THE LINK BETWEEN GOLD, THE DOLLAR, AND INTEREST RATES -- WHY RISING RATES ARE CAUSING SELLING IN CRB INDEX

GOLD SELLING TIED TO RISING DOLLAR ... Some of you have asked why gold sold off this week in reaction to news of higher inflation. After all, commodities are leading indicators of inflation. Keep in mind that a big part of the commodity advance over the last three years has been tied to a falling dollar. This week, however, the dollar bounced as gold (and the CRB Index) has fallen. The selling in gold is directly tied to a rebound in the dollar. [Please see Monday's message : "Dollar Bounce Hurts Gold"]. Chart 1 compares gold with the Dollar Index. It shows the dollar (solid green line) rebounding off chart support near its late-December low (and an oversold condition). When the dollar rises, gold (and other commodities) correct. Gold is a mirror image of the dollar. The bigger question is why the dollar is rallying. Besides technical considerations, the dollar is also being helped by rising U.S. interest rates. That makes commodities sensitive to rising rates.

Chart 1

RATES AND THE DOLLAR ARE LINKED ... There are a lot of things that determine the direction of the U.S. dollar including the trade deficit and the relative position of competing global interest rates. The direction of U.S. interest rates also plays a role. In other words, the dollar is influenced by the direction of U.S. interest rates. To make that point, Chart 2 compares the Dollar Index (green bars) to the 10-Year T-Note yield (red line) over the last year. You can see them both falling together throughout most of 2004. The first trough in bond yields in November preceded the first Dollar trough by about two months. The February 2005 trough in bond yields preceded the latest dollar trough by a month. That's the normal sequence. Interest rates usually turn before the dollar does. The recent upside breakout in bond yields makes the dollar more attractive to foreign investors. Rising rates may not be enough to pull the dollar into a major uptrend. But rising rates may be enough to keep it in a trading range for awhile. A firmer dollar makes gold and other commodities prone to profit-taking.

Chart 2

RATES TURN BEFORE THE DOLLAR ... Chart 3 gives a longer view of the relationship between rates and the dollar. The 10-year T-Note rate (red line) peaked at the start of 2000. [Short-term rates peaked a year later at the start of 2001]. The Dollar Index peaked at the start of 2002 -- two years after bond yields and one year after short rates peaked. Bond yields troughed in the spring of 2003. Two years later, the dollar is showing signs of stabilizing. Since the dollar is tied to the direction of interest rates, and commodities are tied to the dollar, that makes commodities sensitive to the direction of rates as well.

Chart 3

LONGER-TERM VIEW OF CRB AND THE DOLLAR... Chart 4 gives a longer-term comparison of the CRB Index (monthly bars) and the Dollar Index (solid green line). The CRB Index is trading at the highest level in 24 years and is in an overbought condition. It's due for a pullback. The Dollar Index is finding chart support at its 1994 low. That makes it ripe for a rebound. That's not enough to turn bullish on the dollar or bearish on commodities. It is enough, however, to explain why the dollar is starting to stabilize and why commodities are entering a downside correction. It may be time to take some profits in commodities; but too soon to turn bearish.

Chart 4