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Keeping
in mind the old spring (coil) metaphor, or Say's Law, or even the
well known physics law - "every action causes an equal and
opposite reaction" - let's
imagine interest rates were already pushed as low as they could
go by late 2002... to or beyond the boundaries of so-called equilibria.
But then (in the second quarter of
2003), imagine that interest rates were pushed down even lower.
I'm talking about long term rates, which the Fed typically has less
control over, and which were reported as sticky (unresponsive to
the Fed's rate cuts) in 2001. In
other words, even while the FOMC slashed short term rates from 6%
to 2% in 2001, long term rates hardly fell that year (they ranged
from 5.5% at the beginning of the year to a low of 4.2%, but ended
the year at around 5% - see graph further below).
In fact, the only reason they fell
to the 4% range to begin with was that Treasury Undersecretary Peter
Fisher pulled our leg about a suspension of the 30 year bond in
October (2001) - on account that the surplus would inevitably return,
and that it would be less expensive for the government to issue
shorter term bonds in the meantime.
But medium and long term yields didn't
stay down. They went down for a week or two, then shot up real quick.
That didn't stop the gang from trying again.
At about the same time, Greenspan
was lobbying Congress for an expanded open market operations mandate
- to include longer term Treasuries and mortgage backed securities
on the basis that the ongoing budget surplus would eventually make
obsolete the effect of their normal operations in the shorter end
of the market (supposedly the pool of Treasury securities they are
allowed to buy and sell would dwindle because the surplus would
be used to buy them back). Believe it. They said it.
But presumably, the market did not
believe it.
When they realized nobody was really
buying the prospect of indefinite budget surpluses another angle
began to see the light of day. They called in the term "unconventional
tools". Specifically, the Fed said it now planned to force
"long term" rates down by buying longer term maturities.
I'll be darned. Same thing, different spin. You know the story.
The term was circulated by
the press every time there was bad news, or whenever stocks fell
too sharply. It became a catch-phrase that fueled a climactic bond
bubble into the summer.
Have a look at the chart of the 10
year Treasury yield below and notice the late 2001 and early 2002
back up in yields (from 4.2% to 5.5%) - which we contend was largely
the reaction to the prior forced policy decline.
Remember, the bulls were breaking
the Dow out then too, and they claimed the rise in yields was due
to a strengthening economy rather than inflation expectations or
failed policy. I guess they
just couldn't take that last little push in March 2002 though, because
shortly after that stock prices plummeted.
Yes, I am telling you what you already
know, that falling interest rates are bullish for stocks, and rising
interest rates just ain't good at all.
However, this time, when stocks turned
down, yields really fell, particularly after gold prices peaked
early in June 2002 (as was also the case this past March 2003) and
as stocks just kept on falling.
The combination of a new bear market
low in stock prices in September, widening terror anxieties, and
the threat (or promise) of "unconventional tools"
that circulated through Wall Street trading desks easily overcame
the obvious inflationary developments - such as a weak dollar,
soaring housing market, and strong commodity complex - and yields
fell sharply into May 2003.
 The
Fed wasted no time rousing deflation fears - we call it the head
on method of tackling inflation expectations.
Even after the rally in stock prices
that finally got under way post March, the
promise of a yield cap reached a pitch investors could hear all
the way to China... literally! No doubt they bought bonds over car
insurance.
The more they spun, the harder yields
fell. It seemed to work. Stock prices gained, just like they often
do when that happens. In fact, I can't see how the stock rally would
have done without it.
In the end, as the stock and commodity
markets increasingly crowded them out, it turned out to be mostly
talk.
They sure pushed this thing all the
way to the wall.
But two key things happened. First,
gold and commodity prices were stoked by it, as they were in late
2001, and thus reaccelerated to higher highs. Second,
the interest rate spring unwound this time as it did after the mini-Treasury
rig effort of late 2001.
Let me ask, what better evidence
is there that bond yields were pushed below market than the fact
that they just shot up at their fastest pace in almost 20 years,
and wiped out all the cuts back to July 2002 in one and a half months?
- such that the 10 year bond yield is back up to 4.5%, not a heck
of a lot lower than its 5.5% high in 2001.
I want to establish this fact. It's
important. As the market sees through this charade, gold prices
are gonna get pushed higher, and so will yields. How long can the
Dow rise in the face of that?
It should be obvious that the Fed's
open mouth policy impacted other markets - stocks, commodities,
etc. - significantly, as well as the economic aggregates (on the
way down to a 3.1% ten year bond yield at any rate), and that it
will equally if not unpredictably impact them in reverse on a jaunt
back to the 5% range, or higher if we're really right.
It should also be evident that it's
unfolding now (strong gold and rising rates), as September encroaches,
and the new stock trading season has begun. For most of the year
so far, markets have worked hard factoring in all the bullish consequences
of the Fed's policy. They haven't considered the other side of the
coin since last fall.
I am confident you'll soon see that
the Fed's effort to unstick the yield market in the last few years
is not only self-defeating, but has clearly strengthened the fundamentals
of our overall gold sector hypothesis.
Going Into September
The US dollar ended down last
week but finished up for its 3rd month in a row in August. The move
had no chart or technical significance and could simply be countertrend.
The bulls rallied it up to its 200-day
moving average the week before, straddled resistance there for most
of last week, then fell away from it by Friday and bounced back
up to it yesterday. The three month uptrend is intact; the last
highest short term low is at 95 on the trade-weighted index. The
bears have to push through there to signal a fresh down leg.
The US dollar index mirrors the European
currencies most on the charts. Meanwhile, the Canadian, South African,
and Australian currencies so far have refused to confirm the Euro
and Swiss Franc's August lows.
Now, yen bulls are taking another
stab at breaking out, finishing a bullish outside day just yesterday.
I can't imagine the Swiss Franc trading down much if the dollar
breaks down against the yen now, or if US stock and bond markets
CONTINUE to underperform the European markets in coming weeks -
as they have since the Euro peaked in June.
The gold sector continued strong
last week amid bad Fed rumors and good headlines for the global
economy. We've said it before. They're climbing a wall of worry
- unlike Wall Street's current infatuation. Still, it's gold's role
to lead, and as strong as gold prices have been in recent months,
bulls have yet to break out.
Cutting Through the Euro Baloney
Japanese authorities say enough
is enough on the yen's rise, that it's just a correction in the
euro that's causing it. The next day Treasuries pop as if the Japanese
were buyers. They usually are. It rarely fails - so far.
Meanwhile, the western media has
other incentives. It says the euro is falling because of either
a) a global recovery led by Japan, or more typically b) a global
recovery led by the US; in both cases Japan and the US are said
to be benefiting more than Europe.
But we observe that hot money flows
seem to prefer both Japanese and European bonds & shares to
US bonds & shares, and that the upward trending trade surplus
in Europe alone argues that the latest slide in the Euro is probably
just corrective / technical.
Dollar bulls would counter that the
trade surplus is growing in both Asia and Europe, which proves
there is a US led global recovery underway.
We would counter, that if it were
the case, that US equity markets would have to perform even better
than they are, or that interest rates would have to practically
double (in order to carry the twin deficits). Otherwise the greenback
would have to falter in order to correct the trade imbalances. There's
no way around it.
Yet the policy after math of the
90's bubble has kept many investors relatively bullish on the dollar,
despite its young bear market outgrowth.
Consider three important differences
between now and then:
1) Where the strong dollar of the
late nineties - propped up in part by improving relative real
returns in US assets stoked by currency crises in Europe and Asia
- was a self reinforcing boon to interest rates and stock values,
the weak dollar is typically the opposite.
2) Where the late nineties boom
in US dollar denominated assets was at least born out of the semblance
of a tight monetary policy, the current 12 month boom is born
out of a no holds barred cowboy style inflationary policy whose
designers claim is intended to avoid the consequences of deflation.
3) Whereas the late nineties boom
ran alongside an administration that at least paid tribute to
the idea of a balanced budget, the current boom is a textbook
case application of Keynesian deficit spending.
What does it mean?
In the United States in particular,
it means disinflation is gone. Fiscal prudence is gone. The hawks
at the FRB, well, they've turned a blind eye. But there are consequences.
Inflation expectations are likely
to continue to rise, the dollar is likely to remain weak, and interest
rates are likely to soar... as we keep saying, especially once most
investors figure it all out. It's happening right before your eyes.
And it's precisely why we believe US markets have underperformed
all others over the past few months - not because of a global recovery
trade.
Thus, we look at the Euro's correction
as the product of countertrend forces favoring the US dollar at
the moment, which seem unsustainable for even a few days longer
(but may be).
One way or another, either the dollar
has to fall in order to correct the current account deficit, or
interest rates have to rise. But at 25 times earnings for the S&P
500, any significant increase in interest rates is likely to pressure
the dollar if it chokes off the official capital flows currently
supporting it. The more inflation there is, the more the dollar
becomes overvalued, and the more this process pressures interest
rates higher tomorrow.
This is what gold prices have been
predicting well since 2000, and it's been coming to fruition. Always,
under the patronage of the Fed, there is much more inflation than
productivity. There is no recovery
trade. There's just the noise typical of countertrend moves.
The remainder of this letter (Gold
Stocks with the Most Potential Upside on $100 Move in Gold to $475)
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Edmond J. Bugos
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