With the Indian wedding season long gone -- and in the absence of a rush to get a shiny new gold grill like Flava Flav -- the one thing driving the price of gold higher is the falling dollar.

Forget about rising demand in China for gold jewelry and “The Year of the Pig.” That’s old news now. Mind you, the projected growth in Chinese demand is sure to keep gold prices high, but it’s no longer a pressing catalyst for pushing prices higher this season.

No, the prop forcing gold prices to an unseasonable rise is the absolute failure of the dollar to gain any traction against other currencies, like the euro.

On January 2, it cost about $1.34 to buy one euro. Now it costs about $1.37. Also since January 2, the U.S. Dollar Index has fallen more than 2%. In the same amount of time, gold prices have climbed 0.7%.

Sounds unimpressive so far, right? So let’s dial things in a bit to see just how closely these values correlate.

Over the past year, the U.S. Dollar Index has had three distinct drops.

June 13, 2007 – July 24, 2007: -3.8%
January 29, 2007 – April 27, 2007: -4.4%
October 12, 2006 – December 4, 2006: -5.2%

During these three drops, here is what gold prices have done.

June 13, 2007 – July 24, 2007: -0.8%
January 29, 2007 – April 27, 2007: +3.5%
October 12, 2006 – December 4, 2006: +11.1%

The most recent drop in the U.S. Dollar Index hasn’t brought the same kind of rise out of gold. I think that’s mostly due to the cyclical shortening of demand that occurs in the second and third quarters.

Obviously, there’s a fairly strong correlation between gold prices and the euro. ( See this Barchart to find gold prices tracking the euro, though with a great deal more volatility.) That means as the dollar falls against other currencies, gold’s value rises.

Which makes sense since gold is priced in U.S. dollars.

Now, of course the ratcheting up of gold prices is not a one-for-one deal as the dollar falls, though historical evidence shows that over time, taking average prices, it works out pretty closely.

It’s in these sudden drops in the dollar and sudden rises in the price of gold that traders can really make their money.

But let’s face it: There are so many other factors that affect the price of commodities, and even more that affect the value of currencies. So much so that even the experts get it wrong sometimes.

So what’s the best way to play these fluctuations?

Ultimately, that depends on which side of the line you stand on. First, you have to take a look at the big picture and decide if you’re bullish or bearish on gold (or the dollar) over the long term.

By long term, I’m talking years. Find a decade-long gold chart or longer. Kitco.com has several ways you can look at historical data. So does the World Gold Council (requires free registration).

I happen to be a long-term bull on gold. That means, five years from now, I think gold prices will be higher than they are now.

How much higher? Could gold prices really hit $2,000 an ounce, like some gold bugs predict?

It’s possible. Since July 2002, gold prices have climbed about 109%. A similar rise over the next five years puts gold prices at $1,381. Not quite $2,000 an ounce, but remember, gold bugs have an extremely long outlook, and they’re more than likely going to hold gold no matter what.

One way to stay long gold is through the StreetTracks Gold Shares ETF (GLD:NYSE), or through buying actual gold coins or bullion.

You may not be a gold bug. They don’t care if gold goes up or down 10% over the next two months, because they believe five years from now, gold will be worth more than it is today.

You, on the other hand, may care… particularly if you trade futures. So here are some price levels to watch for:

$660: A bounce at current levels could send gold prices back to $680, with a brief resistance at $670. No bounce could mean gold may drop down to between $640 and $650. (Editor’s Sentiment: I think a bounce here is likely.)

$680: A push past $680 offers a clear road to $700, where gold futures have twice met with strong resistance. Resistance at $680 forces gold back to $660 with slight support at $670. (Editor’s Sentiment: Resistance is likely if the move up to $680 happens quickly -- within the next month.)

$640: Failure to find support at the $640 level spells a drop to $620, and then possibly as low as $580. Support at $640 could buoy prices back up to $660, though gold will likely find strong resistance back at that level. (Editor’s Sentiment: If gold drops to $640, it is highly likely that prices will find support at that level.)

Conversely, the dollar is getting a slight reprieve. How long this “breather” lasts remains to be seen. The market sell-off last week certainly didn’t help spirits. However, when the euro retraces, it takes its time.

The 1.8% drop since July 24 may only be half over. The previous drop in the euro clocked in at 3.2% over the course of a month and a half.

Translation for the near term? Over the next month or two, gold prices may trade rangebound, meaning a bounce at $660 takes gold to $680, while resistance at $680 pushes gold back to $660, and so on.

Traders, look for a change in these dynamics if gold breaks either support at the $660 level or resistance at the $680 level.

Sara

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