Overview

Bonds - it is likely that bond prices peaked on 23rd March. We do not, however, foresee any major downside in bonds until the second half of the year.

Stocks – the coming week should follow a similar pattern to last week, that is, a pullback in the early part of the week followed by a continuation of the rally during the week's second half. We are probably within 2 weeks of an important top.

Gold - consolidation continues, but a major reversal to the upside should occur by mid April. Gold stocks should be accumulated on pullbacks.

Inflation Watch

The Fed began the year with an apparent desire to 'mop up' excess liquidity as indicated by January's reduction in Reserve Bank credit and a consequential drop in the total supply of money. However, attempts to restrict the rate of money supply growth now seem to have waned with M3 increasing by $76B during the first two weeks of March. Although the Fed has not directly brought about the recent surge in the amounts of credit and money, it has certainly not taken any preventative action.

Official short-term interest rates have been hiked by 0.5% so far this year, but it is not logical to expect that a small increase in the cost of money will necessarily result in a decrease in the availability of money. This is because the investment demand for borrowed money is not just determined by the interest charge on the loan – it is also influenced by the expected return on investment. Even a 20% interest rate is not a problem for someone who expects to earn 50% by investing the borrowed money.

The Fed's modus operandi of fixing a short-term interest rate and then supplying whatever liquidity is needed to keep that rate at the targeted level is certainly not an effective means of curbing the demand for money. When asset prices are booming the anticipated return on investment is just so much greater than the prevailing cost of money that small increments in short-term rates have no impact. A more effective strategy would be to reduce the supply of money and let interest rates self-adjust to a level that brings money supply and demand into balance. Such a strategy is certainly within the Fed's charter since, according to its own web site, the responsibility of the Federal Open Market Committee (FOMC) is to make "key decisions affecting the cost and availability of money and credit in the economy" (emphasis ours).

So, why doesn't the Fed act to restrict the availability of money? Is it because, as Mr Greenspan says, "it is not possible to manage something you can't define"? Or is it because so much money is now created outside the banking system that the Fed has simply lost control?

It is our view that the Fed could, if it chose to do so, restrict the growth in the supply of money. For example, government-sponsored mortgage agencies (Fannie Mae and Freddie Mac) played an important part in mitigating the unfolding liquidity crisis during 1998's final quarter. When these enterprises helped re-liquefy the system by aggressively expanding their balance sheets via the large-scale purchasing of mortgages, they were acting at the behest of the Fed and/or the Treasury. We do not see why the opposite result (a contraction in credit) could not be engineered at the current time if the Fed chose to exercise its influence/authority with this aim in mind.

Rather than being unable to restrict the growth in credit and money, we believe the Fed is unwilling to take such an approach. This conclusion (that the Fed is unwilling to restrict credit growth) is based on the fact that the central bank is managed by government appointees and is owned by private banks (see Note below). Since the overriding goal of politicians is to be re-elected and the overriding goal of banks is to achieve short-term profit targets, it makes little sense for the Fed to act in a way that would bring about a prolonged credit contraction. A contraction in the total amount of credit and money, or even an extended slowdown in the expansion of credit, would certainly result in a recession and would therefore be detrimental to political aspirations and bank earnings.

Note: In July 1983, the list of member banks holding Fed Bank of NY stock included 27 NY banks. 59% of the total outstanding shares were held by the following 6 banks: Bankers Trust (6%), Chase (14%), Chemical (8%), Citibank (15%), Manufacturers Hanover (7%), Morgan Guarantee Trust (9%). The ownership would have changed since that time due to changes within the private banking system, but the big picture remains the same. (Thanks to Edmond Asseily for the Fed ownership info). The 7 members of the Federal Reserve's Board of Governors are appointed by the President and confirmed by the Senate. The President also nominates, and the Senate confirms, 2 members of the Board to be the Chairman and the Vice-Chairman. The 7 governors then form a majority on the 12-member FOMC.

The US Stock Market

In last week's Update we speculated that the S&P would likely achieve a new record closing high above 1500 by the end of the month. The ferocity of the rally following last Tuesday's quarter point rate hike led to this target being reached one week earlier than expected. The market now appears to be over-extended and we should therefore see another pullback during the first half of the coming week. However, due to the impact of quarter-end buying by mutual funds any pullback at this time is likely to be short-lived and we should see new record highs in the S&P by the end of the week. The biggest risk, in the very short-term, is probably the OPEC meeting on March 27th. If OPEC fails to confirm a meaningful increase in production and the oil price surges anew, then the current rally may be prematurely derailed (an outcome that may actually be bullish on a longer-term basis).

We have little doubt now that the intra-day S&P low of 1325 on 28th February will prove to be the low point for the year. It is also likely that the NASDAQ Composite's intra-day low of 4450 on the morning of 16th March, a level that was successfully re-tested on 21st March, will prove to be an important bottom. It appears that the NASDAQ's recent double-bottom occurred in the midst of substantial margin selling meaning that the correction, although very brief, caused many weak hands to be flushed out of the market.

Unless the market explodes upwards over the next few weeks and reaches, say, S&P 1700 and NASDAQ 6000, we will remain confident of a strong market during the year's second half. However, any substantial extension of the current rally may cause us to re-think that optimistic view.

The best time to buy usually occurs when the market feels terrible, that is, when it appears obvious to one-and-all that prices are about to collapse. Similarly, the worst time to buy usually occurs when the market feels wonderful, that is, when putting money to work in the market feels like the easiest and most natural thing to do. Despite the spectacular gains that have been achieved in selected technology stocks the market has not, at any point since the end of December, exhibited the unthinking optimism that is generally associated with peaks. We have seen wild speculation in some high-tech issues, but a number of nagging worries have never been far from the surface. Such concerns as the surging oil price, the inverted yield curve, a Federal Reserve that appeared to be targeting the stock market, Y2K-related earnings disappointments and evidence of a tightening labour market have contributed to the constant presence of a healthy amount of angst. However, the continuation of the current rally for one or two more weeks may lead to the type of unbridled bullishness that is the hallmark of an intermediate top.

Gold and Gold Stocks

In last week's Update we suggested that it would be illogical to invest in gold "if you believe that all movements in the price of gold are orchestrated by powerful anti-free market forces (governments, central banks, a cabal of large private banks)". This does not mean we think the gold market is free from manipulation. We are, in fact, quite certain that the gold market is manipulated and believe that GATA is really onto something. Perhaps the Exchange Stabilisation Fund is being used, as its name suggests, to stabilise the exchange – the gold/dollar exchange. However, whilst we would be ecstatic to see those who have been manipulating the gold market brought to justice we would never invest in gold if we thought that justice being served was a prerequisite for a higher gold price. Our desire to be invested in gold at the current time is based on a belief that any artificial suppression of the gold price is doomed to fail, and fail soon. It will fail due to the extremely limited supply of physical gold.

If the estimates of the World Gold Council and Frank Veneroso are anywhere near reality, then there is a monthly deficit of at least 100 tonnes in the supply of physical gold. Unless at least 100 tonnes of physical gold can be obtained from the existing aboveground gold stock every month, the gold price will rise. It does not matter how many paper contracts are traded at the LBMA or elsewhere – paper claims to gold cannot be used to satisfy fabrication demand.

There has been no change in our short-term outlook for the gold price since last week's Update. We are still expecting a trend reversal to occur by mid April, but a drop below 280 would not be surprising over the next 2 weeks. We continue to recommend the accumulation of high quality, lightly hedged gold producers on pullbacks.

Steve Saville
Hong Kong
27 March 2000

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