GoldenBar Briefs
21 June 2001

Deflation argument is gaining…
A few reasons: one is that perceptions of declining demand are rising, particularly in the manufacturing sector. The NAM (the National Association of Manufacturers) has been complaining that the strong dollar is killing them, which is perhaps having the effect of accelerating perceptions of slowing demand rather than breaking confidence in the dollar - narrowing dollar resolve.

The second is that key commodity prices and indexes are deflating. The CRB has made a lower low this week, driven lower by copper prices, which are leading the industrial metals complex, lower, as noted last week, and energy prices, which seem to be reacting to the same set of implications on demand. The crude oil chart (intermediate) is beginning to reveal a bearish bias, and could break down.

The third reason that the deflation argument has been gaining ground is that the trade deficit has been "gradually" narrowing on declining import demand, priced in US dollars.

However, and as a matter of fact, there is a significant difference between actually having an involuntary induced monetary deflation and observing specific deflationary forces, especially if the deflationary forces are deliberated by dollar policy.

Anything, which is deliberated is usually done so with an agenda but cannot be sustainable without new deliberations. At any rate, we have noted in the past that any decline in commodity prices that has resulted from the near 20% rise in the dollar since January is not a demand led decline. It's a price adjustment, motivated by the transfer of purchasing power from foreign trading partners to the US dollar. While the bearish developments in oil prices do surprise us, there is no sign of a slowdown in global consumption. Oil and gas inventories are not piling up because no one wants them.

On the contrary, rising inventories are a sign of continuing accumulation if anything. Yet, markets have been seeing this buildup as a future supply glut… another coup of dollar policy.

The strong dollar has served us well - Paul O'Neill, Secretary to the US Treasury Department

But here is the irony - the same currency policy was, and still is, responsible for the relative shortage of onshore natural resource capacity, as well as for accelerating inflation rates in Europe. And it is deliberated… to various economic and political ends.

Nonetheless, such a price adjustment in commodity prices is only temporary if it doesn't generate real growth, which it cannot, and if it continues to do away with the incentive for further investment in exploration and domestic production capacity.

The weakening manufacturing activity does not surprise us, but the reaction by the markets does. Rather than seeing it as the inevitable tension of an abusive dollar policy, markets have taken to a different signal today. They see it as impetus to a capital spending led boom in the technology and financial services sector. Bulls continue to view the manufacturing sector as the old economy, which is no surprise, but seeing them actually buy the line is.

What has changed?
Strategy. Consider the stock market action today: there were reports of big volume coming back into the market today, and feverish activity on the NYSE trading floor. Note that my observation about strategy coincides again with a deteriorating market condition - the markets, as we noted this week to subscribers - were rolling over again, particularly the NYSE blue chip composite index. Transportation issues were up almost 2%, while the utilities were down nearly 4%. Bank stocks were bought heavily - interestingly just as their charts were portending breakdown. Credit card companies were being bought, and there was a general wave of interest in the tech stocks, particularly the biotechs, which drove the Amex Biotechnology index up almost 6%.

Greenspan Bullish on Basel II and Conceptual Content of GDP
In two speeches issued by the Chairman yesterday to the Committee on Banking, Housing, and Urban Affairs and to the US Labor Department, Greenspan gave the dollar a strong tout, first with bullish inference for Basel II, the new regulations and policy procedures invented by his colleague William McDonough, who heads the Basel Committee on Banking Supervision. He sees the changes made to risk management and capital adequacy standards as generally supportive of a strong banking sector, as the transition is gradually implemented over the next few years. Indeed, he offers that the new changes are aimed at solving the problem of deteriorating loan quality by curing the

"… pro-cyclical pattern of easing and tightening of bank lending and accordingly increase bank shareholder values and economic stability." Alan Greenspan, June 20

In the second speech, he credited the growth in post WWII productivity for the out-sized increase in conceptual GDP, relative to physical materials, and thus encouraged the labor department to focus on the educational standards, which have helped create this "conceptual GDP."

Right there is what drove the stock market activity today… Greenspan is still bullish on banks and productivity, which is why the banks and technology stocks were the recipients of new buying interest. Talk of lower interest rates now that deflation expectations appear to be rising, temporarily at least, have ignited the new economy theme on Wall Street this morning.

Dollar Debate and the Strategy
We believe that the FOMC would like to lower interest rates next week, but that they have been finding the move difficult to justify, with rising inflation rates. This month's CPI and PPI (lagging indicators) were mild and reflected the success of dollar policy in "exporting" its inflation overseas this year. But as we noted last week, the ECB is having grave difficulty in managing this inflation, leading to our conclusion that they were ready to raise interest rates.

However, now that some of the inflation expectations in the U.S. have been culled, and the deflation debate has gained some footing, it is possible that the Treasury is prepared to allow the dollar to decline against the euro. If the FOMC lowers rates by 50 basis points next week, thereby allowing the euro to appreciate, the pressure for higher global interest rates may recede, for the moment. To some extent, we can't help but wonder whether the Europeans are using the GE/HON deal as extortion against the strong dollar?

Meanwhile, Goldman Sachs can begin to criticize the Japanese economy (it has) for not buying enough goods, and set up the dollar toggle - from the euro to yen, and back. Dollar policymakers need the dollar to decline against the euro, but they need to keep it firm against the other currencies, else risk dollar inflation. Will the Japanese support a strong dollar in order to re-inflate their economy? Not if they are trying to get the Asian region off of the dollar standard and persuade them to support a regional currency board, or unit.

These ad-hoc strategies, creative as they are, provide zero solution to the problem, but rather an international infrastructure, which allows the problem to remain hidden, if only increasingly temporarily. The problem is too many dollars. A 50 basis point rate cut will crush the bond market and dollar. There is no way the new economy will get a lift off of that. But gold prices will.

Good Luck,
Ed Bugos

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