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Gold and the dollar smile: why you need more than just technical analysis.

Bijgewerkt op: 11 apr. 2021

Please read the Disclaimer before reading this article.

Before reading this article, I recommend you to read my previous article:


In August, the dollar managed to put in a (temporary?) bottom.

For those that follow the markets closely, this wasn’t a surprise.

Since its peak in March, the dollar declined 10% over a period of 6 months. Markets never move in a straight line, there are always short term countertrend moves.

Sentiment in the dollar was extremely negative at the beginning of August. At the same time, speculators were extremely long the euro (and thus short the dollar) and the decline in the dollar was starting to lose momentum, as reflected in the positive divergence between the dollar and its RSI.

Source: chart top right: SentimenTrader, @sentimentrader

chart bottom left: Macro Charts, @MacroCharts

At the end of last week (Friday, October 9), several gold analysts were rather negative on the dollar. The breakout in the dollar seemed to have failed after three weeks.

Another week has passed and it looks like they have to change their minds again. It seems to have been a false breakdown.

A lot of technical gold analysts note that both the dollar and gold are at a crucial point. At the end of last week, they were negative the dollar, this week, they are a bit more positive.

As an investor, this is of course not of much use. If you are negative one day because the dollar’s breakout appears to have failed, only to turn positive again a few days later because it turns out to be a false move, you will quickly lose confidence in technical analysis.

This is the problem when you only use technical analysis. You often have to change your mind when a market appears to have made a move but it later turns out that it was a false move or that you hadn’t drawn your trendline correctly.

As a technical analyst, do we just have to wait until the dollar gives us a clear signal to know in which direction its next move will be?

And then we have to take into account that this first movement could be a false signal…

Isn’t there a way of knowing in which direction the dollar is likely to move from this current pivotal point?

There certainly is a way! It’s called fundamental analysis.

At the end of last week, I wrote: “I’m also not convinced that we have seen the top in this temporary dollar rise. I agree that the dollar doesn’t look good technically. But some fundamental models I follow show that the dollar is not yet ready to continue its long term decline.”

From a purely technical standpoint, the dollar was indeed not looking that good. However, I have enough experience to know that technical analysis is not the holy grail with which you can predict everything.

To demonstrate the power of fundamental analysis, I will first take you back to the beginning of 2018. After that, I’ll come back to the current situation in the markets.

Situation in early 2018

In December 2017, the gold price started to rise sharply to arrive just below its multi-year resistance level in early 2018, ready for a breakout. Surely this is what most analysts thought back then.

From a technical standpoint, gold was indeed at a critical point.

However, I disagreed that gold was ready to break out.

First of all, sentiment around gold was extremely positive. The dollar was acting very weak at the time and there were a lot of geopolitical headlines that seemed to be bullish gold.

Speculative positioning was enormous in early 2018. (When gold, after its big decline in 2018, reached this critical resistance level again in February 2019, there was almost no speculative interest. This was a clear indication that gold was now ready to break out.)

Not only were most investors thinking that gold was going to break out, even the mainstream media thought this:

Source: Barron's

The above articles were published in January 2018. Gold consolidated 3 months below its multi-year resistance level and then dropped very sharply.

If you ever think you can invest successfully (at crucial turning points) by following the crowd (the huge speculative long position in early 2018) or by following the mainstream media, I wish you the best of luck.

Another extremely important reason why I thought gold would not break out, was that a breakout was not supported by fundamentals at all.

Before explaining this further, I would like to elaborate on my opinion about fundamental (top-down) analysis.

Many technical analysts swear by using only their price analysis. Price is seen as the ultimate truth. Fundamental analysts usually all disagree, why should you follow them?

As legendary trader Richard Dennis states: “I agree with the metaphysics of technical analysis that the fundamentals are discounted. You don’t get any profits from fundamental analysis; you get profit from buying and selling. So why stick with the appearance when you can go right to the reality of price and analyze it better.”

I fully agree with this statement.

The big problem with a lot of fundamental top-down analysis is that it often involves opinions, theories, and narratives.

Nowadays, for example, you have a group of analysts who think the dollar will (longer-term) appreciate sharply in value. Another group thinks the dollar will fall sharply. Both groups have good arguments. How can you know who will probably be right? Do you really have to make a choice at the risk of being wrong? For this reason, many use technical analysis to see where the price action is indicating which way the dollar will go.

Again, nothing wrong with this train of thought. The number of well-known investors predicting a recession in the US since 2015 with all its consequences, were clearly not that successful until early 2020.

Investors who have followed the often well-researched arguments of these experts may have missed 5 years of the rise in the S&P500 (between early 2015 and the beginning of 2020 when covid came).

Another example is China. Many well-known investors have been predicting a collapse of the Chinese economy for years…

It is therefore not surprising why so many investors focus on technical analysis.

After following a lot of these well-known investors for years, I’ve learned that their views are interesting ideas, but 90% of the time it should only be seen as an opinion and no one knows everything.

What I also found, and this greatly improved the performance of my investments, is that using predictive models helps enormously.

By this I mean that you should use a model that is a leading indicator of, for example, GDP growth.

Then, when all the ‘experts’ are warning of a recession and a stock market crash as a result, you simply have to look at your model to see if they are right.

For example, in mid-2016, many investors were very negative about the US economy and forecasted a recession. However, if you look at the following chart, you can see that the leading indicators of the OECD for the US and Europe were clearly bottoming between April and August of that year. What followed was not a recession or a stock crash, but an improving economy and 2017 turned out to be one of the least volatile years ever for the stock market.

Source: OECD

By using these leading indicators, you no longer have to pay attention to the mainstream media or other experts who constantly bombard you with their predictions. Just look at your model and use the opinions of others as a contrarian indicator.

Now that we know this, we can go back to the situation in the dollar and gold in early 2018.

As most of you will probably know, the gold price is primarily driven by the trend in the us dollar and the real interest rate.

Before we can proceed, we need to understand the movements in the dollar in the short to medium term.

For this, I use the ‘Dollar smile theory’ developed by former Morgan Stanley strategist, Stephen Jen.

This framework consists of three parts:

-right side of the smile: This is where you are when the US economy is relatively stronger than the rest of the world. The fed is hawkish (monetary policy is tightened), which reduces global liquidity. This is negative for risk assets and good for the dollar.

-left side of the smile: Here you find yourself when the entire world economy (including the US) is slowing down or in a recession. Investors’ risk appetite is decreasing and there are safe haven flows to currencies as the USD and JPY, causing them to increase in value.

-the bottom of the smile: At this point, the whole world economy is growing at the same time. Investors are willing to take risks, everything looks good and there is a lot of liquidity.

Under these circumstances, the dollar generally does not perform well.

The chart below shows the dollar smile theory graphically.

The dotted white line represents the ‘smile’ and the bars behind it represent the historical effective performance of the dollar in the different regimes.

You can see that it is not just a theory but that the data since 1985 effectively shows that the dollar smile theory provides a good framework for understanding the movements in the dollar.

Source: Viraj Patel, @VPatelFX

Do you remember what all economists and analysts were talking about in 2017? The fact that the whole world economy was growing together. Everyone was talking about ‘synchronized global growth’.

The IMF wrote in January 2018 the following: “Some 120 economies, accounting for three quarters of world GDP, have seen a pickup in growth in year-on-year terms in 2017, the broadest synchronized global growth upsurge since 2010.”

In 2017, we clearly found ourselves at the bottom of the dollar smile theory. It was therefore not surprising that the dollar fell sharply that year.

Investors extrapolated the dollar’s 2017 downward trend into the future and believed that this would provide the oxygen gold would need to break out in early 2018.

However, it was a mistake to extrapolate the downward trend because fundamentals were changing significantly.

The leading indicators clearly indicated that the US economy would remain very strong. The economic growth in non-US economies on the other hand, peaked in early 2018. (see how the blue line on the OECD chart peaked at the end of 2017 while the US leading economic indicators continued to rise until mid-2018)

The fact that growth in the global economy outside the US peaked in early 2018, while the US economy stayed strong, is also evident in the performance of their equity markets.

The stock markets in the US, Europe and emerging markets all peaked in early 2018 and saw a sharp 10% correction.

After this however, we see a clear divergence for the rest of the year. In September, the US market was at a new all-time high while the European and emerging markets continued to decline throughout the year.

In early 2018, the leading indicators were showing that the US economy would remain strong while the rest of the world would weaken. If we think back to the dollar smile theory, it is clear that we would be in a situation where the dollar should become stronger.

This went against the consensus in early 2018 that the dollar would continue its decline and that gold would break out.

A strong US economy also implies that real interest rates didn’t have much room to fall, something gold needs to rise.

In addition to the leading indicators for the economy that predicted a stronger dollar, I also tracked a leading indicator for the dollar itself based on liquidity.

The chart below from early 2018 shows how this model (dark blue line) is a very good predictor of the evolution of the dollar (light blue line, note that the dollar is inverted on the chart).

Source: Nordea

On top of that, the fed would start to wind down its balance sheet in 2018, the so-called quantitative tightening. This was another element that should be positive for the dollar.


In early 2018, many analysts (and the mainstream media) were convinced that gold would break out and the dollar would fall further.

However, this was completely contradicted by the fundamentals. This is a clear example of a situation where it helps to use both technical and fundamental analysis.

During those first 3 months of 2018, it was very difficult to follow the gold market and not buy when everyone was so positive. The only reason I stayed in cash during that whole period was because I knew for fundamental reasons that a breakout was unlikely. If I had only used technical analysis, my conviction would probably have been much less strong and I might still have bought in, resulting in heavy losses.

Current situation

Last week, I wrote that the dollar did not look very good from a technical perspective. However, I struggled to believe that the dollar would immediately continue its decline because certain fundamental models that I’m following, indicated that the dollar could strengthen in the short term.

The following chart shows how the evolution in liquidity (dark blue line) is a predictive factor of the movements of the dollar.

Do you remember in March when the world seemed to end that several analysts thought the dollar would rise much further?

This model indicated that the dollar was likely to weaken. This is exactly what happened.

Source: Andreas Steno Larsen, Nordea, @AndreasSteno

I agree with most technical analysts who track the gold market that both the gold price and the dollar are (short-term) at a critical point.

Because technical analysis has a hard time predicting which outcome is most likely to happen, I use fundamental models. (Note that I wrote fundamental models. I don’t care about opinions, theories or narratives.)

So my short term view is that I expect a stronger dollar and that we have not yet seen the bottom in the gold price.

Note that in the long run, I am very negative about the dollar. The only thing I expect now is a countertrend movement of a few days/weeks.

All the fundamental long-term models that I follow indicate that the dollar will depreciate sharply in the coming years.

But what about Europe? The euro is a disaster and all European countries have enormous debts! How can the dollar rise if the alternative is the euro??

This is one of those opinions/theories/narratives that I mentioned earlier.

This is also fundamental analysis, but it is not the fundamental analysis you need to make money (consistently).

Sure, if you are specialized in this type of analysis you can add value and make a lot of money. But for us, the normal investors who tries to make money consistently and who doesn’t like to wait 5 years for an idea to work, these theories are rather useless. So, focus on what the hard data is telling you, ignore the news, ignore the gurus, and follow a fundamental model.

I would like to conclude with the following three charts that were shared on twitter this week.

The first one comes from Northstar (@Northst18363337).

This chart clearly shows that long term, the dollar will decline.

Source: Northstar, @Northst18363337

The next chart comes from Macro Charts (@MacroCharts).

When you look at this chart, you would clearly think that the dollar found an important support level and is going to increase in value.

Source: Macro Charts, @MacroCharts

The last one is from Aksel Kibar (@TechCharts)

He uses this chart to indicate “the possibility of global USD strength”.

Source: Aksel Kibar, @TechCharts

So, here you have it, the reason why you need more than just technical analysis.

Three different chart, two different conclusions, which one will be right? In my opinion, in the short term the chart of MacroCharts will be correct.

In the long term, it will probably be Northstar’s chart that will prove correct. (I’ll elaborate on my fundamental long term dollar views in a future article.)

My conclusion from last week is therefore maintained: “Because we haven’t seen a clear bottoming formation in gold or the miners, I think it is possible we go lower again.

However, if it becomes clear that we have seen the bottom, I will not doubt to put my money to work again.

I have no problem putting my opinion aside and adjusting my strategy.”

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