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February 11, 2007

Precious Points: Now Boarding the Flight to Quality!
by Oroborean

This weekly update has been right on every trend since we called Fed policy a "buy signal" back in October after a nasty selloff the month before. We were talking down the odds of a rate cut well before it became the mainstream view on Wall Street. And we were out and out bullish on precious metals this January when we proclaimed the so-called death of the commodities rally "greatly exaggerated"!

If you've been following the money with us lately, then you know that both stocks and bonds sold off at the end of last week with precious metals and mining stocks as the prime beneficiaries. With the Fed signaling slower growth, oil getting expensive again, subprime mortgage lenders going belly up, and Iran rattling the saber, smart traders have recognized the need to put get their money behind assets with intrinsic value and out of worthless paper. Classic flight to quality!

Not only is there a need for this market to stash excess liquidity in safe investments in case the stock bear really starts growling this week, a lot of traders out there, even the ones who aren't particularly fond of the precious metals complex, are looking at their charts and thinking that if they'd only bought metals this time last year they could've seen more than 30% upside in gold and more than 50% in silver over just a three month period. These kinds of returns are exactly what we were talking about last year when we called precious metal, the "barbarous relic", and miners, a truly ancient industry, the next big thing all over again.

Now, while seasonality can be an important factor in commodities, it's important to remember that our bullish outlook over the past several months has not been due to some calendar-based superstition, or the need to stay invested, or some pro-metals bias that prevents us saying anything negative. And it's certainly not been due to a hopeful expectation of some doomsday scenario that involves the collapse of the economic system as we know it.

We've arrived at our bullish opinions through careful analysis of technical, fundamental, and economic forces influencing the price of metals week to week that simply tell us that buying gold and silver on the dips has simply been the right move to make money and preserve wealth. We haven't used charts to confirm a bullish picture, we've used them together with a fundamental context to help predict bullish behavior! Last week's rally was definitely encouraging for the metals bulls, but it still didn't put us into the breakout situation we need for all the technical traders to start piling in. So basically we're still at an inflection point, and it just wouldn't make any sense to change our method now and trade on emotion instead of a sober understanding of the facts.

Last week's update said:

While the chances of an actual change to the target rate are debatable, it does appear that bond yields are set to come down over the next few months.

It's... questionable how much damage could potentially be done to metals if Fed officials remain very visible in their concerns about inflation... Since real inflation will always work in favor of precious metals, if the Fed heads stay hawkish and keep their schedules full of speeches and public appearances, any declines in metals will likely remain orderly and appear incrementally over time.

As we expected, bond yields moved lower this week, reversing their recent uptrend, only to move back up on Friday's selloff. It had appeared that yields had turned the corner on their recent ascent (one signal of a potential selloff in equities), and last week's auctions saw significant buying interest. The expectation therefore is that the action of a single day will not to buck the larger trend, which is for yields to continue their move lower. Otherwise the failure of the mortgage industry will accelerate. Of course, all of this is not to say we expect the Fed to cut rates any time soon, as some are once again beginning to expect.

In fact, we had no shortage of hawkish Fedspeak over the last five trading days as presidents and governors reiterated their concern over inflation, a constant discourse that continues to be kindling on the fire underneath the metals complex. Inflation had taken a backseat in traders' minds when oil was expected to retreat into the $30 range and CPI was looking tame, but new factors sprung up last week to put pressure on the dollar and justify the Fed's vigilance. First, unit labor costs in Thursday's employment data came in higher than expected and, while the Fed has had it's blinders on to gold and silver prices, as well as money supply inflation, wage inflation is exactly where it looks to gauge the effects of its policies on the economy.

Even though the Bank of England stood pat after its surprise rate hike, we had the European Central Bank last week indicate that it would most likely raise interest rates at its March meeting and this sent the EUR/USD back over the psychologically significant $1.30 level. Higher rates from foreign central banks make foreign currency more attractive to global investors and make the dollar supply relatively larger. Though the dollar initially rallied on the BOE, Euro strength sent it lower and levered metals to the highs of the week. Further confirming what appears to be a rollover in the dollar index is that expectations for the G7 conference to address the yen carry trade, and global liquidity, have so far produced little result.

In light of these inflationary forces, the Fed has acknowledged there is little it can do for the housing markets, essentially a tacit confirmation that rate cuts will not be forthcoming. But readers of this update have learned not to fear the hawkish Fed, as they are simply confirming what gold and silver traders already know - inflation is much stronger than the official data indicate! The two charts below show that while gold and silver are well above their 20-day ema's, they've positioned themselves between August and December's highs, the immediate support and resistance levels, and are poised for a shot at last May's peaks. Notice the relative strength on these charts is even more favorable for a rally from here than before the parabolic moves last year.

But while seasonality, inflation, oil, and Mid East tension have all played out in favor of the metals recently, there are technical setups approaching that could spell trouble. Remember that if you bought and held this time last year you also saw some serious downside. Keeping in mind that a spike in gold now will put the Fed in a seriously difficult position, it might be reasonable to assume that anything and everything that could be done to prevent a parabolic ascent now will now happen. Naturally, a rumor has recently surfaced that the International Monetary Fund will begin sale of its gold supply to offset the interest income loss of early payment by emerging nations. While we can't comment on this possibility directly, it is important to keep in mind that, at the very least, stumbling blocks could appear.

We've been saying that if metals continued to move sideways that they'd eventually catch the trendline up, but they've decided to fly higher and higher, which has changed the stakes. The long term charts below show that failure to breach last May's highs could prompt a reversal as far back as the bottom trendline, signaling that cautious investors already holding physical metal might be wise to wait for a better entry, possibly at a breakout to the upside.

(Chart by Dominck)

(Chart by Dominck)

Joe Nicholson (oroborean)
www.tradingthecharts.com

This update is provided as general information and is not an investment recommendation. TTC accepts no liability whatsoever for any losses resulting from action taken based on the contents of its charts, commentaries, or price data. Securities and commodities markets involve inherent risk and not all positions are suitable for each individual. Check with your licensed financial advisor or broker prior to taking any action.

Copyright © 2006-2008 Joe Nicholson

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