What a roller coaster. In December it looked like the jobs picture in the US was recovering rapidly and the dollar started to move up because of expectations the Fed would raise interest rates. Then at the beginning of the year, it looked like the reflation trade was back on. Equities kept moving up, despite a higher dollar (normally a funny thing to say, but remember there is the carry trade in USD these days), because at that point an economic recovery was still in the air.

Well, gold never got to the $1200 level again - about $1160 was all it could muster. Not surprising with dollar strength. Then risk aversion came back and whacked the markets for the past couple of weeks. This gave more fuel to the dollar. Gold got taken down to its recent low around $1070, but has hovered in the region of $1080 - 1090 for the better part of this week. Silver got hit hard, of course, and touched $16.

It’s amazing that gold has stayed as strong as it has. In 2008, risk aversion brought it down along with the commodities complex, though not as hard as pure commodities or silver. Last November, right on Thanksgiving Day, Dubai World made gold look like a risk asset that would suffer in risk aversion.  It suffered these past two weeks, for sure, but it could have been much worse.

As of Friday, the US advance GDP report brought a little life back to the reflation trade, though the general markets got taken down again. The 5 min gold chart looks like an epileptic fit, and yet it ended at $1080. Materials showed some strength in the general market. And the Yen was weakening, though in the end risk aversion held the day.

I have to say, in the first week of this episode I thought the reflation trade would come roaring back. After all, Greece getting in trouble and China raising reserve requirements did not mean the end of the world. But the old risk aversion sentiment kept hanging on and kept going strong right through the close of the second week. That’s bad.

Are we due for a relief bounce? Yes, but who knows. The sentiment seems rotten. Also, February is not usually a strong month for equities. In fact, we just had a classic trading signal when the low in January exceeded the low in December. That is a pretty reliable sign that there will be further declines in the rest of the year. Also, this is a mid-term election year, the worst year in the presidential election cycle.

On the other hand, equities were frothy and over-extended by any standards. The rally from the low last March had gone on and on with hardly a correction, and by September or October it was already over-bought. But that’s how rallies can be. So maybe all the hot money got nervous and wanted to take some profits. That’s not the same thing as a market panic.

One thing for sure is the Euro and Pound are not looking good. The currency markets are seeing a definitive move up in the dollar, and the Euro and Pound will take it on the way down just like they did on the way up (inverse of the dollar). This means there are tough times ahead for gold in USD.

So let’s see how quickly the markets pick themselves up. If we get a strong bounce into mid-Feb, the reflation trade might have some life yet. But if there is sideways consolidation and tepid moves upward, the chances are risk aversion has come back in a big way. That lends more strength to the view that there will be another crash later this year.

There are a few ways to play this right now. The most aggressive is to start building a small short position on moves up and just see how things go into March. One way to do this is by buying puts, for example on GLD or SLV. If you have a long-term view and want to free up some cash for a possible screaming buy later this year, then sell a bit on moves up. It all depends on your time horizon, entry levels, and personal situation.

Let’s see how the next couple of weeks unfold. The projected near-term top of $1350 in gold is not completely out of the question, but the likelihood has dropped below 50%. However, it might be a very good time to buy gold in other currencies, on any weakness in the dollar.