Written by guest contributor Jennifer Gorton from Forex Traders

When the Sub-Prime Mortgage Crisis erupted in 2008, the U.S. Dollar began one of its most rapid bull cycles in history as investors all over the world ran into the safety of U.S. Treasuries. When economic crisis hits the economy, investors are primarily concerned about one thing—capital preservation, and the two most popular investment vehicles for capital preservation are currently the U.S. Dollar and gold. Gold has been a long-time favorite asset of investors who are seeking safety. Not only is gold an inflation hedge, but in times of economic uncertainty, it tends to outperforms commodities significantly, as investors buy up the yellow metal with fury. The U.S. Dollar, on the other hand, strengthens mostly on the back of the U.S. government reputation. During times of uncertainty, U.S. Treasuries are still seen as a completely safe bet. The chance of default on government debt is viewed as near 0 by investors, so the U.S. Dollar tends to become very strong during times of risk aversion in the financial markets. Thus, the U.S. Dollar and gold share an interesting relationship as “safe-haven assets.”

The current economic recovery in the United States, and around the world, is hitting a major period of serious slow-down. In early 2010, the recovery seemed to be doing very well. The Federal Reserve and Bank of England were both expected raise interest rates during the 2^nd half of 2010, and the Fed was quite hawkish on the recovery outlook. Things started to change as the year progressed, however. The EuroZone Debt Crisis weighed on the recovery as it caused a decreased optimism in investor sentiment around the world. Then, in June, key economic data began to strongly disappoint to the downside in the United States. Retail sales, housing numbers, employment figures, consumer demand—it seemed as though every piece of key economic data released confirmed the United States recovery was slowing significantly. During June and July, the U.S. Dollar took a beating as it became clear the Federal Reserve would most likely not be able to raise interest rates in 2010. However, it still seemed as though the Bank of England and European Central Bank would, so investors sold the Dollar in exchange for the Pound and Euro. Then, in late July it became clear the recovery was also weakening significantly in the U.K. and China. Bank of England Governor Mervyn King made it clear the U.K. had a “long road” to travel before full economic recovery could be realized, and he made it pretty clear the U.K would not be raising rates anytime soon. This negative outlook from England and the U.S. coincided with a confirmed slow-down in the Chinese economy, as the monetary tightening actions by the Chinese government took effect and resulted in slowing economic growth down considerably.

Thus, in early August, this combination of a bearish economic outlook in the United States, United Kingdom, and China all combined to cause a significant rally in the U.S. Dollar and gold. This rally should continue throughout the 2^nd half of 2010.

As you can see in both graphs above, the U.S. Dollar and Gold have both appreciated strongly in August as investors have begun to make a run into safe-haven investments.

Why Gold and Dollar May Rise Much, Much Higher

Currently, major investor concerns regarding economic slow-down are confined to the United States, U.K. and China. The EuroZone is not really being targeted at the moment because it appears that the Deb Crisis is completely under control, and the European Central Bank has not been nearly as dovish in its rhetoric as the Fed and the BOE. However, many economists are expecting a major slow-down in the EuroZone during the 2^nd half of the year due to the strict austerity measures the EuroZone has adopted in the last few months. These austerity measures are expected to weigh on economic growth in the EuroZone, and if the slow-down is significant, it could be the tipping point that causes an all-out flight-to-quality run in financial markets, which would, of course, cause significant rallies in Gold and the U.S. Dollar.