This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Gold hit a 7-week low on Dec. 22 from recent optimistic data of the U.S. economy. For example, U.S. existing housing sales jumped more than expected, and GDP grew at a 2.2% rate in the third quarter, the fastest pace in two years, amid a larger-than-expected downward revision. The upbeat news lifted the dollar and pushed yellow metal prices to below the $1,100 benchmark. (Fig. 1)

Bullion has gained 23% this year on a strong inverse relationship to the Dollar as the longest recession since World War II eroded the confidence in dollar and boosted gold’s status as a safe haven.

Tide’s Turning

But the tide seems to be turning. Gold prices have steadily tumbled with high volatility since peaking on Dec. 3 at $1,218.30 per troy ounce with the dollar gaining 4.4% against a basket of six currencies.

The frenzy to cover dollar shorts seen over the last three weeks sent the greenback onto its first monthly increase since June; meanwhile, gold has fallen about 8.1% (a much needed technical correction, by the way, as indicated in my earlier article.)

The Same Old Dollar

The trade has also been supported by a steepening of the spread between the yield on the U.S. 10-yr note and the 2-yr note. The markets take this steepening as an indication that the economy will continue to recover.

However, it’s difficult to make the case that the outlook has changed in such a way that warrants dollar strength.

The United States is still $12 trillion in debt with a double-digit unemployment rate, more spending, higher taxes, while the monetary policy will likely remain loose in 2010.

The Obama administration has warned that if the debt ceiling is not raised, the government risks default as early as New Year’s Day. Democrats have estimated that to get through the 2010 elections, Treasury needs to have the debt ceiling raised by as much as $1.8 trillion above today’s $12.1 trillion cap.

No, it is illogical to conclude that the buck’s rise from near rubble is due to material improvement in the fiscal or monetary conditions in the U.S. Rather, it is the decline in the euro and some other key currencies has accelerated due to substantial weakness as compared to the Dollar.

New EU Sovereign Risk

The greenback has been the primary beneficiary of Fitch and Standard & Poor’s credit rating downgrades of E.U. member Greece and similar worries about Portugal, Spain and Ireland.

Capital is fleeing out of the euro due to possible sovereign risk in the E.U. states, which sent the euro plunging, and dollar (quite ironically) reclaiming its status as “the currency of choice” on the risk aversion side.

Gold’s Euro Affair

For this reason, gold’s price movement this month has been largely dictated by the euro instead of the Dollar due to the capital shift triggered mostly by the E.U sovereign risk. This has prompted an almost record high short-term correlation between the EUR/USD currency pair and gold prices. At the same time, the inverse correlation seen between Dollar and alternative asset classes remains broken as both stocks and Dollar have advanced in previous trading sessions. (Fig. 2)

This fairly significant shift underlines important market themes and the likely direction of gold in the short to medium term.

Long-term Underpinned

Regardless of the new development with EUR/USD, gold’s long-term prospect remains underpinned mainly by the following factors:

• Strong continuing central bank demand - Central banks have now become net buyers of gold in the last half of 2009. A Chinese official recently was quoted saying China should increase gold reserve to 6,000 tons in 3~5 years, and 10,000 tons in 8~10 years from the current 1,054 tons (as of April this year.) Russia also has bulked up on its gold reserve by 20.1% since the beginning of this year to 612.74 metric tons, valued at almost $23 billion.

• Rising inflation fear - Inflation is a by-product of reflationary monetary policies, low interest rates, and expanding government debt in virtually all of the major industrial nations.

Dollar in the midst of a multi-year decline - The Federal Reserve’s announcement that it would keep interest rates low and money cheap for an extended period makes it almost inevitable that the Dollar will continue to weaken.

• Growing investment demand - Gold investment demand has gone up by 25% to 220 tons this year. Diversified stock funds have been buying gold bullion, piling into gold ETFs and stock of gold-mining companies as insurance against a worrisome monetary situation, possible inflation situation, and partly to enhance their returns.

• Supply constraint - World gold mine production will likely continue to decline for at least another five years.

Short-term Mixed

Bulls: ICE commercials reportedly nearly doubled their net short positioning in the greenback. That could be suggesting that the dollar rally is at risk of a near-term top or reversal, which could give gold a boost.

Continuing positive money flow into gold ETFs also suggests that investors are buying gold on the dip at below $1,100 levels lending support to gold.

Bears: On the other hand, the global financial crisis from over a year ago has now morphed into a sovereign debt crisis. The fresh downgrade of Greece’s sovereign debt rating by Moody’s on Dec. 22 could trigger a renewed bout of flight to dollar, which could further hit gold prices as it did earlier in the month on similar fears.

Bloomberg reported that futures traders are now betting on a 48% chance that the U.S. Federal Reserve will increase the target rate for overnight lending between banks by June. This could suggest the dollar may extend this month’s biggest gain since February as the perception of a recovery in the U.S. economy pushes up yields, damping the dollar carry trades.

In addition, the hedge funds are now on the sell side of gold and until they switch to buy mode, the carry trade unwind is likely to continue.

Technically Speaking

Based on the latest CFTC commitment of trader report (as of December 15), the number of long speculators for gold was beginning to fall back to around 363,000 as some them may be beginning to sell with the recent weakness.

After the large drop of the past week, there are likely to be lots of margin calls which could force liquidate more long positions, potentially putting downward pressure in the coming days.

Almost all the short term gold technical indicators, such as MACD and StochRSI, are bearish. Gold also has broken below its 50-day moving average, so further downward move could be in the cards. (Fig. 1)

2010 - A Love Triangle

Although euro has strengthened in the last couple sessions, it is more of a retracement rather than an ongoing trend. If euro continues to weaken against the dollar, we may see even more short-term pressure on the gold. But gold should find support around $1,075. A further pull-back to around $1,000 - $1,025 could be a buying opportunity depending on individual portfolio makeup and investment horizon.

Index-wise, if EUR/USD drops below 1.40 or the Dollar index (DXY) breaks above 80, we could see gold dip below the $1, 000 mark.

Optional Plays

Gold is currently undergoing an important technical correction cycle. Year-end profit taking, new year portfolio re-balancing, and various macroeconomic factors will likely make it a very testing few months for all markets, including gold, at least through mid 2010. During that time frame, it would not be a surprise to see gold sink below the 200-day moving average, currently around $988.

Investors interested in hitching on the gold train could consider buying options as an alternative way to play the gold market in addition to bullion, ETFs or futures contracts. For now, option expiration dates at least six months in the future (June 2010 onwards) seem to be the best bets at this time.

Bling Bling Gold Glitter

Gold is set to continue to glitter as an investment choice in 2010 due to its better long-term performance expectation relative to other investment vehicles, in the context of the profligate government spending, mountainous national debt, and the multi-nations calls to remove the Dollar from the reserve currency status.

In that sense, the seemingly lofty $2,000 gold price could very well be reached, or even higher, albeit continued high volatility and sharp reversals along the way. On that note, gold is best suited for long-term investors with a well diversified portfolio.

“To have gold is to be in fear, and to want it to be sorrow.” ~ Johnson

*Dian Chu, Market analyst, trader and financial writer for Seeking Alpha, Zero Hedge, Daily Marksts, iStockAnalyst & StraightStocks. My articles also appear in Reuters, USA Today and BusinessWeek, etc. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. Previous employers include Enron, Time Warner & Clear Channel. I’m currently working in the U.S. for the energy sector.

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Source: Dian Chu, Economic Forecasts & Opinions, December 25, 2009.