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February 25, 2007

Precious Points: A Perfect Storm in Metals
by Oroborean

After long fall and winter seasons of expecting only gradual upward trends in the metals, with suspicion of large, fast moves, the bias of this update shifted two weeks ago as we described all the bullish fundamentals aligning in favor of the metals complex. We warned traders that a breakout had not yet occurred and that, while there was enough demand to prevent an all-out selloff, buyers should look for favorable entry points (we even took the opportunity to do a little shameless self promotion and mention our proprietary trend charts).

Specifically, we said:

"Even with bullish seasonality, money supply inflation, higher demand and geopolitical instability all creating a floor beneath gold and silver, it's still going to take a decisive catalyst to send these metals rocketing back to last May's highs and beyond."

This week, in case you hadn't heard, we got something like that catalyst and a really nice rally in precious metals. As a bonus, because the mining stocks tend to suffer when equities in general move lower even if the metals are strong, there were particularly good deals this past week for traders snatching up shares and calls in the miners on weakness. Basically, anyone who bought the dips over the last two weeks made serious money, but traders watching the trend charts at TTC caught the exact bottom on Tuesday, as illustrated by the chart below.

As we might have expected, Tuesday's selloff was just the calm before the storm, for, on the horizon, powerful market forces were gathering to create the perfect environment for an awesome metals rally!

First was the rate hike from the Bank of Japan, over which it was appropriate to have some concern, since a rate hike in Tokyo contributed to the rapid decline in metals last spring. Indeed, the higher interest rates initially put downward pressure on precious metals since the yen is the source of so much global liquidity and metals always do much better when they don't having to be sold to fund other investments. But readers who recalled last year's "Gold and Goldilocks" update knew not to fear higher interest rates. Indeed, the negative pressure from Japan began to abate very quickly as Japan promised subsequent hikes will be orderly, not unlike Greenspan's hikes in 2005, and at least six months apart. In other words, after Tuesday's selloff, New York woke to learn the yen carry trade was not going to unravel in a single night!

This, of course, was the setting in which the higher than expected CPI data was received. But, while gold is the natural beneficiary of renewed inflation concerns, just as with the Japanese rate hike, the CPI release did not fuel an immediate rally. Traders' first reaction was instead concern over the domestic economy and the future of interest rates, since the comfort of the Fed's recent dovishness quickly evaporated in the face of sticky inflation figures. Around 10:30 Wednesday morning though, as the data was more thoroughly examined, sentiment began to shift towards the notion that higher inflation was not a threat, but actually caused by a strong economy creating increased demand. You might recognize this as precisely the logic the Bernanke Fed has been using since last October, which anyone who reads these updates knows was a screaming "buy"! In fact, the Goldilocks scenario in general, where the economy grows forever at a sustainable pace, is essentially an official sanction of perpetual, institutionalized inflation.

Of course, since economies don't naturally grow in a straight line, but in cycles, it takes vast injections of liquidity to smooth out what would otherwise be a recessionary period. Wednesday also saw the release of updated M2 figures showing growth near 8% over the last three months, compared to 5.6% for all of last year. Money supply is now at a record high, over $7 trillion, a clear indication that the market prosperity enjoyed over the past six months has come on the back of not just low Japanese lending rates, but the Federal Reserve and its open market activities. In fact, this is the heart of the Goldilocks economy: the Fed doesn't have to adjust its target rates because it can inject or remove liquidity at will and has become increasingly adept at directing that money with its "jawboning", no longer facing the "pushing a string" phenomenon that's dogged FOMC committees of decades past. Thus, as TIPS spreads and inflation concerns in general rose this week, bond yields across the curve continued their move lower. Of course, lower interest rates have been a theme of this update recently because there's little doubt the housing market is the key to the consumer and the future of this economy, and the ultimate test of the Bernanke Fed's policies.

The perfect storm in precious metals this past week has pushed the metals above last summer's highs (November high in silver). While profit-taking and a retest of these critical levels is entirely possible in the short term, the charts below show gold and silver traveling through the open window described here over the last two weeks and reaching, but not yet at, overbought levels on their way back to last May's highs. Dip-buying on Tuesday proved very profitable, and it will likely continue to do so.

Out of an abundance of caution, we should note yet again that gold above $650 and looking for $700 makes headlines. While under the radar until now, the metals are lately being tossed about in the media as yet another sign of creeping inflation. Despite what the Fed might say or not say, expensive gold is in fact the thorn in its side that tends to undermine its credibility. So far there's been no overt targeting of the metals markets, though the hawks might have hoped for a better response to the Japanese rate hike with the ECB also looking for higher rates.

While the Fed's stopped short of a rate cut, it's inflated the money supply to buoy the equities markets and corporate earnings, and metals have reacted accordingly. Can the Fed now afford to reverse course just as crucial housing and economic data is set to be released next week? Will deteriorating housing numbers and a downward revision in GDP be enough to swing traders back to the rate cut camp and keep bond traders buying, or will a high PCE keep inflation hawks on the wing? And what is the future of the dollar as foreign central banks continue to tighten?

It's also important to note that speculative longs in the gold and silver COT reports now stand at their highest levels since last spring. It's as if there was some truth to the statement made here two weeks ago that:

"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."

There were simply too many people looking at calendars and licking their lips for there to be a serious selloff. Ever the contrary indicator, it remains to be seen how long this speculative fervor will last, but, as expected, the metals ETF's outperformed the underlying metals this week as investor demand spiked and created the rally we just witnessed. If fast-moving traders continue to get on board it looks as though there could be a heated blowoff top. Unfortunately, it's often long term, buy-and-hold-minded investors who get burned in this situation if they continue buying on the way up and don't sell into strength.

Whatever your method or style of trading, understanding the forces at work in a market will ultimately allow you to enter and exit at the most opportune moments, ahead of the crowd. To stay on top of the evolving action in precious metals, and to get technical and fundamental analysis of all the major markets, make a great risk/reward buy and join Trading the Charts.

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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