Dollar and Gold: The New Odd Couple

Despite the conventional wisdom that they work against each other, both have strengthened recently.
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A funny thing happened during the dollar's summer advance: Gold rallied too, defying the conventional wisdom about the relationship between the two.

Whereas the greenback is benefiting from signs of economic recovery, gold's advance is largely tied to expectations for inflation's revival, thanks mainly to the

Federal Reserve's

aggressive policies. For now, experts believe the two assets can remain strong simultaneously, although that situation is unlikely to be sustainable in the long term.

In the short term, meanwhile, the dollar's momentum appears to be waning a bit, at least vs. the euro, while the yellow metal's upward ascent is accelerating.

Gold's rally from its mid-July lows near $340 per ounce (and another setback in early August) became a full-fledged breakout on Wednesday. The yellow metal rose $7, or 2%, to a three-month high of $374.10 per ounce, breaking a technical downtrend at $367.50 in the process.

"Fundamentals call for a further rise in the price of gold as the Fed's assertively loose monetary policy has greatly increased the supply of dollars relative to the amount of gold for sale," wrote Jes Black, currency analyst at MG Financial Group.

Meanwhile, after trading under $1.08 intraday Tuesday for the first time since mid-April, the euro recovered and was trading at $1.088 late Wednesday. The euro again was up slightly against the dollar to $1.089 Thursday, while gold slipped under 1%, with December gold futures closing at $371.60.

"While the dollar remains well bid against the major

currencies, a technical breakout in gold would likely spoil the rally, especially against the commodity currencies such as the Australian and Canadian dollars," Black suggested.

Meanwhile, Frank Holmes, chairman and CEO of U.S. Global Advisors, a San Antonio-based money manager with over $1.1 billion in assets, said the fed funds rate remaining below the inflation rate, in conjunction with "massive" Federal deficits, historically leads to a weaker currency. Furthermore, gold's strength "is telling you there's a possibility of competitive devaluations" coming, he said, referring to policies whereby nations take steps to weaken their currencies in order to spur export growth. (Japan, by repeatedly buying dollars to weaken the yen, and China, by refusing to let the renminbi float, already are effectively pursuing such beggar-thy-neighbor policies.)

However, Holmes cautioned against reading too much into this week's thin preholiday trading and not everyone is convinced gold's outbreak augurs weakness for the greenback.

Rather than determining the dollar's fate, gold's primary function is as a discounter of future commodity price inflation, said Martin Pring, editor and publisher of

The Intermarket Report

. Movements in the dollar act as an accelerator or restraint to gold, but their relationship is not as dramatic as many presume, he said.

Similarly, gold isn't directly tied to the stock market's fate, Pring continued. "Gold really only has a relationship to the stock market because gold is a barometer of future price inflation and, at some point, rising

Treasury yields adversely effect corporate profits."

Although yields have risen this summer and shares are "overextended and susceptible to a

near-term decline," Pring doesn't think we've yet reached that critical juncture.

Nevertheless, the veteran technician concluded that financial market indicators -- including strength in other commodities such as silver and platinum -- look "very inflationary" and that gold has embarked upon a "significant new up leg to the bull market." He forecast this next leg will take the yellow metal "somewhere into the $400s, perhaps higher."

Panning for Picks (Reprise)

As noted

here recently, I remain long the

(TGLDX) - Get Report

Tocqueville Gold fund and continue to believe nearly all investors should have some exposure to gold and related stocks.

U.S. Global's Holmes takes a similar approach, recommending investors put 5% to 10% of their assets in the sector. "Different asset classes have different cycles

and gold helps in bad markets" for financial assets.

In selecting the stock of any commodity-based company, the "three critical pillars" are growth in reserves and production, preferably with reserves growing faster of the two, and growth in cash flow -- or indications such growth is forthcoming soon. (As an aside, he also said any commodity where there's demand from China is likely to rally and the inverse occurs for those commodities where China has ample supplies; some experts believe China's demand for gold will ultimately exceed India's.)

Based on that criteria, and because a strong rand is hurting the profitability of South African miners, Holmes favors midsized North American producers such as

Wheaton River Minerals

(WHT)

,

Bema Gold

(BGO)

and

Northgate Exploration

(NXG)

. He also mentioned

Apollo Gold

(AGT) - Get Report

, a smaller-cap (and more speculative) name, which was first listed on the Amex this week.

The $47 million

(USERX) - Get Report

U.S. Global Investors Gold Shares fund is long each of the aforementioned, with Apollo Gold being its single largest holding, according to Morningstar.

The fund was up 13.1% year to date as of Aug. 26.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.