How does one reconcile the powerful Santa Claus rallies that are underway on global equity markets, while the gold market is simultaneously enjoying its greatest bull market in 25-years? Gold is not just moving swiftly higher against the US dollar. Gold has more than doubled in Japanese yen terms from 5-years ago, to stand at 64,000 yen per ounce, its highest in 18-years. Against the Euro, gold is trading at 460 Euros per ounce, an all time high, and 32% higher from just four month ago.
Traditional market signals of higher inflation, emanating from soaring copper, crude oil, gold and the CRB index have not led to higher US Treasury bond yields. Instead, Asian central banks are recycling dollars acquired through currency intervention, and Arab oil kingdoms are recycling Petro-dollars into the safe haven US bond market, through their London based brokers, regardless of market value or the inflation outlook, depressing long-term US Treasury yields by up to 100 basis points.
So while the Federal Reserve was lifting the federal funds rate over the past eighteen months, foreign central banks kept a lid on long term rates, locking yields on the benchmark Treasury 10-year note into a tight sideways trading range for the past two years. The famous bond market vigilantes of the 1980's who punished the Fed when the US money supply was out of control with higher bond yields, have been beaten into submission by China, Japan, and lately, by Arab oil kingdoms of OPEC.
Among the myriad of influences that can impact the global economy, one cannot overlook the pivotal role that persistently low bond yields had in fueling the most rapid world expansion in three decades. The persistence of such low bond yields in a period of rapid growth has created enormous bubbles in gold, base metals, crude oil, US home prices, emerging market bonds and global equity markets.
Yet at a meeting of the top-10 central bankers on January 9th>, European Central Bank chief Jean Claude Trichet sought to link the low bond yields and the flat US Treasury yield curve to the G-10's vigilance in combating inflation. "We think that the credibility of the central banks is very, very important and has proven to be effective as regards to inflation expectations. Inflation expectations are low worldwide, another sign of central bank credibility," he said.
But behind the scenes, Trichet has pursued a policy of "asset targeting", pegging the ECB's repo rate below the Euro zone's inflation rate to engineer a 23% rally in the EuroStoxx-600 index last year. Europe's negative interest rates nurtured $1.04 trillion of Euro mergers and takeovers in 2005, which in turn, injected more fresh cash into Euro equity markets, and fueled explosive growth of 8.5% for the Euro M3 money supply. The ECB used to consider 4.5% growth for M3 to be consistent with low inflation.
However, in "hard money" terms, the impressive 23% rally for the EuroStoxx-600 index in 2005 was only an optical illusion. The EuroStoxx-600 was outpaced to the upside by a 31% surge in gold prices against the Euro. Compared to gold, the EuroStoxx-600 actually fell 8% to 0.712 Euro /ounce from about a year ago. Gold added an extra 8% against the Euro in the first two weeks of January, sinking the EuroStoxx-600 further to 0.689 Euro /ounce.
Targeting the lowest credit costs in six decades during a period of strong credit demand, meant the ECB had to pump more Euros into the $9.3 trillion economy than needed for inflation-free growth, triggering double-digit house price increases in countries such as France and Spain. Thus under Trichet, the ECB's monetary policy has evolved into the Greenspan Fed's model of stimulating consumer demand through the "wealth effect" with higher equity and home prices.
Trichet has turned 180 degrees away from a speech he gave before the Federal Reserve Bank of Chicago, on April 23, 2002. Then, Trichet sounded like a fierce opponent of "asset targeting", and said central bankers should avoid using interest rates to prop up or reduce inflated prices for stocks, real estate, and commodities. "We should be extremely cautious in reacting to asset price bubbles. It would be like opening a Pandora's box, where investors take risks because they think policy makers protect them from losses," he said.
"Central bankers can't determine the appropriate value of assets. It is generally hard to assess whether price movements are the result of fundamental changes in the economy or whether asset prices evolve according to some pathological path. Central bankers watch bubbles, which may increase consumer confidence, spending and investment when they inflate and impinge upon financial stability when they burst. Governments should use market regulations to discourage bubbles instead of expecting monetary policy to do so," Trichet said.
Finally, in September 2005, the European gold market joined the global bandwagon, and broke out of a five-year sideways trading range to the upside, recognizing that the ECB had joined the Bank of Japan and the Federal Reserve in rigging asset markets. On January 12th, ECB chief Jean Trichet could not muster the courage to lift the central bank's repo rate above the Euro zone inflation rate, triggering a 2% surge in gold prices to 460 Euros /oz the next day.
Still, the ECB's easy money policy pales in comparison to that of the ultra-easy money policy of Bank of Japan. Tokyo remains the cheapest source of capital on the globe and is fueling asset inflation worldwide in equity and commodity markets. Global financial markets have become so sophisticated that traders can borrow cheap money in Europe and Japanas easily as they can in the United States, to leverage their purchases of natural resource stocks, crude oil, gold, or even Brazilian and Russian bonds, all benefiting from soaring commodity prices.
Tokyo's Nikkei-225 stock index finished 40% higher in 2005, its biggest annual gain since the 1980´s asset bubble, on expectations that Japan's once morbid economy can post steady growth and exports. Foreign investors bought a net 10.21 trillion yen of Japanese equities, a record for a single year. Land prices in Tokyo, which had fallen 80% since peaking in 1990, rose last year for the first time in 15 years. In "hard money" terms however, the Nikkei rally was just an optical illusion, unable to outstrip gold's 44% climb to an 18-year high of 64,000 yen per ounce.
Japan 's ruling elite tried to squash the gold rally by ordering the Tokyo Commodity Exchange to lift margin requirements by 33% to discourage speculation. The tactic worked for a brief time, and triggered a mini panic, knocking gold 13% lower to $495 per ounce in New York. However, news that Barrick Gold and Placer Dome were joining forces to put more gold into fewer hands, and China's future plans to diversify its massive US dollar reserves into other currencies, including gold, ultimately foiled Tokyo's grand scheme.
Millions of words have been written about the Bank of Japan, known for its heavy handed intervention tactics in the foreign exchange market, dueling speculators to defend the US dollar and the profits of Japanese exporters. But the BOJ doesn't limit its intervention to the forex markets. The central bank also buys of 1.2 trillion yen of Japanese government bonds each month, and monetized 42% of the budget deficit last year. The BOJ floods the Tokyo money markets with an excess of 30 to 35 trillion yen, ($300 billion) above and beyond the demands of local banks.
Japan's overly generous monetary policy has pinned local interest rates at zero for four years, and in a long delayed reaction, ignited a frenzy for real estate and natural resource shares on the Tokyo Stock Exchange similar to the country's asset-inflated bubble of the 1980's. And if a Nikkei bubble does develop, the Bank of Japan could wait too long to take counter measures, as it did the last time, allowing Japanese share prices to show signs of irrational exuberance.
Tokyo 's national debt is now approaching 774 trillion yen ($6.4 trillion), or 151% of its economic output. The Ministry of finance is staunchly opposed to a tighter BOJ policy, which could drive up the yen against the dollar, and increase the cost of financing the debt. Yet if the BOJ keeps the current policy in place when consumer prices start to rise, it will lead to negative interest rates in real terms. That will have an easing effect. Already, Japanese producer prices have been in positive territory for the past two years, leaving the BOJ far behind the inflation curve.
But while the Nikkei-225 lost 4% to the gold market, and the EuroStoxx-600 lost 15% last year, the Dow Jones Industrials surrendered 23% of its value, falling below 20 ounces of gold per one Dow share, to its lowest level in nine years. The results might have been far worse. Not until the appointment of Super-dove Ben Bernanke to lead the Federal Reserve and the onset of powerful stock market rallies abroad did Santa Claus come to Wall Street.
Bernanke's reputation as an easy-money man is engraved by his most infamous speech in November 2002. "The US government has a technology, called a printing press that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
Thus, the Santa Claus rally that has lifted Dow blue-chips 8% higher to the 11,000 area was just another optical illusion. Gold rallied 19% or $90 per ounce since the Bush appointment of Ben Bernanke to the Fed on October 24, 2005. Both gold and stock market bulls have a lot of money riding on Bernanke. Everybody knows the fortunes of the US economy will rise and fall with the direction of home prices, and the appointment of Bernanke, was a clear signal to the marketplace, the Fed would do whatever it takes to keep home prices from falling.
How would the new Fed chief react to a spike in oil prices if Iran unleashes the "Oil Weapon" in 2006, and cuts off oil exports of 2.4 million barrels of day, in reaction to UN sanctions? "If inflation has recently been on the low side of the desirable range, and inflation expectations are likewise low and firmly anchored, then less urgency is required in responding to the inflation threat posed by higher oil prices. In this case, monetary policy need not tighten and could conceivably ease in the wake of an oil-price shock," Bernanke said on October 21, 2004. Thus, Bernanke might point to the flat or inverted yield curve as credible proof that inflation expectations are firmly anchored on the low side, and start lowering rates in reaction to an oil spike.
Iranian hardliner Ahmandinejad has threatened to cut off 2.4 million per day of oil exports if the UN imposes economic sanctions on OPEC's second largest oil producer. "Those who use harsh language against Iran, need Iran 10 times more than we need them. We suspended enrichment voluntarily, but now we don't want to suspend any longer. Other nations do not have the right to deny our right," he said.
US Secretary of State Condoleezza Rice said on January 16th, that Iran "crossed the threshold" with its recent nuclear actions and the world must act fast to send Tehran to the UN Security Council. On January 15th, Republican Sen. John McCain of Arizona said the US might ultimately have to undertake a military strike to deter Iran. "I don't think it helps to speculate. We have said all along that the president always keeps all of his options, but we are on the diplomatic course."
McCain called the nuclear standoff, "the most grave situation that we have faced since the end of the Cold War, absent the whole war on terror. We must go to the UN now for sanctions". While acknowledging that President George W. Bush has "no good option," McCain said "there is only one thing worse than the United States exercising a military option, and that is a nuclear-armed Iran. If the price of oil has to go up then that's a consequence we would have to suffer," he said.
Sen. Evan Bayh of Indiana, a member of the Senate Intelligence Committee, said there are sensitive elements of Iran's nuclear program, which, if attacked, "would dramatically delay its development." Republican Trent Lott of Mississippi, said that despite a massive military commitment in Iraq the United States has the capability to strike Iran but it would be difficult and other options must be tried first.
US Vice President Dick Cheney arrived in Egypt on January 16th, at the start of a brief Middle East tour that will include visits to Saudi Arabia and Kuwait, in a flashback to a similar trip he made several months before the US invasion of Iraq.
But while the yellow metal handily beat the big-3 equity markets last year, it lost 12% to "black gold" last year in a continuation of a four-year bear market. Gold fell to as low as 6.57 barrels of US light crude oil per gold ounce in the third quarter of 2005, or 58% below its high in 2002, before it was rescued by a second half recovery. Arab sheiks in the Persian Gulf might have already begun stockpiling gold ahead of a possible military confrontation between the US-Israeli alliance and the Iranian-Syrian axis, over Tehran's secret nuclear weapons program.
Gold's recovery carried the yellow metal through horizontal resistance at 7.5 barrels per ounce, and then penetrated a downward sloping trend-line at 8.25 barrels, confirming that a major bottom has been reached. If crude oil spikes to $70 per barrel under an Iranian self-inflicted embargo, and if gold recovers to the mid-point of its five year trading range near 11 barrels of crude oil per gold ounce, that would project a gold price of $770 per ounce. However, those are two big ifs.
Global blue-chip stock funds are often purchased as a hedge against monetary inflation, and the coincident rally in gold prices might only confirm the bullish outlook of many investment bankers and mutual fund managers. However, lurking below the surface, gold's rally might also be linked to geo-political tensions in the Persian Gulf. If Tehran's Ayatollah refuses to back down, the world could witness either a nuclear armed Iran with long range Shahab-4 missiles or a nasty military confrontation.
Under either of those two scenarios, crude oil and gold could soar, and the global Santa Claus stock market rallies would come into clearer focus as optical illusions.
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