The mounting crisis in the Eurozone presents another tailwind for gold. The situation in Greece continues to deteriorate, as it is widely suggested that the country will ultimately be unable to repay its debts and will eventually enter into default. Such an event wil have ripple effects through the rest of the Eurozone including the other at risk sovereigns of Ireland, Portugal, Spain, Italy and Belgium. This has thrown into question the long-term stability and viability of the euro currency. Such euro instability is a bullish tailwind for gold, as investors seek an alternative store of value to protect against crisis.

The situation in Europe also presents a potentially bearish headwind for gold, however, particularly on a short-term cyclical basis. This is due to the fact that the euro, until as recently as the beginning of May, was trading at historically high levels relative to the U.S. dollar, at 1.4940. It is currently just -2% off of these highs as of June 3. Overall, the euro is over +20% above its previous lows at 1.1913 from June 2010 when investors were last focusing on the Eurozone potentially breaking apart.

From a technical perspective, the May peak in the euro is starting to have the look of a double top, which could imply that the euro may ultimately break through the previous 1.1913 level to reach new lows. Since gold is priced in U.S. dollars and the rise in gold over the last decade has been heavily supported by U.S. dollar weakness, such a major correction in the euro currency would imply a major dollar strengthening. This could drag on future returns for gold. (Click to enlarge)

Looking back, since the financial crisis in 2008, the euro has entered into three sharp corrections that extended over several months. In each of these instances, gold moved lower at least to some degree along with this decline in the euro.

All of this raises the following question. Supposing you want to maintain your gold position as a long-term investment, how can you protect or even enhance this position against the potential for a short-term rally in the U.S. dollar? More specifically, how can you effectively get long gold against the euro instead of the U.S. dollar? Four potential choices to address this question are listed below.

1. Short the Euro

An obvious first answer would be to short the euro currency against the U.S. dollar in a position size that was proportional to your gold position. This could be done by shorting a euro ETF such as the Currency Shares Euro Trust (FXE), which would effectively convert your gold priced in U.S. dollars to gold priced in euros. However, many people may be uncomfortable with the idea of shorting, particularly in a volatile market segment such as currencies. In addition, many investors may be overseeing portfolios that are long only mandates that prohibit short selling. As a result, this may not be a suitable alternative for many investors.

2. Long the Inverse Euro

A second option would be to consider going long an inverse euro currency ETF. These ETFs are designed to go up when the underlying investment is going down (thus if the euro went down, the ETF would go up). The ProShares UltraShort Euro (EUO) is one such possibility. Several issues might cause investors to pause in pursuing this option, however. First, the most liquid inverse euro ETFs are leveraged at two times, which means that if the euro goes down, the ETF will rise by twice this amount and vice versa. While this has some appeal from a portfolio efficiency standpoint, it may offer too much volatility for the typical investor. In addition, these ETFs become increasingly inefficient and prone to leakage the longer the holding period, particularly when markets are more volatile. For example, if you bought the EUO at its inception in late 2008 and held it through the peak of the euro sell off in June 2010, you would be up less than +2% versus a euro that was down over -5%. Conversely, if you bought the EUO at its inception in late 2008 and held it through today, you would be down over -30% with the euro up only +9% versus the U.S. dollar over the same time period. In other words, long-term holders of EUO under this scenario would have been up less than half on the upside and down more that 3x on the downside. As a result, such inverse ETF instruments are not ideal unless your tactical trading perspective is measured in days or weeks at most.

3. Long the U.S. Dollar

A third option is going long the U.S. dollar. This in essence makes one short the currencies the U.S. dollar is long against and can be accomplished through an ETF such as the PowerShares DB US Dollar Index Bullish Fund (UUP). This positioning within the ETF is accomplished through the use of futures contracts and has the U.S. dollar long versus a basket of developed global currencies including the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. Although the euro is still by far the key driver of UUP performance, it is not necessarily a pure play for the U.S. dollar against the euro currency. With that being said, the euro does constitute 58% of all currency exposures in the UUP, which is by far the largest, and the returns correlation since the beginning of the financial crisis is a -0.96. As a result, the UUP represents a solid choice in this regard, but should also be held for short-term to medium-term periods at most due to the modest returns leakage that occurs versus the U.S. dollar over longer time periods. (Click to enlarge)

One important note about each of the three options listed above. If you are using these in a taxable account, they can make life more complicated come tax filing time including having to deal with Schedule K-1s. This is something worthwhile to keep in the back of your mind when selecting these ETFs for any such gold hedging strategy.

4. Long U.S. Treasuries

A fourth option worth consideration is going long U.S. Treasuries. Not only is this the most straightforward of the four approaches (including no issues at tax time), but it may also provide the best return enhancement. This can be done using a U.S. Treasury ETF such as the iShares Barclays 7-10 Year Treasury ETF (IEF) or the iShares Barclays 20+ Year Treasury ETF (TLT). While certainly not a near perfect negative return correlation between the euro and U.S. Treasuries, at -0.51 and -0.56 respectively for intermediate-term and long-term Treasuries, these correlations are still strongly negative. Moreover, when the returns relationship has diverged, this has often occurred during a time when both the euro and U.S. Treasuries are rising. Thus, the timing of the trade does not have to be as precise as the first three options above and a more extended time horizon can be taken on if desired. In addition, over the last several years, the instances when the negative correlations have come into effect most prominently is during periods when the euro is in the midst of a sharp correction. For it has been at these same times that U.S. Treasuries start to rise at a greater magnitude. Lastly, holding a position in U.S. Treasuries provides income as well as the potential for price appreciation while also helping to neutralizing the exposure of your gold position to a rising U.S. dollar/declining euro. (Click to enlarge)

So if you are long gold and would like to maintain this position, but you believe we are entering a phase where the U.S. dollar is set to strengthen relative to the euro, (with the end of QE2 quickly approaching and the crisis in Europe continuing to unravel) all of the above provide options to accomplish this goal depending on your circumstances. Accounts with a higher risk tolerance and a more tactical short-term approach may wish to consider alternatives such as shorting FXE or going long EUO. Portfolios with a still fairly high risk tolerance and a somewhat broader medium-term view may find interest in going long the U.S. dollar through the UUP. And those investors that have a lower risk tolerance and would like to keep positions more straightforward in their portfolios while still taking on a tactical strategy to insulate their gold positions may seek to use U.S. Treasury ETFs such as the IEF or TLT.

Any of these options implemented either as a full hedge (equal to 100% of your gold position), a partial hedge (less than 100% of your gold position), or even an excess hedge (greater than 100% of your gold position) may be appropriate for consideration depending on your individual time horizons and risk tolerances.

Disclosure: I am long GLD, IEF, TLT.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.