Financial outcomes continue to unfold according to the long term lines of probability. Events of the past two weeks and the past few days in particular have strengthened my recently expressed expectation was that gold and its shares were at a good entry point, that the dollar had begun a significant leg down, and that the volatility index had been so low for so long that a turn in stocks was likely. The fundamentals of the Kondratieff winter are beginning to reassert their dominant theme.
The number of articles, editorials and programs on the demise of the dollar has been astounding: So much so that a perverse bounce might be in the offing. The Snow flurries early last week surrounding our Secretary of the Treasurys comments about the desirability of rising long term rates and a strong dollar reveal the policies of our monetary authorities. Or at least their wishful thinking has become increasingly transparent. They will jawbone to counter-balance the pundit's views so that the dollar decline will be orderly. Long bonds in the free market will be allowed to decline somewhat as long rates are allowed to gently rise. By inference, paper gold will not be sold aggressively to dampen long rates. But the Fed will not raise short term rates anytime soon, and choke off central bank liquidity and their hopes of an election year economic recovery. So debt will continue to be herded to the short end. Little else could be more bullish for gold as the past several days have indicated.
Interestingly these Snow flurries all take place as President Bush is pushing for "free market currency pricing" while visiting with his Chinese counterparts. Of course, translated to Chinese this means, "Raise your currency 40% or so, hang your tenuously solvent banks out to dry, cut your exports dramatically and reduce your citizen's income." So our bull in the china shop has the shop owners rushing about, diving for falling plates and cursing out loud. Barton Biggs, in conversation with the talking heads, remind us all that we have a great deal. China is sending us all manner of stuff much cheaper than we can make it ourselves, and taking dollars and dollar denominated treasuries in payment. Both of which are destined to fall considerably in value. So what's the problem? America's exporting of jobs is not politically expedient in an election year. Populism is driving policy.
This populism is evident on both sides of the equation: A situation where politically expedient measures to relieve financial discomfort will have unintended consequences. Competitive currency devaluation may well spill over into protectionism, tariffs and trade wars much sooner than anyone expects. Foreign direct investment in China is becoming increasingly unpopular with their social engineers, as is the increasing price of commodities which will need to be purchased with devalued dollars. The take home lesson of last week is no more cheap gold for China, especially now as the gold market is being liberalized. Mr. Market may well be starting to discount this effect. As well he should.
So is there anything to counterbalance this bullish picture for gold? Perhaps the recent decline in money supply? Will we experience a collapse in liquidity that drives the general stock market down taking gold shares with it? Commercial liquidity has taken a precipitous decline of late. The GSEs' hedging has distorted the global interest rate derivatives market to the point where it is unlikely that their role as primary pump to the money supply will continue as it has over the past few years. And treasuries are bid less and less aggressively as time passes. So the heavy lifting will be up to the Fed and their printing press. They are rapidly becoming the last line of defense as the options continue to narrow (pun intended). Any such action will be at the expense of the dollar. This appears to be reminiscent of the 30s in America, but this time around the better comparison is to the Weimar Republic.
A tipping point nears: Where we shift from deflation to hyperinflation. A subtle point that is ill defined. After the transition, even the most brilliant of economists will not agree on what has transpired. But the symptoms will be undeniable: The technical behavior of the market will change: Subtly at first, then with astonishing volatility. Technical analysis will fail the traders. Market timers will be confounded. This includes many in the gold camp.
Traditional investment strategies will act like a ring in the nose of the gold traders, leading them away from the obscene potential in the gold markets. This can already be seen on a small scale, as dips are bought with increasing aggressiveness ahead of the technical analyst's expectations. This implies that new money is moving into the market: Money that will behave very differently. There will come a day where the gold traders stand in awe of a missed move upwards, tied to a post by the ring in their nose. This may take place after a liquidity induced decline, but you can prudently hedge your gold shares position with a decent bear fund rather than try to time your trades. Regardless gold shares would likely recover in a few months, so I choose to stay long and strong. The biggest threat to your upside in this market is thinking that the tug on your nose is leading you to the feeding trough, when in fact it is now time for the slaughterhouse.