollar.

Bucking the Trend
Gold and stocks aren’t known as correlated asset classes, to be sure. So their almost perfectly choreographed moves in opposition to the dollar meant that analysts had to explain not only their individual moves, but why they were moving in unison.

Of course, it wasn’t too difficult to connect the stock and gold moves to the weakening dollar. But from there, most supposed experts were left scrambling.

They mentioned a growing dollar carry trade, wherein extremely low interest rates in the U.S. prompt investors to borrow dollars to fund riskier and higher yielding investments elsewhere.

This trade has, indeed, grown. And it will continue to have an impact, as long as the Federal Reserve Open Market Committee’s statements keep noting that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

If dollar interest rates are going to be low for the foreseeable future, why wouldn’t you arbitrage those low rates against higher yields elsewhere?

Another excuse put forth for dollar weakness has been the comparatively stronger economic growth rates in China and the rest of Asia. It seems obvious that Asia is far ahead of the West in the economic recovery, and this relative strength has been attracting capital to the dollar’s detriment.

But the columnists and talking heads on CNBC missed some of the most compelling reasons for the dollar’s swoon:

• The surprisingly broad push for a new global reserve currency to replace the dollar. China, Russia, Brazil, France and other nations have joined an international chorus calling for a new global reserve currency regime, one most likely based on a revamped International Monetary Fund (IMF) special drawing right (SDR).

The calls for talks on this issue have come so frequently, and the silence from the Obama administration has been so obvious, that what once seemed little more than bluff and bluster now appears to be the advance signs of an inevitable abdication of the dollar’s reign as the king of currencies.

I’ve covered this frightening development in recent columns so you know that if President Obama allows this to occur I’ll view it as one of the greatest foreign policy failures in American history. And the fact that the current administration doesn’t view it as such is what truly scares me.

• The socialization of the American economy. From bailouts to nationalized health care, from more steeply progressive tax rates to the assumption that government can dictate private sector compensation…and the myriad other assaults on capitalism and individual liberty now coming out of Washington, it’s obvious that the America of tomorrow will no longer resemble the dream of our founding fathers.

This concerns not only freedom-loving Americans, but also anyone anywhere in the world with assets in the U.S. When foundational principles are ignored as a matter of political expediency, when the rule of law offers protection only to favored classes or industries, then capital will flee to regimes that offer greater safety and certainty.

This is, in fact, a big factor behind the diminishing role of the U.S economy, and the decreasing relative value of the American dollar.

• The massive issuance of U.S. dollar debt and currency. I don’t want to belabor the point, but the world has been flooded with liquidity via the creation of unprecedented levels of new debt and currency.

The U.S. hasn’t been the only violator in this regard—only the most egregious.

Some argue that the Federal Reserve, having created much of the new liquidity with the figurative stroke of a pen, can mop it all up just as easily. They ignore the fact that if the Fed was so prescient and powerful it would have never been faced with having to create all that liquidity in the first place.

The Fed is so fearful of deflation, and has become so politicized, that it will almost assuredly overshoot the mark and leave its foot on the monetary gas pedal too long.

The bottom line is that the supply of fiat currency in the world at large has risen precipitously, but to a significantly greater degree in the U.S. While this will translate to higher asset prices generally, it will also translate to a lower relative value of the U.S. dollar.

The writing is on the wall, and investors know it.

A Battle Royale
In the meantime, the bulls and the bears have drawn the battle lines over gold and amassed on both sides what may be the most powerful forces we’ve seen for years.

Consider that the Large Commercial Net Short position in gold has risen to record levels, but on an absolute basis and as a percentage of total open interest. On the other side of the bet the speculative long position has also soared.

As long-time readers know, the large commercials are most often correct in their bets on gold. The reasons for this are two-fold: 1) Because they are so intimately involved in the gold market they understand the underlying forces much better, and 2) because they are typically hedgers who reflexively short gold in a rising price environment, their increasingly larger selling tends to create a self-fulfilling prophecy in lower gold prices.

So, again, when they pile on historically large short positions, gold usually heads south. However—and this is an important distinction—when they are wrong, they are wrong in a very big way.

As I noted last month, a prime example of this came in late 2005, when the large commercials were forced to cover their bets against gold en masse…with the result being a leap in the gold price from $450 to $700 over the coming months.

So the current situation is crucial. If the large commercials are forced to cover, they could send the price skyrocketing.

If the speculative longs are forced to sell out, gold could crater.

Ironically, some of the pressure has been let off by gold’s recent retreat below $1,000. The Commitment of Traders (COT) report for the week of gold’s highs shows that the larger commercials had added even more to their short positions, establishing a new record of 287,610 contracts net short.

However, this huge cumulative short position also acts as a cushion on any price declines. Undoubtedly, as the gold price fell from the recent heights, commercials began covering some of those short positions, helping to prevent further declines.

The physical gold market has also entered into this battle. Here we see a number of new factors coming into play…

First off, we saw the announcement by Barrick Gold that it had—finally, after a $750/ounce rise in gold from 2001—decided to buy back all of its remaining gold hedges.

Whether you think this announcement is bullish or bearish depends on your position in the market…and whether you’re a “glass-half-full” or “half-empty” sort of person.

In other words, once Barrick bought back all of its hedges (and it was rumored that they had already begun doing so in the preceding weeks), then that potential bullish factor would be removed. That’s the glass-half-empty view.

The glass-half-full view holds that Barrick’s upcoming buying will only add more pressure to an already drum-tight gold market.

Not long after Barrick’s announcement, we heard from the International Monetary Fund (IMF) that it was ready to begin the sale of 403 tonnes of gold. This didn’t have the bearish effect that similar announcements have had in the past when this issue has been trotted out to dampen gold price rallies.

It didn’t scare the market much this time because the sale would either come under the umbrella of the Central Bank Gold Agreement (where central bank sales had already slowed to a trickle), or the entire amount would be taken up by China or another central bank. The latter event would be net bullish for gold, by implication more than direct effect.

And finally, we’ve seen surprisingly strong physical demand from Asia, particularly India, despite the rising gold price. The reason? Festivals in India and government programs encouraging gold buying in China helped boost demand, and the weakening dollar meant that gold’s price rise was mitigated in local currencies.

So we can expect that any significant decline in gold, especially if it’s not accompanied by dollar strength of the same degree, will be met by increasingly large physical demand from Asia.

A Pressure Cooker About To Blow
So, the battle lines have been drawn, and it seems the gold price is destined to break strongly one way or the other.

Technically, the extensive consolidation pattern traced out by gold argues for a break to the upside. More fundamentally, the towering net short position of the large commercials seems to favor a correction, although the recent decline below $1,000 may have alleviated some of that pressure.

Regardless of the outcome, it seems safe to say that this rally has already demonstrated greater strength and resilience than anyone ever expected. Even if gold corrects, the price has spent enough time well above $1,000—setting new daily close price records in the process—to make this an important and confirming move.

As I’ve written before, I fully expected gold to begin rising between late-July and mid-August, beginning a stealth rally before much of the market started paying attention again after Labor Day.

Then I expected the fall physical buying season to support the price into the holiday season, whereupon—at some point—investors would begin to realize how much currency and debt had been created across the globe and begin buying up gold as the only viable counterbalance to massive currency creation.

But I never expected this whole scenario to play out within a few short weeks. For the record, gold dipped—briefly—back below $1,000 a couple of times, as cynical investors bet that the metal would once again fail to hold the millennium mark…or as concerted forces worked to prevent it from doing so.

But then the metal broke free from the attempts to shackle it. It even established a new record price when it closed over $1,002.80. So what’s behind this latest spike in gold?

Short answer: No one knows for sure…but there’s been no shortage of speculation from pundits everywhere.

My view is that the important transition in investor expectations that we’ve been predicting is being completed. And the result is that investors now understand that the dollar simply must fall in value relative to other currencies—both the actions and inactions of U.S. officials over the last few months completely support that view.

Moreover, all currencies will fall in value relative to commodities, primarily gold, as debts must be inflated away…and as the oceans of new currency created during the bailouts are pulled into commerce by the nascent global economic rebound.

From another standpoint, gold bugs have to be comforted by the level of skepticism that still accompanies this rally. If a true bull market “climbs a wall of worry,” then gold seems to be advancing steadfastly up a near-vertical slope of concern. There has certainly been no shortage of naysayers and unbelievers during the metal’s ascent past the $1,000 plateau.

And, frankly, there have been some valid reasons for concern. The large commercial net short position in gold, for example, just shot to record levels, even as heated demand for gold forced prices into backwardation. As Gene Arensberg and I have noted, the large commercials are rarely wrong in their prognostications.

But when they are wrong and are forced to cover their massive shorts (as in 2005), they are spectacularly wrong—and the gold price explodes higher in a short-covering frenzy. Were they going to be right or wrong this time?

Then we had the announcement in September by Barrick Gold that it had—finally, after a $750/ounce rise in gold from 2001—decided to buy back all of its remaining gold hedges.

This blockbuster announcement left many wondering if a top in gold had been marked. Indeed, considering how Barrick’s market calls over the years had been so perfectly erroneous, it was understandable that some experienced traders, the esteemed Dennis Gartman among them, considered this an opportune time to exit some of their bullish gold bets.

But perhaps that conclusion was just too simple…to easy…to be correct. Perhaps Barrick, with their sources inside the most hallowed boardrooms of Wall Street and Washington, were tipped off that gold was about to break loose from all efforts to constrain it. Perhaps they realized that the commercials were going to have to cover their short positions. Perhaps they became aware that the bottoms of government vaults had finally been reached…or at least a decision had been reached that no more official supplies would be forthcoming to dampen the market.

We can wonder all day long. But, as my old friend Jim Dines is wont to say when pointing at a particularly compelling chart, “Don’t think. Look!”

And it doesn’t take a master of technical analysis to look at gold’s chart and marvel at the power and clarity of this bull run. In fact, gold’s remaining real resistance has most likely already been cleared. The old intraday “high” of around $1,030 was fairly ephemeral. With the old, March 17, 2008 record close on of $1,002.80 on a spot basis growing distant in its wake, gold is truly breaking out to new territory on a nominal price basis.

And yet, on a real, inflation-adjusted basis, there is plenty of headroom ahead—to at least $2,200 in current dollars.

Yes, anything can happen…and gold could be driven back below $1,000 at any time. Gold’s foes may not have much ammunition in terms of bullion, but they still have bull—and plenty of it. While the rally was largely sparked by Ben Bernanke’s pronouncement that the recession is technically over (a fact we announced in July), the right words spoken at the right time by the right person could throw a barrel of cold water on this gold rally.

Regardless, as I’ve stressed over and over again, we are on the right side of the long-term move. Stand pat in your general allocations, while taking profits where prudent.

Case in point: Pundits have been making a lot of hay recently over gold’s apparent role-switch. Instead of rising on bad economic news and acting as a safe haven, the metal has been falling. And instead of falling when the economic picture brightens, it’s been rising.

Of course, gold’s fortunes are tied to the U.S. dollar, which remains (at least for now) the reigning king of fiat currencies. But the dollar has also apparently reversed roles.

So what’s going on here? Have gold bugs entered some sort of Bizarro world where down is up, up is down and they need to start hoping for a rip-roaring economy instead of a fiscal catastrophe?

Good News Is Golden

When you dig just beneath the surface of the recent headlines, data points and trend lines, you see that things aren’t quite as confusing or misplaced as some might imagine.

Bottom line: The investing world is currently divided between those who think another economic crisis lies ahead and those who feel that “happy days are here again”… or at least will be soon.

So, follow the logic: Negative economic data raises the specter of another economic nosedive toward deflation. In that scenario, investors are assuming the U.S. dollar would rise in value as the prices of everything else fall. The dollar would also function, as we saw at the depths of last year’s credit crisis, as a safe haven investment, and would accordingly benefit from this demand.

Of course, gold could also do well in a deflation. In the Great Depression, for example, gold and gold stocks were about the best investments you could make (if you had any money left), because gold was also the official U.S. currency at the beginning of the downturn. And later, when the gold standard was abandoned by FDR, that decision was accompanied by a dramatic devaluation of the dollar and upward valuation of gold.

But forget about this for now. Few investors today realize that gold can do well in a deflation, and the rest wouldn’t believe it if you told them. So this doesn’t currently factor into the decision-making of the investing public at large.

Now let’s look at the other side of the coin. Positive economic data points toward a recovery, which in turn means an unlocking of the U.S. credit market.

As you know, the supply of U.S. dollars has been expanded—by trillions of greenbacks—thanks to the various bailouts, Federal debt issuances and monetization, corporate and mortgage debt buy-backs and other assorted efforts to liquefy the U.S. economy. But relatively little of this new currency has been put to use: Monetary velocity—money at work in transactions—has remained moribund.

Think of it this way: A veritable ocean of fiat notes has been amassed, but this flood of money remains trapped behind a dam. Banks are risk-averse and reluctant to lend. Consumers are concerned that unemployment is still high and are reluctant to spend.

But if things start to look up, as they appear to be doing now, the dam holding back this ocean of money will burst.

That means inflation… which means a lower dollar and higher gold prices.

And here’s another way to think of it: We may be seeing only a tiny spark of life in the economy. But if that spark is enough to rekindle risk-taking by lenders and consumers it will be as if a bucket of gasoline is being thrown upon the budding flame.

And then, at some point, we’ll see the stimulus spending finally hitting the economy. As with nearly all government meddling in the free market, it will hit at the worst time… and throw more gasoline on the fire.

Keep in mind that I’m not predicting either the positive or negative scenario in the discussion above; I’m only explaining the thought process of the market right now.

So what do I think? Frankly, I’m worried about the next couple of months, as the stock market is discounting much better economic performance than we’re going to see anytime soon. It might not be pricing in “perfection,” but it’s definitely pricing in “pretty damn good.”

The slightest hiccup in the recovery will send the longs running for the exits, eager to capture whatever profits they’ve amassed on paper. This would likely precipitate a very significant sell-off in the U.S. and global stock markets.

That prospect aside, I do think that an economic recovery is beginning to take hold, both in the U.S. and in the economies of our major trading partners.

As you know, I noted last month in the article Gold Quietly Marshalling Strength that the recession here was technically ending, although there would be considerable economic pain still ahead.

So it appears we’re going to dance along a razor’s edge for the next couple of months.

Simply put, the world has been on vacation. Yet, despite the inattention, gold has been quietly building strength throughout much of the summer. The month of July, for example, was quite good for gold, as the metal steadily rose before meeting resistance at around $955.

Still, as we enter the fall, it seems as if gold is sitting tight on a very strong foundation. The market continues to anticipate the return of physical demand in September, along with the impact of America’s loose-money policies and stimulus spending.

Some forward-looking speculators have already entered the market in anticipation of these factors kicking in, but there is still plenty of room left for more longs before the market could be considered crowded.

In the meantime, the large commercials, as our talented associate Gene Arensberg has been reporting in his “Got Gold Report” for Gold Newsletter readers, have been piling up their short positions during gold’s summer rally. But once the dollar begins rolling over again, these commercials will be in an increasingly dangerous position.

As I’ve noted before, these guys are usually right. But when they are wrong, they are spectacularly wrong.

In the past, when the commercials have been forced to cover large-scale short positions, gold has exploded higher to a new price plateau. As an example, consider late 2005, when the commercials were caught badly offsides, and gold catapulted from $450 to over $700.

I’m not saying this will happen anytime soon, but, with federal deficits now measured in trillions of dollars, with deficit- and debt-to-GDP ratios rising to levels that presage at least a doubling in long-term interest rates, and with proposed nationalized health care programs that would further inflate the national debt, the prognosis for the dollar is not good.

The federal debt is already far beyond manageable levels. The only way to control it at this point is to inflate it away. And investors know it.

As I said months ago, it seems we’re on a collision course to repeat the mistakes of the 1970s. But this time, “it will be like the ’70s on steroids.”

In the meantime, many of the resource companies we’re following are making news with their summer exploration programs. At the same time, there have been significant developments on the mergers and acquisitions front, as challenged companies merge to build strength through synergy, and as weak companies are consumed by the strong. Our readers have already multiplied their money on a number of these stocks, and there will undoubtedly be more to come.

It all adds up to an uncommonly interesting—and potentially profitable—market ahead.

As I noted in the July 27 article, Summertime Doldrums return as Old Adage Holds True, a number of bullish economists were predicting that last month would be the first this year to show growth in industrial production.

But looking at arguments from both the bulls and the bears, I thought the end of the recession was at least a few months away.

But positive news on housing starts (up 3.6 percent in June; 582,000 vs. consensus
531,000) was the last shred of evidence I needed to convince me otherwise. And I’m not the only one: Based just on jobs data showing a dramatic reduction in new jobless claims and the very recent up-turn in the Ratio of Coincident to Lagging Indicators, Dennis Gartman (thegartmanletter.com) was the first to declare an end to the recession.

To be sure, Dennis has been way out front on this for some time, noting how important these two indicators are, and how reliable they have been in determining the precise ends to previous recessions. If they are to be believed, they have done so again.

So what does this mean for investors?

From an economic standpoint, we will still see bad news aplenty, including an unemployment rate that will continue to rise for some time.

As far as our approach to the markets, the technical end to the recession is also less important than you might think. Trading in stocks and commodities will continue to be exceedingly volatile, as speculation drives them to levels far ahead of the economic data, only to see profit-taking and the occasional dropping-shoe send them hurtling back downward.

For gold and the rest of the metals complex, it will continue to be a case of watching the bouncing dollar. Whatever drives the greenback higher or lower, will push gold quickly and decisively in the other direction.

China Takes the Gold
In the world of gold, China has seized the lead in the two most important categories: supply and demand.

The Middle Kingdom had already captured the title of world’s largest gold producer, thanks to its surging production and South Africa’s tumbling output. But now, according to the World Gold Council, China’s economic recovery has vaulted it to the top rung among gold consumers.

The council notes that gold jewelry demand rose significantly in the first quarter of 2009, while gold demand in India plummeted. This allowed China to overtake its fellow developing juggernaut in terms of gold demand.

Specifically, Chinese gold demand rose from 103.3 tonnes to 105.2 tonnes, in the first quarter, while Indian demand fell 83 percent, from 107.2 tonnes to 17.7 tonnes.

We’ll see if this trend can hold true for the rest of this year, but gold bugs should hope it does not. Last year, India soaked up 650 tonnes of gold, compared to China’s 400 tonnes. While rising Chinese demand is good news, we’ll need India to return to the market to underpin this bull run.

China and Russia have been the loudest and most insistent anti-dollar agitators so far, but they’ve recently been joined by the rest of the “BRIC” gang (India and Brazil), while France and other European nations have also begun carping about the dollar’s dominance.

While acknowledging that such chatter can be bearish for the dollar (and therefore bullish for gold), I’ve dismissed the likelihood that the dollar will ever be deposed as the king of fiat currencies.

Now I’m not so sure. You see, there are many advantages that come along with having your national currency serve as the international medium of exchange. Primary among these is the ability to export many of your economic problems to other regimes. So it’s a good and desirable position to be in.

For this reason, throughout human history, the role of international reserve currency has naturally devolved to the dominant military power of the age.

During the Roman Empire, the visage of Julius Caesar could be found on coins circulated throughout the Western world. When England ruled the seas during the Victorian era, the pound was the standard-bearer for all the world’s currencies.

And after America grew to become the world’s most powerful nation in both military and economic terms in the first half of the 20th Century, the U.S. dollar became the top dog among the world’s fiat currencies.

It wasn’t easy to attain this lofty status. The price was dear in terms of treasure and blood. But at this point, with no other military superpower extant, it’s not that difficult of a position to maintain. All that’s needed is to maintain the current level of military might and reasonable economic growth.

In other words, given our current status, it would be very difficult to lose our role as the world’s economic bell cow. If it were to happen, history would judge the event as one of the greatest economic and political failures since the dawn of human civilization.

Frankly, the only way this could happen would be if we allowed it to happen. Which is why I’m worried now.

When you consider that President Barack Obama has traveled to Russia with an armful of concessions, eager to negotiate on equal terms with this second-tier nation, then you begin to think that perhaps he doesn’t understand America’s position in the world.

When you consider that he has already toured Europe’s capitals apologizing for our previous arrogance—and is pushing through “green” legislation that will unfairly burden our economy for no real gain in global carbon emissions and is generally trying his best to make sure our overseas friends and enemies like us—then you begin to wonder if Obama really wants America to keep its mantle of leadership.

Given all this, it seems at least plausible to me that, if presented with some new global reserve scheme with roles for the world’s major trading currencies, that the Obama administration might acquiesce in the interests of “fairness” or “justice.”

Remember, Secretary Timothy Geithner has already been guilty of a slip of the tongue along these lines.

Such a development would be an absolute travesty—a complete abandonment of duty to America’s best interests. And I’d have to judge it, still, as being highly improbable.

But it is more possible now than at any time since the dollar first achieved its lofty status as the king of fiat currencies. And that should worry us greatly.

In June, as you’ll fondly remember, gold and gold stocks were in full-blown rally mode. At the time, I was telling you how this summer was shaping up to be the exception to the rule of seasonality for gold and other investments.

That rule—capsulized by the adage, “Sell in May, and go away”—holds that buying demand for investments withers away during the summer months, as vacations and other pursuits distract attention from the markets. For gold the effect is even more pronounced, because physical demand from Asia also dries up during this time frame.

But, as gold and other commodities were rallying in April and May… as even the much-beleaguered U.S. stock market was marching steadily higher… it seemed that we might be in store for an exception to the rule. In short, the summertime doldrums were on the verge of being replaced by a very hot summer market.

That might still happen. But there have been some big shifts in market direction and sentiment since our last issue. As far as the commodity play goes, not only has the bloom come off the rose, but the entire plant has begun withering under the summer heat.

The Rally Falters…

The rally in commodities was based on the idea that the worst was over for the global economy and a rebound was either imminent or already under way.

This idea was helped along by a Chinese buying spree in commodities, particularly copper. While most recognized this for astute restocking at bargain-basement prices, it also helped build faith in a China-led global economic recovery.

The Middle Kingdom, after all, led the world in the relative size of their economic rescue plan and the speed in which they enacted it. Moreover, their spending was directed toward infrastructure projects that actually stimulated the economy—an idea that would seem obvious anywhere but Washington. Therefore, one would expect that China would lead the world out of the recession, and in fact economic data out of China, to whatever degree it was reliable, began to point toward recovery.

So, there was some basis for the argument that the tide had turned for the global economy. And there was enough basis to lead speculators to pile into commodities, driving prices to heights that discounted a far stronger economic rebound than could possibly be provided.

Money was finally being made again. And considering the depth of the bottoms from which stocks and commodities were bouncing, the profits were quite extraordinary.

Coming from a trying period when profits of any kind were scarce, investors began to take profits by early June. The momentum was dying, and all that was needed by mid-June was some kind of spark to send the crowds rushing for the exits.

On June 22, a World Bank report projecting a deeper global economic downturn through the end of the year provided that spark. Commodities plunged, extending a slide that had begun at the beginning of the month for the metals, and about mid-month for oil. This sell-off further bolstered the argument that the party had ended for commodity bulls.

Rebound…Or Double-Dip Recession?

The late-spring rally in metals faltered because there just wasn’t enough evidence supporting the argument for a significant and imminent economic rebound in the U.S. and the rest of the developed world.

Yes, China was looking better. But would it be enough to pull the entire world higher? Not likely.

At this point, investors are still torn between the prospects of an extended downturn (perhaps even a double-dip recession that would test previous lows), or a recovery beginning in the third or fourth quarter of this year.

The factors that would contribute to a continuance of the recession are painfully obvious, and it wouldn’t take much for them to destroy any hope of a rebound.

From an economic viewpoint, the U.S. remains in a precarious position. Housing must recover before any significant or sustained recovery will be possible, and the real estate market remains mired on the downward slope of the cycle. Prices have only begun to fall to levels that reflect reality, and massive inventories remain to be drawn down.

In addition, the credit markets, while improving upon the disastrous state of affairs last fall, are still dancing along the edge of a precipice.

Mortgage rates must remain low if there is any hope of a housing market recovery, which places the Fed smack dab into a vicious cycle. To keep rates low, the Fed will be forced to continually accelerate its purchases of Treasury and mortgage paper…thereby monetizing the debt, fueling inflation and pressuring interest rates higher.

The investment markets recognize the trick box Bernanke and Co. are locked into, and will certainly take full advantage of the Fed’s supporting bid.

From the viewpoint of the markets, the rally in stocks, and commodities, was obviously far ahead of any economic justification. In stocks, every standard of value, from P/E ratios to book values, show that the market has made the transformation from undervalued to quite expensive.

While the U.S. stock market has come up with more than its share of surprises over the past few months, the technical and fundamental underpinnings look exceptionally weak at this point.

Add it all up and you might consider the path to recovery as being uphill…and passing through a minefield. After all, while the pace of the U.S. economic decline is slowing, it is still in decline. Any negative development at all—from new interruptions in credit flows, to a crisis in commercial real estate, to a major banking default or any other “dropped shoe”—could collapse fragile consumer sentiment and send the economy back in the tank.

Conversely, we have to recognize that there are valid arguments for a rebound in the second half. Bulls on the economy argue that companies wasted no time cutting to the bone in this downturn. Employment and inventories are at barest minimums, and any increases in production will lead to dramatically improved inventory builds, employment and investment.

The auto industry is a prime example. Analysts estimate that auto production has fallen so low in the U.S., that it could increase by up to 75 percent without adding anything to inventories.

Because of this anticipated effect, some bullish economists are forecasting that July will be the first month this year to show actual growth in industrial production.

And, of course, companies also used the global economic collapse as an excuse to take massive write-downs and losses, which led to even worse earnings (and losses) over the last two quarters. Thus, any earnings at all in the quarters ahead will show dramatic improvement. While these earnings improvements will be somewhat misleading, they will still add fuel to a potential market rally and resulting positive sentiment.

Any positive sentiment will add to another factor many analysts are now banking on: pent-up consumer demand. The idea here is that consumers have put off many purchases that are temporarily discretionary but ultimately necessary. It’s the theory of a “threadbare economic recovery”—businessmen, for example, can put off buying a new suit for some time. But eventually, when they wear a suit down to bare threads, they simply have to go out and get a new one.

Those arguing for economic growth this year are banking on this effect helping to some degree.

But the most important factor may be the long-awaited arrival of stimulus spending. Granted, the stimulus package foisted upon us by Congress and the Obama administration was misdirected and hugely inefficient. But it was also stupendously large—so large that its sheer size ensures that the flood of spending will assuredly juice up the U.S. economy to some extent.

On balance, looking at both sides of the argument, it would seem that the prospects for an economic rebound in the near term remain dim, and that the summer slowdown in the markets—including the metals—will remain in force.