Why is Justice bullish on gold and the dollar at the same time? Because both have 2-out-of-3 odds of working higher. Read on to find out more...

On Tuesday Taipan Daily foreshadowed the resolution to a paradox – how it’s possible for your editor (or one of them anyway) to be near-term bullish on gold and the dollar at the same time.

Today we’ll explore that idea a little more (hopefully without making things too complicated).

Let’s begin by keeping in mind that all market forecasts boil down to likelihoods and probabilities. Trading is an odds game. That implies relative degrees of certainty, and occasional extremely high degrees of certainty, but rarely a 100% sure thing.

Take the best starting hand in No Limit Hold ‘Em, for example – two aces in the hole.

Pocket rockets, American Airlines, Bullets... whatever you call ‘em, it doesn’t get any better than pocket aces before the flop. And yet, in an all-in confrontation, aces will still sometimes get beat (10% to 20% of the time roughly) by a lesser hand. As with poker, you can have 80% or 90% certainty, but a dead lock is rare. Hence the usefulness of odds-based scenarios.

Two out of Three

From an odds perspective, your editor is bullish on the dollar and the gold in two cases out of three. There are two scenarios where gold goes up over the next few months, and one where it goes down. There are also two scenarios where the dollar goes up, and only one where it keeps going down. The middle scenario, involving crisis, is the one where both gold and the dollar rise at the same time.

The three potential scenarios for gold run as follows:

• First, the “ongoing recovery” scenario. The broad market continues to power higher for a few months yet on stimulus euphoria and perceptions of global recovery, even as the Federal Reserve keeps liquidity levels high.
• Second, the “fresh crisis” scenario. Speculative fever escalates to the point of frenzy, leading markets over the cliff to a 1987 crash type event.
• Third, the “molasses” scenario. Positive sentiment diminishes, with inflation expectations falling down alongside, and the market turns sluggish like molasses in January.

The “Ongoing Recovery” Scenario

The first scenario is bullish for gold because inflation expectations have long been primed by the prospects of global recovery.

What’s more the two most dollar-heavy players on the planet, i.e. the heavyweights in Washington and Beijing, have done their part in supporting a positive psychological environment for gold. China has made noises about continuing its stimulus rather than risking the dangers of early withdrawal, Chinese consumers are beginning to step up their gold accumulation, and the Federal Reserve has openly indicated its willingness and desire to keep liquidity high and interest rates low for a sustained period of time.

Again, this is all bullish for gold (and gold stocks), because a return of inflation would be seen as a positive development in a deflation-plagued global economy.

The “Fresh Crisis” Scenario

The second scenario is one in which the frenzied game of musical chairs being played by the bulls comes to a sudden and violent end. We have precedent for this type of outcome in the crash of 1987.

Back then, just as we have now, there was a huge market ramp-up into September/October based on increasingly stretched fundamentals.

In 1987 there was also an overlay of deep monetary policy concern, with many attributing the crash itself to Treasury Secretary James Baker's ill-timed remarks. Today we have the same monetary policy concern (via actions of the Federal Reserve) and a rising tide of trade war protectionism, highlighted by the spat over Chinese tires and chicken feet (!) in recent days.

Last but not least, the crash of 1987 was deeply aggravated by “portfolio insurance,” a program trading strategy in which large quantities of stock index futures were automatically sold as the market fell. Once the crash got underway the program trades spun out of control, sending the market into meltdown.

Today’s equivalent of portfolio insurance and program trading is the impact of “black box” quant trading and “high frequency trading,” or HFT. The potential disruptive impact of HFT is so great, and the strategy so unsupervised, that one notable player in the HFT space warned the authorities that “the next Long-Term Capital meltdown could happen in five minutes” (referring to the massive hedge fund blowup of 1998).

In the event of another market crash, there is precedent for gold and the dollar rising simultaneously in their role as last-ditch crisis havens. This is just what we saw in the early months of 2009 (before the epic March rally took hold).

The “Molasses” Scenario

The third scenario, in which the markets turn sluggish and despondent while inflation pressures are kept at bay, is the one in which gold fails to perform. A lukewarm global economy, combined with dull saw-toothed markets and a lack of conviction on the inflationary side, could put the yellow metal back into retreat.

But this scenario also feels the least likely for multiple reasons. For one, it just feels like something big is brewing. Either Mr. Market is ready to ramp up his recovery optimism to an even more insane degree... or we are headed over the proverbial cliff when equity fever abruptly breaks. On top of that, investor awareness of America's long-term debt predicament is rising. There is no way out of the current mess, except by way of printing press.

Mania Versus Crisis

The U.S. dollar’s weak scenario, in contrast, is the one in which the bulls embrace a full-on mania (a good one for gold).

If we reach a point where risky assets of all types start going vertical (in “melt-up mode”), the dollar could see more downside as it is aggressively sold with reckless abandon.

But even here there are built-in sanity buffers in regard to just how far the dollar can fall...

An overly strong Canadian or Australian dollar, for example, could do real economic damage to the recuperating Canadian and Australian economies. The same is true of various European and Asian currencies. Central bankers of various stripes do not see a rising home currency as an unalloyed good. If anything they are keenly aware of the export sector dangers.

What this means is that a further falling dollar could act as a brake on global recovery, by way of imposing overly strong currencies on other export-led economies. The central bankers of the world have competitive reason to support the greenback, much as they might hate doing so, if it means keeping the local currency down and export prices competitive.

Meanwhile, in a 1987 crash type scenario, the U.S. investor funds currently out scouring the globe for returns would suddenly come rushing home to safety, driving up the value of the buck. A foreign-investor rush back into Treasury bonds would also be a dollar-positive event.

And, finally, in the “molasses” scenario, currency traders’ burning desire to sell the buck fades away along with dying global recovery euphoria and misplaced inflation expectations. A sluggish outcome could be one where the dollar goes into a choppy consolidation range, not gaining a whole lot, but not getting hammered down relentlessly either.

At some point, the overextended rubber band snaps back – or plays into the hands of a short squeeze.

Other Related Topics: Currency Investments , Gold Investments , Justice Litle , Macro Trader , Precious Metals , U.S. Dollar

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