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a currency & gold market analysis
The week started with enormous volatility surrounding America's almost certain march to war. Gold prices surged $8 in overnight trade, S&P futures were off sharply, and the US dollar was hit hard before the US open.
The new world order military alliance (UK, US, and Spain) announced after a weekend summit it was going to abandon the new US resolution, and end any other effort to rally further UN support to disarm Iraq. The message was clear and expected.
An already divided parliament in the UK was shaken as Robin Cook, cabinet minister in the House of Commons, resigned in a protest against the war - leaving Blair to rely on support from his opposition party (Conservatives).
But don't mention the war...
Despite the gold favorable overnight reaction, there was a sharp reversal in all markets the moment the bell rang in New York. The bulls took the Dow up almost 300 points in its fourth back to back session of strong gains.
Since last week's low (7416), the Dow is up 700 points. Now that's volatility. Odd reversal though.
Most indications were that it was a short covering rally. But so what. That doesn't mean anything. Bears should be looking out for how the market acts as it reaches resistance regions - around 8300 for the DJIA and 875 for the S&P 500 for instance.
The main impetus to trade has recently seemed to come from a combination of two main developments - lower commodity prices, and Tuesday's FOMC rate cut (probably already factored to an extent).
The lower commodity prices are the result of a lot of things - they were probably overbought to begin with; markets are discounting the same outcomes that occurred in 1991 as the actual conflict nears; as well as news from the department of energy that it would tap its SPR (strategic petroleum reserve) in the event of supply disruptions.
The most bearish outcome for gold in the near term is the bullish Wall Street scenario, naturally, that as soon as the war starts, the war premium will disappear and gold/oil prices will fall. To tell you the truth, we don't know what'll happen, but we've noticed that markets have been wanting to unwind the war premium for the better part of a month.
Wall Street bulls expect gold and oil prices to come crashing down, and they expect to lever off of that momentum in paper values this week with an FOMC rate cut, perhaps followed by some European cuts, and who knows what other kinds of bullish nonsense.
Unfortunately for them, bond traders are voting what they think about another rate cut (see chart). Look out for a steep drop in the bond here. More on that further down below.
After the market closed Monday, President Bush declared that Saddam Hussein and his sons have 48 hours to leave, that the time for diplomacy has come to an end.
Sharp criticism was hurled at the French all day to shift the blame for the extent of world disunity, presumably. China and Russia reiterated their opposition to the war, and Russia also declared that an invasion without approval by the UN security council was illegal despite UK-US legal opinions to the contrary.
The flurry of coverage coincided with an evacuation of foreign citizens from Iraq. It seems as though we've reached a point where anything could happen.
New York City is expected to increase its terror alert status just in case... America now awaits a response from Iraq's dictator.
The time for diplomacy indeed has come to an end, and so has the time for talk.
We just wouldn't know what to say except that regardless of how sound the reason is for change in Iraq, the process of war is likely to give rise to another Saddam. I realize the intent is perhaps to do otherwise - i.e. to deter future terrorists and dictators. But that hasn't so far been the course of history.
Major Reversal in Treasuries is at Hand
In his March essay, Mr. Gross points out that real bond yields are already close to zero in light of his most likely inflation forecast - 2 to 4 percent beginning next year and continuing for several years beyond.
But he is careful not to be overly bearish on bond prices - after all, he contends, primary trends don't respond that quickly to the facts.
In our mind, it is commendable that anyone in his position (as the manager of the world's largest bond-Treasury mutual fund) has the testicular fortitude to acknowledge the possibility of a bear market in bonds.
Moreover, he's right. Major market trends do take time to reverse.
But this time may be different. The reason is, a run on the dollar is precisely what we anticipate to occur / has been occurring.
It's important to note that while Treasuries have sustained a 20 year bull market in terms of prices, the dollar's bull market lasted only five years - from 1996 to 2001 - using the dollar index as a proxy.
First the Dollar: Most of those gains in the dollar came relative to the European currencies, which were mired in a transitional period at the time. However, they also came in relation to the currencies of nations that typically pursue devaluation policies favoring the export sectors, as well as those of the underdeveloped world trying to lever their own inflation off that of the Fed's.
But the US dollar's bull market began to show narrower participation as early as 1998, after which it stopped making new highs against the Yen, or even the Canadian dollar in fact. By 1999, despite an historic paper mania driving the US "dollar index" to new highs, "primary" oversold conditions in oil and some of other commodities began to compete with the dollar's attractiveness. In other words, the dollar began to peak relative to some of the key commodities.
Since then, gold has led those commodity values to new five and six year highs, and similarly, the dollar index to new four year lows.
Topping behavior in the dollar index first became apparent in the fall of 2000, and then more clearly by July 2001, but in the dollar overall, it became evident as early as 1998.
Anyhow, the signal for the bear market in the dollar occurred in our view when the dollar index fell through 108 during July of last year (see reversal low on chart), and it was confirmed when gold prices broke up through their 1999 high at $339 during December.
The topping behavior lasted a little over a year in the dollar index chart, which is reasonable in the context of a five year bull market.
The bear market in the dollar has only begun, but the first leg might be nearing an end. Our medium term target for the US dollar index is for a drop to between 91 and 93 (currently 100). It's possible that the market may correct upward first, or it's possible that it goes straight to that level in coming weeks or even days. A countertrend correction shouldn't be too surprising since the dollar index has dropped from 120 to 100 in only 12 months now. We're not calling it, but it could happen.
Source of Disinflation Theme is Strong Dollar: As the 20-year bull market in bonds got underway, fixed income investors first enjoyed the benefits of disinflation trends during the early eighties resulting from a plunge in gold, oil, and the commodity price excesses of the seventies. From 1981 to 1986 both gold and the CRB halved, while the US dollar index almost doubled after a 10-year bear market sequence ended in 1981.
Those steep declines in gold & oil values sustained a bull market sequence in paper values beginning in 1982, and ending in 1987. They were initially a major force in the disinflation developments during the eighties.
The connection and conclusion is relatively simple. It's the dollar stupid. Weakness in the dollar (not just relative to other currency) is usually the source of rising inflation expectations, and vice versa.
Confidence in Fed - Source of Strong Dollar: The 20-year bull market in Treasuries has gone through several phases, but overall, the trend is explained by a general increase of confidence in the Fed, particularly relative to the prior inflationary period of the seventies.
The first boost came naturally (1981-1985) - from a reversal in major commodity / dollar trends favoring a higher revaluation of paper assets. The second boost came in 1987 as Greenspan wrote his first Put to head off a financial calamity resulting from the events surrounding the crash. Following on that lead, the Greenspan Fed, and Rubin Treasury learned how to juice market confidence in the Fed's role as lender of last resort. You know the story.
The grand finale came when Maestro Greenspan orchestrated the 1998 succession of rate cuts aimed at heading off another calamity - LTCM - but which triggered the most impressive stock market and dollar blow off in history.
In fact, the ensuing bubble in paper valuations, and the bullish effect it had on the dollar's valuation in our view is the most important factor explaining the cause of falling commodity values in US dollar terms from 1996 to 2000.
Thus, inflation rates were seen to be low because inflation only counted to people if it was easily discernible. When real prices fall, and paper prices rise, inflation is invisible to the vast majority of market participants - especially if they're all long paper.
However, the difference between the early eighties and the late nineties was that in the former period, the dollar's recovery was sustained by the fact that its prior bear market had probably run its course. During the latter period, the dollar's gains were dubious.
Thus, we'd argue that the bond market increasingly began to run on fumes, and I think that the pivotal change in the relationship between bond yields and stock prices during 1998 was an early manifestation.
Extreme Divergence Between Yields & Inflation Outlook Set Stage: Since the bear market in the dollar began last year, and since commodity prices first bottomed in 1999, bond market investors continue to cling either to the disinflation or the deflation theme, both of which require a stronger dollar to sustain. This is classic top behavior - denial. Nobody yet believes the accumulating inflationary evidence no matter how frank it is. Every piece of inflation news continues to be rationalized.
The point I'm getting at is this. Excluding the potential for a - short term - corrective rally in the US dollar, it's continued weakness means that the bond market could be on the verge of its first sharp decline in years. In the context of the secular bull market, a 20 point plunge in bond prices would still only be a correction (though it would put the 30 bond yield in the 6% range, around where it was during 1999) no worse than what occurred in 1983, 1987, 1994, and 1999.
In other words, a bear market top could develop in bonds for years, as Gross says, but the bond is so overvalued in relation to the inflation argument that this top could easily be marked by steep drops without even denting the secular trend.
Long term trends are defined by wide ranging trend channels. In the case of the long bond, the long term channel is about 20 points wide, which means that a countertrend move can move quite the distance before signaling a primary reversal (see the reversal low for the 30 year bond in the chart above).
Consider gold. It swung from $255 to $340 before revealing a primary bullish sequence in the chart. To gold bulls it was like water torture. But to shorts that align their trading strategies to long term chart trends, many ended up staying short for the entire nearly $100 point (or 30 something percent) swing. Some are still short just because that made them mad... never let your emotions trade for you!
Similarly, by the time a bear market in bonds is apparent in the long term charts, the damage will probably already be enormous.
In the short term, we're not yet forecasting a primary rollover in the bond. But we are expecting a reconciliation of the winning inflation argument to be factored into bond yields the moment the dollar's bear market persuades fixed income investors of its continuance. And we're expecting it to be a sharp move (up in yields), due to the degree of disconnect between inflationary fundamentals and inflation expectations.
Further, we would dismiss Mr. Gross' estimate for inflation as a conservative one... 2 - 4 percent?? I don't think so. I guess if you count the numbers puked out by the government's price series, maybe, but we don't believe those numbers in the first place. They smell as bad as puke. Sooner or later the market'll think so too.
Anyhow, our conclusion is this. Mr. Gross may prefer an overvalued Treasury to an overvalued stock, but we prefer a fairly priced gold stock to either.
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