Overview

Bonds - absent a boost from flight capital seeking a safe haven, bond prices are likely to move lower from here.

Stocks – the recovery rally from the April 14 low is almost complete. Short-term downside risk has increased.

Gold - strength in the US Dollar is putting downward pressure on the gold price. Gold is unlikely to rally until the Dollar begins to decline.

Inflation Watch

The most surprising thing about last week's higher-than-expected Employment Cost Index (ECI) is that it was higher than expected. Expectations were, for some reason, set ludicrously low. The ECI is now rising at a year-on-year rate of 4.3%, the fastest pace since 1993. Several years of inflation are finally beginning to have an effect on the widely-watched indices.

First quarter GDP came in at a lower-than-expected 5.4% thanks to a large decline in net exports and a drop in government spending. Some commentators claimed that the not-so-hot GDP growth (compared to the previous quarter's exceptionally high mark) was good news because it means there will be less pressure on the Fed to raise rates. We find this logic extraordinary since a slowdown in growth in parallel with rising prices and costs is the worst possible scenario. However, if past experience is anything to go by the first quarter GDP growth rate will be revised upwards next month.

The Euro Crisis

Last week we discussed the unfolding Euro crisis and on 25th April we sent the following e-mail to the ECB suggesting a potential solution to their apparent dilemma:

"Dear Sirs,

with the continued decline in the exchange value of the Euro versus the Dollar, there has been some discussion in the press that the ECB may raise interest rates to support the Euro. Such talk may or may not be accurate, but even if rates were raised there is certainly no guarantee that the Euro's slide would be halted. In fact, raising official interest rates would potentially jeopardise Europe's economic recovery and may actually have the opposite effect on exchange rates – the Euro may decline further relative to the Dollar as investment capital exited European debt and stock markets.

When a currency establishes a long-term downward trend a critical loss of confidence almost always eventuates. A declining currency provides a benefit for exporters, but this benefit is more than offset by the on-going exodus of investment capital and higher prices for imported goods such as oil.

Assuming the ECB would prefer a firmer Euro and bearing in mind that hiking interest rates would be fraught with danger, why not use the enormous gold holdings of Europe to enhance the perception of the Euro? Gold is still widely considered to be the ultimate form of money because it is the only form of money that is not someone's liability. If the Euro's gold reserves were substantially increased such that gold made up, for example, at least 50% of total currency reserves, then three things would likely happen:

1. Confidence in the Euro would grow, stopping the Euro's decline and elevating both its numerical value and its status relative to the Dollar. Investment would flow into Europe and the Euro would no doubt garner heightened support as a reserve currency
   
   
2. The gold price would rise, thus increasing the value of Europe's official gold holdings and further strengthening the position of the Euro in the foreign exchange markets
   
   
3. Euro interest rates could be adjusted based purely on European economic requirements, that is, currency exchange rates would never be a determinant of Euro interest rates. In fact, the natural interest rate for the Euro would likely gravitate, over time, towards the gold interest rate.
   
   

The above is submitted in the hope that a large increase in the Euro's gold reserves will be seriously considered. Unless I have made a logical error, a much higher gold reserve position would bring an enormous and long-lasting economic benefit to Europe."

We have not yet received a response to the above letter and do not expect one.

Despite what many people think, governments and their central banks are usually not stupid. They only seem stupid because people make the mistake of thinking that politicians and central bankers generally have the long-term interests of the nation at heart when deciding on economic policy. When we begin with the premise that the driving force behind most statements and decisions is to win the next popularity contest (election or nomination), government action (or inaction) becomes more comprehensible.

The Euro's decline is an example of the short-term taking precedence over the long-term. The ECB and the European governments are not stupid – we are certainly not telling them anything they do not already know when we highlight the benefits of a substantial increase in gold reserves. The almost non-stop erosion in the Euro-Dollar exchange rate since the introduction of the new European currency in January 1999 is the result of a deliberate policy of devaluation that is now, perhaps, spinning out of control. Taking a short-term focus the policy has been a resounding success – Europe is experiencing an export-led economic recovery without having to suffer the political and social pain that major, much-needed structural changes would bring. However, this policy has set the world up for yet another currency crisis.

Following its meeting last Thursday the ECB stated that "The present level of the Euro does not reflect the strong economic fundamentals of the Euro area". Of course it doesn't. The Euro area runs a large trade surplus and economic growth is picking up. However, European monetary authorities have made the Euro cheap to borrow and, through their obvious unwillingness to take any meaningful action to stem the currency's decline, have given speculators a green light to either pile into the Euro carry trade or short the Euro outright. The Euro's on-going capitulation has also ensured that any Dollars accumulated as a result of the trade surplus are immediately exchanged for Dollar-denominated investments.

The more we consider the plight of the Euro the more we are reminded of 1998 and the panic unwinding of the Yen carry trade that caused so many problems for hedge funds.

The US Stock Market

Current Market Situation

In our April 17 Update we suggested that April 14 represented a selling climax and that a strong rebound would commence almost immediately. A recovery from the April 14 low was expected regardless of whether or not a future plunge to even lower levels was on the cards. During the next few days the market faces a critical decision – was the rally since April 14 a short-lived reaction within an unfolding bear market, or was it the first part of a new upwards leg in a continuing bull market?

We suspect the former, but we will probably know for sure by the end of the coming week. If the past 2 weeks constituted a bear market rally then we should see the market begin to drop by the middle of the coming week. An unsuccessful re-test of the April 14 low would then likely occur around mid May, followed by a final capitulation and a major low (read: buying opportunity) around the third week of May. If the NASDAQ100 (NDX) is able to close higher on the week then we are probably too bearish and the market will find support above the April 14 low during any subsequent sell-off.

Gold and Gold Stocks

Using the performance of the market in the past to forecast the market's future is fraught with danger because, despite the similarities that are sometimes apparent, the differences that always exist often ensure an alternate outcome. For example, we have never been interested in using the 1920s and 30s as a template for the outcome of today's stock market mania because the differences between the monetary systems in existence then and now do not only suggest a different outcome, they guarantee it. There are, however, a number of similarities between today's unfolding events and the occurrences of 1998 that encourage us to compare these two periods.

In 1998 the world's equity markets peaked on July 17. Over the following 6 weeks the markets worked lower in parallel with increasing pressures in the debt market. During the same period the gold price also drifted lower, prompting many commentators to crow that gold's loss of safe haven status was now fully confirmed. In the currency market the US Dollar was firm as the initial response of many investors to financial market turmoil was to retreat to the perceived safety of the US Dollar. The strength of the Dollar at the time, in the face of a falling US stock market, was also the result of the continuing build-up of Yen carry-trade positions. Then, at the end of August 1998, the game suddenly changed. In the final 3 trading sessions of August the Dow suffered a cumulative loss of 1,000 points, reaching its lowest daily close of the year on August 31. Gold also achieved its lowest daily close on August 31. It was at the end of August that the Dollar began to weaken, a move that accelerated into October as the Yen carry trade was unwound. As the Dollar fell throughout September and into early October, the gold price rallied.

In 2000 the equity market peak occurred on March 24. As per the situation in 1998, the first 5 weeks of the equity market's decline have seen a strong Dollar and a weak gold price. Other similarities between now and 1998 include:

1. Pressures in the debt market (widening credit spreads as investors become more risk-averse and switch into higher quality debt instruments)
   
2. The build-up of an enormous short position in a leading currency (the Euro) due to interest rate differentials (between Europe and the US) and the belief that the current trend will remain in force (the Euro will continue to drop)
   
3. High-profile hedge fund problems. In 1998 we had the LTCM fiasco, today we have the dismantling of the Tiger Fund and the restructuring of the Quantum Fund.
   
4. A proliferation of bearish gold market commentary, with gold's failure to immediately respond to stock market weakness being hailed as proof that gold is no longer considered a safe haven in times of turmoil
   

If the similarities between 1998 and 2000 persist then we should expect a sharp drop in the stock market during the next 2 weeks, with gold bottoming at about the same time as stocks. Market Vane's bullish percentage for the US Dollar recently hit 97%, suggesting that the Dollar is very close to a top. Note that a few days after oil's bullish percentage hit 98 in early March there was a spike upwards to $34, after which the oil price began to slide. As soon as the Dollar begins to decline there will be a rush to close out Euro short positions to lock-in profits, thus bringing about a surge in the Euro-Dollar rate. Gold has, to date, been a victim of the strong Dollar / weak Euro environment and will be a beneficiary of the de-leveraging that we suspect will take place.

We cannot emphasise strongly enough that a sustainable and meaningful rise in the US Dollar gold price cannot occur in parallel with a strong Dollar. At Friday's closing price, the US Dollar gold price was 9% below its Oct '98 peak, whereas the Euro/ECU gold price had risen by 22% over the same period. What we are seeing is Dollar strength, with that strength being magnified by Euro weakness.

Below are two charts, one showing the Euro-Dollar exchange rate from January 98 to the present time (the ECU-Dollar rate is used prior to 1999) and the other showing the Gold-Dollar exchange rate over the same period. The gold price is far more volatile than the Euro-Dollar rate because gold's liquidity is substantially less than that of the Euro.

Until the line on the Euro chart starts heading in the other direction, a gold rally is unlikely.

(The charts are provided courtesy of Pacific Exchange Rate Service and are the copyright of Prof. Werner Antweiler, University of British Columbia, Vancouver, Canada.)

Steve Saville
Hong Kong
1 May 2000

The reader is invited to respond to Mr. Saville's wisdom via email:
sas888@netvigator.com

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