Article originally submitted to subscribers on 3rd December 2006...
The Big News:
In case you haven't heard, the US Dollar broke significant support 2 weeks ago and is poised to test the all important 80 level.
Actually it's a lot worse than that!
Chart 1 - US Dollar Monthly
The break below 85 completed a Cup and Handle formation (blue arrow) with a target of 78.
A sustained move under 80 would be catastrophic for the Dollar in that it would complete a larger Head and Shoulders pattern (blue line at 80 = neckline) with a target below 60! This would be tantamount to wholesale DUMPING of the US$ and in all likelihood an end to its Reserve Currency status.
In the face of what's shaping up to be a Dollar crisis what do you expect the Stock and Bond markets to be doing?
Swooning?
Try again.
The Dow continues to hover around all-time highs. The Bond market continues to move higher and the Utilities Index is making fresh all-time Highs.
Hardly the reaction you'd expect right?
Add to the mix a decidedly Bearish news flow - manufacturing weak, housing sales falling, Walmart sales dropping and unemployment benefits up substantially - and you've really got to be scratching your head wondering if the markets have gone MAD?
No, the markets are doing exactly what they should be doing. It's our perspective that is skewed.
The brilliant John Murphy of Inter-market Analysis fame puts it; there is a time lag between a falling Dollar and a falling Stock and Bond market (paper asset markets).
In Inter-market analysis the link between the Dollar and paper asset markets can at times be very unconvincing. The key to unravelling the mystery is the commodity and, more importantly, the Gold market.
A declining Dollar is most definitely inflationary as the cost of imports rise. The timing of a drop in other paper asset markets is after Commodities have responded to the inflationary infusion. That is, the inflation must first filter through the commodity market before there is a knock-on affect on the Bond and Stock markets.
Commodities must be screaming inflation before other paper asset markets respond.
Now in the case of Gold, there are 2 necessary ingredients to create a sustained move:
- A slowing economy and
- An increase in inflation expectations
A proxy for slowing growth is Gold outperforming economic sensitive materials e.g. industrial metals. The Australian Dollar is a good proxy for industrial metals:
Chart 2 - Gold in Aussie $ - growth slowing but more required to sustain upward trend
What we see here is that Gold has been outperforming the Aussie Dollar since October but has not broken any new ground (blue line) - more evidence of a slowdown is required.
Inflationary expectations
One way to gauge inflationary expectations is to view the spread between Treasury Inflation Protected Bonds (TIPS) and unprotected Bonds of the same maturity. The theory being that when investors perceive a greater inflationary risk they would prefer TIPS versus unprotected Bonds and hence TIPS should outperform.
Chart 3 - 7-10yr Bond Fund vs. Inflation Protected Bonds
Based on the above chart, inflation expectations remain very low amongst investors. The unprotected bonds have been outperforming the inflation protected bonds since early 2005. The current structure however looks unsustainable as price has gone parabolic (blue line) but the MACD internals (bottom blue line) have not confirmed.
In summary: inflation expectations are beginning to pick up but we're not there yet.
We are now in a position to understand why other paper asset markets haven't fallen apart in the wake of a falling Dollar:
Growth is moderating and inflation expectations are beginning to rise, but there is just not enough evidence to conclude that a sustainable Gold rally is upon us.
As the Dollar continues to fall, the ingredients for a major Gold rally should slot into place. We will have our Perfect Storm yet but for now the markets are saying, "Needs more time ..."
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