14 May 2004: 'Traders are beginning to talk about the rising price of milk and cheese; these guys don't shop. I think it means that inflation is creeping into their consciousness. I wonder what it means for markets' - paraphrasing Bob Pisani, CNBC commentator, reporting from the NYSE. But Gold is dead!
That's what it feels like out there. You have inflation news popping up all over the place to confirm our hypothesis. Yet gold prices sink... even before they could sustain a break through the 1996 high - the long awaited bull market break out - in the first place. It's really not as though the stock market, at 20 times trailing earnings, has priced any real extent of the inflation. How many commodities have to make all time highs - even without the impetus of the China story - for the inflation to better reflect in financial asset values? Is the world really so hung up on the core CPI for its clues on inflation? It sure would seem so. What is the reward for resisting the delusion after all?
Anyway, in the short term anything can move markets if enough people believe it in my experience. So we must take account of the ideas that are proliferating regardless if they don't reflect our views. For instance, the bulls point out how wonderful the stock market is hangin' in there despite daily record highs in gas prices.
But then, we were surprised how well the market rallied at all, while this was going on all of last year.
It's been amazing that despite all the inflationary debris the stock market surged onward and upward regardless. All of it pointed to higher rates; but the market surged onward according to the Fed's queue. It only made sense because the Fed capped yields very effectively at the time, and if you assumed that the average investor couldn't tell the difference between real profits and fleeting money profits, or long term and short term profits - which frankly is not that large a leap. Fleeting profits are those that arise out of a change in the value of the common medium; they disappear as soon as the devaluation has made its way through the prices of all goods, especially that of labor... when it finally wakes up from its siesta. They are the kind of profits that fool businesses into consuming part of their capital base. They are an artificial kind of profit derived from the government's deficit spending increases and the central bank's inflationary habits. They are not true or sustainable economic profits, and consequently don't deserve the same valuation that they achieve during periods where the inflationary byproduct is more benign - perhaps due to a productivity shock or the like, such as the productivity boom of the last decade when the inflation was less obvious and the currency was supported by extraordinary but temporary events.
So yes, I too am amazed that the Dow has held the 10000 mark for so long; as amazed as I am that gold has yet to take over the 1996 high ($420), AND KEEP IT! But I don't take anything bullish for the Dow from this state of affairs. Like Pisani, the crowd is slowly waking up to the inflation reality. The question is slowly becoming, how high do rates go, and what should stock multiples be?
Notwithstanding the gradual awakening, by some accounts stock bulls are still in the frame of mind where they believe that a few rate hikes by the Fed would cull the economy of its inflation problems, and then they could get back to business buying 'em up. The bad news for them is that higher rates aren't likely to stop the inflation. All they are likely to do is cause investors to reconsider the valuation of future earnings (stocks), and curtail some of the artificial stimulus driving those enterprises that benefited from an easy money policy (where rates are thought to be kept below a theoretical and subjective true market level) and can't exist without one.
Deleveraging - that's the current buzzword. It's not a new term. It has a few common applications but the one I hear most at the moment essentially involves the idea of a yield curve carry trade being unwound. Investors are assumed to have borrowed short term money and went long the Tbond, or stocks, or commodities, or foreign currency assets as leveraged trades. The consumer is assumed to play a part also in that as these asset values fall consumers will rush to liquidate their assets and goods in exchange for money to pay down their debts with, as if the economy was already on a gold standard and there were no central bank.
But the significance of these ideas has been amplified because the dollar has bounced. Today we're going to review the factors affecting the US dollar, both real and apparent in order to assess the case for gold - since the US dollar outlook is absolutely the most important factor next to money supply growth affecting gold prices.
USd Bulls Bullish on Rates, Pushing Technical Boundaries of Bearish Case
The US dollar has been pushing the boundaries of resistance. On Monday bulls pushed the USd index through the resistance range (91.50 to 91.79) that was defined by both, the 200-day moving average, and last October's lows. Those lows were important because they represented the 1998 low; the break down through this low in November confirmed our bear market hypothesis for the dollar in the primary trend.
The bulls are trying to reverse that diagnosis as we speak. Although they haven't yet they have their sights set on the 100 level no doubt. The shaded region up to that level in the chart here represents the range of resistance to the bull market case technically. Anything short of 100 could easily still be bearish. The recovery of the 1998 low is significant but a bullish reversal in the USd index means getting through 100.
Perhaps the most telling sign of further short term gains in the dollar is the weakness in gold. Gold prices are saying, stand back and see where the dollar wants to go. Whereas the bearish turn in the China story early last month might have popped the leveraged commodity bubble right on top of gold (which didn't really participate in that theme anyway), what is pressuring gold now is the story on interest rates and their related potential deflationary impact on the dollar. We're revisiting old themes that have recurred to varying extents on every bounce in the dollar to date - but generally to a lesser extent than what used to exist before the dollar's bear market got underway in 2002 (after peaking in July 2001). Last year's dual boom in stock and commodity prices only gave the deflation argument fresh impetus.
First of all, historically higher interest rates have not usually caused money supply to contract in the post gold standard era unless the yield curve inverts (even then it's less than a 50 percent chance - see table on the next page). There is plenty of data to confirm it. Interest rates trended higher for thirty years after the Fed tried to fix them at the same levels they are at today during the fifties.
The bull market in gold and gold shares started soon after they started to turn up. Gold prices were fixed and inarguably manipulated at the time so gold itself didn't participate (except on the black market) until the combination of keeping gold too cheap and reckless inflation caused shortages so large there was no choice but to abandon Bretton Woods - which Nixon did. It was made inevitable by the decades of inflationary policies that preceded it. Any President would have had to have done the same no doubt; maybe that's controversial.
However, it is well-known that the consensus believed that an abandoning of the BW monetary standard would result in a huge dollar rally at the time, and that gold would fall. Several policies were put into place to back the decision up, and confidence in the new Special Drawing Rights as substitutes for gold was strong at the Fed.
But none of it worked. Higher interest rates too did not end the gold bull until thirty years later when the Fed hired Paul Volcker to get it ahead of the curve - even before Volcker several yield curve inversions occurred and had slowed the growth in money; but even then the Fed couldn't slow the average annualized monthly gain in M3 to below a 7% growth rate until the mid 1980's.
Any way you slice it - interest rates go up when inflation expectations do, and only when the Fed puts itself way ahead of the curve for some time can we expect that the policy will begin to support the currency. But even then it does not mean money supplies must contract - it just means that if the strategy goes according to plan the market might regain confidence in the Fed and dollar.
Factors Really Affecting the USd
In order to undertake this policy today, the Fed would have to admit to fighting the inflation, which would first then get more appropriately priced into financial asset values, including the still overvalued FX value of the dollar.
The contrary view that a little bit of cod liver oil now would be healthy for the markets doesn't wash with the historical facts under conditions where the central bank has similarly fallen so far behind the market and stock prices are as expensive - as well as other factors mentioned below. If we're right to think that much of the allegedly bullish economic activity is supported only by an easy money policy then any change in course there is going to end the subsidies abruptly. I doubt the Fed is in that frame of mind today where it risks getting the blame for a downturn; I don't believe it is that confident in the recovery theme.
Perhaps it will be one day when the dollar is no longer overvalued, the trade deficit has contracted, and the exodus from stocks as rates go higher no longer causes the currency trouble, because they're too cheap.
Moreover, besides the Fed's stance there are several other factors that exist today to support the bearish outlook for the US dollar in the intermediate and long term:
The production infrastructure in commodities has been neglected for so long that it will take years of higher prices to correct - higher prices have yet to choke off the growth in commodity demand.
The US trade deficit keeps widening which means prices are still rising faster in the US economy than they are elsewhere, and that the US dollar is still overvalued on the foreign exchange markets.
Foreign central bank interventions - especially by the BOJ - have contributed to the ongoing overvaluation of the US dollar despite its drop in value over the past two years.
The whole world bought into the US-led recovery trade and consequently most everyone is still in stocks whose values reflect the anticipation of low interest rates for the foreseeable future.
The prospect of a new bear market leg in the stock market ignited by a sharper than expected spike in long term yields as the result of a growing inflation awareness threatens to unwind this trade now, which in turn is likely to weigh on the foreign investment demand for dollars.
The significance of the statistical correlation between interest rates and money supply growth, or between the dollar and money supply growth (see table below) is small, especially relative to other correlations. The dollar commonly rises when money supply grows and it has been known to fall when money supply isn't growing. In fact, as discussed in past issues, central bankers have shown a fondness for the Krugman (neo-Keynesian) model: "quantitative easing." Put simply, it means that an aggressive expansion of credit is the formula for strong asset returns, and consequently, a strong currency. Believe it!
I realize that is counterintuitive for gold bulls... er, anyone with a brain that is. But that's only because you understand that money expansions confer no benefits and they undermine the currency's value sooner or later. The fact that central bankers don't realize this today makes me more bullish on gold.
Note the calculation of the simple correlation coefficient for various relationships going back to the seventies in the table to the right.
The most significant correlations are those that exist between 10 year bond yields and the S&P PE ratio as would be expected, as well as between the Gold ratios and money supply, the gold ratios and the equity risk premium, the yield curve and money supply, and finally there is a similarly significant correlation between the PE ratio and the growth rate in earnings - the correlation is slightly more significant in relation to the estimated "real" rate of growth in earnings (i.e. gold adjusted profit growth).
Interestingly, the relationship between gold and interest rates is the least significant in the post 1971 monetary world. This fact would almost certainly change if I adjusted the data for a lag - recall our previous charts on this relationship revealing that gold prices tend to peak and trough "ahead" of bond yields by up to two years.
In any case, matching these data to current trends confirms our hypothesis for a multiple contraction in stocks generally while the correlation between M3 and the gold ratios (Gold/CRB) explains the underperformance in gold prices - because the growth rate in money temporarily slowed in the last quarter of last year - and also suggests that some caution is warranted for the bullish gold outlook if that trend returned.
However, my concern over the impact of the steepening yield curve is mitigated by the Fed's posture on short rates and the current explosion in inflation expectations. Similarly, the narrowest measure of money supply (M1) grew at an annualized average 20% in February and March (or 12% for the entire first quarter), while M3 has turned up to grow at an annualized 9 percent clip practically each month this year again right through April according to preliminary data, which is certainly bullish for the gold ratios (and gold itself).
Notwithstanding the weight of the evidence in our favor, I basically see two things supporting the US dollar's bounce at the moment:
1) The decline in US stock markets has been moderate so far compared with the declines in foreign shares - so in a sense returns have been better in US shares for the past few weeks (more on this below). The dollar bullish press has dragged out its old theories that a downturn in the US economy is even more bearish for foreign markets... the risk premium on foreign shares is rising, they say. Other currencies are seen to fall faster in a US-led downturn because the US economy is the main engine of global growth, etc., etc. Still, the trend in returns is affecting the short term outlook to an extent in my opinion.
2) The return of fashionable deflation themes supported by weak gold prices, a flattening yield curve, and " last year's dual boom in stock and commodity prices," is causing the long term outlook for inflation some resistance as well, conveniently for the Fed.
The dollar's bounce amid a more stable but bearish US dollar capital market environment is the perfect fertilizer for deflation fears to cultivate. Everything went up last year, and so everything must come down; the dollar went down last year, so it must go up too. Or at least that seems to be the sentiment affecting dollar trade. Although I think people are right to be bearish on stocks, for that reason I argue they should also be bearish on the dollar.
USd Resilience Suggests Confidence in Bullish Relative Outlook for US Assets Still Buoyant
I think the dollar is buoyant right now because confidence in the US stock market has not ebbed much despite the recent correction and the higher high in bond yields. I believe stock bulls think they can absorb this back up in yields; hence so long as the correction in stock and bond prices is confined to reasonable limits the dollar could still benefit. Another way of saying it is that so long as US stock prices hold steadier than global markets the dollar could benefit from the higher yields.
In this graph I want to briefly illustrate how my dollar model works - it basically attempts to anticipate capital flows (the investment demand for dollars) by identifying and anticipating trends in relative stock and bond returns, which runs parallel to the theorem that there exists an inverse correlation between USd financial returns and gold (Summers). The shaded regions in the graph here depict what has up until now been the most bearish combination for the dollar's FX bear market - falling relative equity returns and falling bond yields. But now markets are trying to adjust to higher yields. Notwithstanding the inflationary impetus to the higher yields, and the combined implications for asset values, the dollar seems to be attracting net capital flows at the moment. I think the reason is to be found here. Note how the S&P 500 / Dow Jones World ratio (top graph) has turned up despite the relatively sharper rise in USd bond yields (especially their differentials with respect to foreign gov't bonds). This is a bullish combination for the dollar in our model.
It occurred plenty in the dollar bull market past, but the last time it occurred before now was during October of 2002 briefly, and during the final quarter of 2001 more significantly.
We might be seeing some of the Buffet money that left to chase asset returns in foreign currencies last year coming back home now on the presumption mentioned earlier - that foreign markets are even riskier in a US downturn. Or at least that's the best explanation I can think of for the behavior implied in the charts here... far better than the carry-trade or consumer dollar short thesis in my opinion (next section).
Whereas the dollar's bear market so far has been defined by falling relative capital market returns and yields, and the most bullish combination for it is the opposite, there are two more basic combinations to consider: both involve an environment where stock and bond prices are coupled - in one case both stock and bond prices are rising faster than in other markets and in the other they are both falling faster than in other markets (I don't like to adjust the data for real returns because that would involve more assumptions - changes in the nominal data on a relative basis have been sufficient to describe changes in the outlooks for real returns).
At any rate, history hasn't been as decisive in the implications for the dollar deriving from the former combination where stock and bond prices are outperforming the world averages; but in the case where stocks and bonds fall it is usually quick and bearish for the dollar - climactic if you will. It usually occurs at the end of a dollar rout (though not necessarily at the end of its bear market), as it did after each such occasion in 1973, 1980, 1987, and 1994 to name a few instances in memory.
Since this phase has still been absent from the dollar's bear market - and because the dollar's bear market is supposed to lead to higher inflation expectations and higher yields - I still expect it to mark the end of the dollar's current stretch, which will probably still only be the beginning of its secular bear market.
The basis for that outlook rests with my belief that yields are going to rise faster and sharper than most participants expect, and that the stock market, is going to discount an extent of inflation it hasn't considered since the seventies. This exactly will weigh on the dollar if and when it unfolds.
So far the US stock averages have pulled back to their moving averages while the bond yield is not yet rising faster than expected. This is to some extent reflected in the graphs above and explains the dollar's current resilience in my view. Meanwhile, the widening trade deficit proves that the dollar is still overvalued on foreign exchange markets (which I would attribute largely to the efforts of foreign central bank intervention during most of the dollar's decline), and soaring costs for lumber, energy and food in the US economy continue to draw attention to the inflationary excess haplessly washing up on shore like an oil spill in Alaska.
For now, the uptick in relative USd denominated stock returns in the graph above could simply represent a temporary repatriation flow of investment funds and other foreign currency bets while the widening USd yield differential could be attracting enough dip buyers in the Treasury market to support the dollar but not enough to support the bond. Either way it suggests that there is still a bullish bias implicit in the outlook for real US dollar returns despite the building inflationary evidence to the contrary.
Beyond the occasional correction I don't expect yields to stop rising and I expect the US stock market to underperform its global counterparts for the foreseeable future.
However, it is when you see this latter event begin to occur that the dollar is likely to rollover. It is a significant sign that the bond isn't relenting much even on sharp down days in the stock market. It suggests to me there's more upside in yields to go. The question for the dollar outlook then, and hence gold, is at what point will that prospect cause US shares to underperform the global average?
Fashionable Ideas Apparently Affecting USd Trends
Debt can grow indefinitely in the post gold standard era in dollar terms unless the central bank itself abandons the policies producing the boom in credit. This is the truth that the bull market in gold will one day reveal. People must not believe that the policy of inflation is endless. Remember that sentence. Its veracity is the absolute key to opening the bull market in gold up wide! The Fed works hard at keeping you from believing it. I bet that Sir Alan is utterly joyous when people all on their own come to the conclusion that a contraction in the money supply (when there is a fully equipped engine for inflation and no gold standard) is in the offing - and one that is uncontrollably wild at that! You can't help people even if you try.
The line that is crossed when people abandon a particular paper money, according to von Mises who lived through a few such cases, is precisely the discovery or realization that the policy of expanding paper notes is endless. We have had a century of this and still people can't reckon it's endless. But it is this reckoning which is the difference between what really ultimately occurs and what occurs according to the laws of physics - that is those which exclude the interjection of human valuation judgments.
Just because debt levels are big does not mean that they have to one day contract. This is the whole argument against fiat money systems. If it did, there would be no point in owning gold. You could just buy dollars near the end of a boom and hold them through the bust and do just as well - even if gold was the only thing that went up you could do just as well owning dollars if everything else went down. Gold would never receive a premium over the other commodities, which we know is not the case.
The trend in USd gold prices over the century still describes a currency that is constantly falling despite the fact that these trends have been interrupted by long periods of stable or falling gold prices. But it is during periods that the dollar drops quickly - due to a pent up devaluation on foreign exchange markets - where it begins to affect prices and interest rates most dramatically and where the danger of a demonetization arises.
I am absolutely confident that people will see this one day - when gold is going past our long term targets. The fact that they don't yet is both frustrating, on the one hand, and confirming on the other. I truly believe it means the bull market in gold is still very young. And it confirms my assessment for the dollar, that it hasn't fallen as fast as it would have without the interventions, yet.
Anyway, while I don't at all subscribe to the hypothesis of a consumer driven deflation spiral when there's a central bank ready to print as much as they need and when foreign owners of dollars still have much to sell on a serious down turn in stock and bond prices (see the section, "according to Hoye..." in our May 7th issue - wake from thy slumber), there is another idea dollar bulls have discovered that is harder to dispute.
It is suggested that a carry trade existed where investors borrowed short term funds and leveraged up their bets on all sorts of things last year - commodities and stocks (foreign and domestic). This plays fabulously into the mind of a devout deflation predictor after all things went up like they did last year.
At any rate, naturally, a historically steep yield curve is going to cause some of these types of carry trades to occur. I can't dispute it. You could explain the downtrend in the US dollar amid the outperformance of foreign securities in the 10 months to February this way - that hedge funds and other traders sold the dollar short and put on bullish leveraged trades overseas. It happens to parallel our contention that the dollar fell despite the Dow rally because markets performed better overseas.
Notwithstanding, I have two observations.
First, any borrowing in the short term is just that - short term. In all likelihood these have already been unwound, or maybe should have been. Second, what ever happened to the yen-dollar carry trade that allegedly underpinned the US dollar's rally in the years 1995 all the way to 2000? Now that was a carry trade. I think it gave new meaning to the term, carry trade. People were supposedly borrowing yen at negative real rates and ploughing the funds into tech stocks and mortgage shares in the US.
I've been waiting for years for that trade to unwind. It gradually has; but the yen has yet to outperform the other currencies where the carry trade hardly existed to the same extent if at all. Why is that? I don't know. But it's a fact. We're still waiting on the explosion in the yen on the reversal of the yen-carry trade of the nineties!
I have no choice but to write these bullish theories about the dollar off as only fashionable - owing to the later stages of a dollar bounce. Just like I wrote a cautious call on gold shares last year because I didn't want our credibility to hurt in a downturn, I think that some gold bulls are jumping on this dollar bandwagon similarly, so as to give credence to an idea that might make them wrong about gold in the short term.
In other words, I think it shows a lack of conviction in the gold bull, which may in hindsight be just the buy signal the market needed. Whatever I believe, the fact is that what is giving gold trouble now is the dollar's resilience and threat to reverse a downtrend. I think it's a veiled threat similar to the hawkish one by the Fed; but we have to monitor its trade here for a sign that the bulls are failing to reverse it. Gold should feed off any signs of that.
POG: Delayed Reaction, or Bearish Sign?
One of the main factors contributing to the dollar's strength is the weaker gold price itself.
But this week's news has all been good for gold. Despite reports of a decline in China's trade surplus with the world, the US trade account worsened further into March - indicating ongoing price pressures in the US economy. The weekly monetary figures issued by the Fed show money supply growing briskly again after taking a time out in the fourth quarter of 2003. The soaring oil and gas complex is making headlines. We also heard this week that consumers spent less of their shrinking disposable incomes in April after splurging in March. Both stock and bond prices continued to sink. New tensions on the geopolitical scene began to flare over controversial public footage - first of the way US authorities treated their POW's, then over the even more horrid methods of the enemy in its treatment of a hostage. The United States announced export sanctions on Syria. After trending down for about a year while Bugos has been jumping up and down about inflation the whole time the government this week finally confessed to a higher year over year growth rate in prices for April at all levels.
The PPI finished goods number grew an annualized 8 percent in April and 3.7% year over year following on sharp increases in the crude component of this index - some of which are probably still going to be coming through (building up if you will). The US April CPI figure, released Friday morning, allegedly grew at a more modest annualized 2.6% clip, but the trends are up; moreover, the core rate surprised analysts by outpacing the headline figure (all items grew 0.2% in April, core grew 0.3%) also because the increase in gas prices apparently hasn't come though yet. The gap between 10 year Tnote yields and the equivalent inflation indexed security yield has so far outpaced the increase in the 10 year Tnote this week - reflecting an increased consciousness about the reality of inflation even before the price data.
What is clearly happening here is that the market is beginning to consider the inflationary arguments that we've been writing to you about for years. The operative word is "beginning." Pretty soon maybe even Jude Wanniski will know what inflation really is if such pondering leads to the right questions. So what the heck is gold's problem? Maybe nothing. Well, aside from the dollar's recent resilience in the face of it all that is. I've argued that the spike up to our target range (now $475-$500) will be on just such heightened inflation awareness. Up until now the gold and commodity boom have been dominated by side themes - the dollar, terrorism, falling rates, a boom in China, etc. The gold and commodity trends have been marked by a clear uptrend in inflation expectations all along but this fact was consistently overshadowed by the other, perhaps more exciting if not misguided headlines.
This was not because there was no inflation; but because it wasn't widely perceived - owing in part to the Fed's efforts at managing this. Inflation has raged and continues to. The fact that it is showing up in the data at all is cause for concern because, as you know, the CPI and PPI by default understate it (since increases in money supply don't translate into price increases uniformly any increase at all is excessive - absent the monetary impetus prices would naturally fall, not uniformly, but generally over time... the value of your buck would rise!).
The nonsensical idea that strong growth is causing yields to rise has been pushed into the background and the market is suddenly faced with the prospect of inflation, which it has to factor into its valuation of stocks, bonds, gold, and currency relationships - because it hardly has up until now. The Fed is probably going to remain relatively easy (relative to what would be required to stop the inflation). The question has become, how high will prices and long term yields go now and how much do we have to discount stock values by? The answer is quite open ended. As people become more confident that the inflation will continue despite, and even because of, falling stock and bond values gold will roar like the king of the jungle it is! Don't you think we're close?
Gold bulls have yet to recover the week's decline but they're working on it Friday morning. They must recover the $385 handle now to halt the downtrend, and then $400 before turning the short term trends up again. The correction in gold prices has been modest (less steep) relative to the other precious metals for good reason - it underperformed them on the way up. Nevertheless, the longer we stay below the 200-day moving average the more credence we must give to the double top hypothesis arguing for a further drop to $350.
This is especially true in my opinion in light of the increasingly bullish gold news. It's like watching a company report terrific earnings and the stock does nothing; it often means the news is factored in.
On the other hand, I've seen delayed market reactions to good or bad news before - even in markets that are either widely traded or watched. Indeed, I've watched this market closely for years and can virtually assure you that the inflation outlook has not been accurately considered in the least. It's been ignored, misunderstood, and displaced by other more exciting ephemeral themes. The new facts are like headlights suddenly making out a deer in the road ahead. Investors are staring at them, dumbfounded, because the Fed has talked about low or no inflation for months. What a set up.
The mainstream press usually ends up talking about what we have already written about months earlier. To that end I predict they'll soon be buzzing about the growing labor unrest in the United States economy amid a fresh dollar crisis... just ahead of the election. This is tomorrow's news. If I'm understating the extent that the market has factored any inflation to date I'm certainly not understating its consideration of this likely future course of events. Nevertheless, in order to confirm our bull market hypothesis on gold, the parameters are as follows:
1) we have to better the 85-87 rally,
2) we have to take out the 1996 high and keep it, and
3) we have to outperform the other commodities in the process.
Anything less than that in light of events, including a plunge to $350, would mean that we're overlooking something and it would cause me to seriously reconsider my views. Maybe it would just make me more bullish.