"The Fed's approach to monetary policy may force it to cut rates if the subprime and credit issues reduce overall demand for base money… In addition to the technical indicator provided by the 5-week and 5-day moving averages shown above, the fundamental outlook for the intermediate term is based on this potential devaluation of the dollar if the Fed is forced by credit issues to intervene." ~ Precious Points: Good as Gold, July 21, 2007

"Bernanke's speech was exactly the sort of rhetoric you'd expect from a man prepared to undertake a massive devaluation to try and stave off a credit crisis." ~ Precious Points: Are Metals Next, July 14, 2007

"It's a safe bet to expect the Fed to do what it always does in times of crisis, allowing the credit markets to inflate the money supply and stimulate the economy, even if it is only an economy of debt." ~ Precious Points, June 24, 207

Given the beating taken by the major stock indices last week, metals fared somewhat better even though gold closed back under the 5-week moving average and silver back under the 5-day average. Two consecutive closes above these levels has been a useful indicator of the short term rally in these metals and, though the recent weakness dampens the signal's suggestion of new highs, the extension of the bull market in precious metals may very well still be preparing to get underway.

Volatility was always expected as a component of this new up move. The chart above in gold shows a break below the 5-week moving average that often signals a retest of the 50-week moving average. If the heavy selling pressure that some are beginning to fear does in fact materialize, a trendline test at $620 is likely. The shorter time frame daily chart below shows gold approaching oversold levels on the RSI and first support at the 200-day moving average, currently about $651.35, with the 50-day average also serving as a key level. An upward move faces overhead resistance at the 5-week moving average, about $664, and the 5-day average at $672.

Silver has frankly been a mess lately, testing the resolve of precious metals investors. The convergence of the 5-, 50-, and 200-day simple moving averages prompted a technical breakout, which has now failed and produced negative crossovers. It may very well, however, also provide a relative equilibrium point around which the white metal may remain bound until the fundamental undercurrents suggesting a new surge in metals are realized.

Beyond seasonal factors that tend to increase demand for precious metals near the end of the year, the intermediate outlook for metals is inextricably linked with the dollar, interest rates, and the housing related credit issues that have dogged the stock market lately and tried lesser men's souls. Rate cut expectations were low or nonexistent when hints of the emerging credit market seizure were appearing in the form of rising bond yields back in June. Of course, at that time, this space was bringing attention to the fact that the Fed's rate targeting regime would force a cut if demand for money waned while credit conditions worsened. The previous update called attention to the fact that rate cut expectations had significantly increased since that time. Rate cut expectations leapt dramatically higher again last week, nearly tripling to 96% by year end and 100% by the end of 2008 Q1.

This update has long called Chairman Bernanke's obsession with containing core inflation a necessary smokescreen, a pretext that would seem to permit and justify policy accommodation if needed, and we now seem to be nearing the threshold. If this is so, and the Fed is in fact preparing to prop up the banking system with a massive influx of new money and/or an interest rate cut, then the likely intermediate to long term effects on precious metals are obvious. Weakness in the metals last week, though, in the face of the looming crisis, provides an important reminder that metals initially suffer as liquidity wanes and policy accommodations are enacted. Remember that gold fell along with interest rates in 2002 and did not begin it's now famous bull run until Greenspan signaled the all-clear and began hiking rates to stem the tide of what was an obvious dollar devaluation.

Last week, then, was somewhat of a return to the low inflation expectations that took root in the spring when core inflation decreased in successive months. A low PCE deflator component in the initial GDP estimate helped to solidify the contained inflation thesis and encourage the rate cut camp. This very intentional consequence of the highly dubious government statistics has been a major headwind for metals over the last several months. The other chief contributor to metals' inability to build on their gains last week was relative strength in the dollar. As it seems London and Frankfurt will take a break from their rate hiking campaigns, the dollar has stabilized against these currencies and slightly rebounded from multi-year lows. As mentioned last week, though this may have a psychological impact on traders, it's largely irrelevant to the value of a dollar relative to gold and silver. Still, the dollar's relationship to other depreciating currencies is also a likely misdirection in the case of a Fed cut.

Early signs of the Fed's eagerness to inject liquidity, and of broker/dealers to accept it, appeared as an additional $8.25 billion in sloshing repo funds last week, $6.25 billion of which was added Thursday alone. If anything like this trend continues, a new leg in the gold bull market seems inevitable. In the short term, though, it's quite possible there will be a recovery in overall outlook, a proverbial calm before the storm that may or may not translate into further advances in precious metals. But certainly if and when the crisis strikes, metals will not be immune from selling pressure.

Bernanke's ambiguous assertion to Rep. Ron Paul that he is confident he can avoid a 1979/80-style dollar deflation - and its effect on trader psychology - should not be taken lightly, particularly given the profound fluctuations his rate targeting policy can produce in money supply. But if this is the start of another 2002-style period that tests the mettle of gold and silver investors, well-timed purchases, and the promise of a new 2005/06-style bull run once the billions (trillions?) of new dollars work their way through the credit markets and into the metals, can be the soothing counterpoint to Bernanke's beautiful, if unsettling, devaluation tune.