The Golden Triangle (GLD)

It wasn’t long ago that wherever you turned the talk was of gold, and of how it was going to go on a rampage because of impending inflation. It seemed as if your taxi driver was prepared to buy a break above $1000 and “drop the flag” for a ride to quick gains. Then economic releases shifted the focus to deflation. Suddenly inflation wasn’t going to be a problem and we stopped hearing about gold.

We’re not sure how the deflation/inflation argument is going to resolve itself. The bursting of financial bubbles are generally deflationary events and inflationary policies are required to fight them. Where that leaves us is in uncharted territory.

But when it comes to investing we are never in uncharted territory as we have the charts to guide us. The first thing that impresses us about the price of gold, best represented in the GLD ETF, is that it has held up. Given how out of favor the bullish argument in gold has been we expected to find lower prices but that’s not the case.

Instead what we have, if you connect the February, June and August highs and the April, July and August lows, is a lateral triangle. And we are rapidly approaching the apex of that triangle which means a break out is not far off. Break outs usually occur before the apex is reached.

One thing lateral triangles don’t tell us is which way price is likely to break. It could go either way. But with the US Dollar Index (DXY) constantly trading into significant support the last few months, weakening it with each penetration, a downside break out in the dollar is likely and with it a corresponding upside break out in the price of gold.

Today the price of gold gapped up and is yet again approaching the top of the triangle. A decisive break above the trend line, which on Monday will be about $94.50, would be a buy signal.

Bear a few things in mind if you take this trade. First, you should see the dollar index break to fresh lows as gold moves higher. Anything less is likely to lead to a false break out in the yellow metal.

More important is the political risk. Faced with an enormous deficit the US government could well take a “benign neglect” approach to the dollar, as an eroding dollar would cheapen its outstanding debt and make it that much easier to repay. But China and Japan have been important buyers of US debt and continued erosion in the value of the dollar could be met by strong protests from these key creditors and cause the US Treasury to defend the buck, effectively curtailing a long in gold.

Such are the risks in a political trade. And all the more reason to get in at the right point on a break out. Buying gold when it becomes extended and obvious is likely to have harsh repercussions.