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Inflation, Bonds, the Dollar and Gold Stocks

The following are slightly-modified extracts from recent commentary that appeared at The Speculative Investor web site.

A Big Picture View of Inflation

The below chart shows, in red, the year-over-year percentage change in M2 (a measure of inflation) from the mid-1970s through to January 2001. The chart reveals that the inflation rate peaked in 1977 and bottomed in early 1995. From 1995 to the present day there has been a pronounced trend towards higher inflation. Note that during the 1977-1995 period the year-over-year M2 growth rate never went negative. In other words, the major trend was towards lower inflation, but deflation did not occur at any stage.

Paul Volcker is usually given credit for reversing the trend towards higher inflation, but in reality the major trend changed in 1977 whereas PV didn't take the wheel at the Fed until 1979. In fact, the year-over-year M2 growth rate fell sharply during the 2 years prior to PV taking over and actually rose during Volcker's first 4 years as Fed Chairman. We are not criticising Volcker - as far as Fed Chairmen go, he was one of the best and is a super-hero in comparison to his successor - just pointing out that, in the fight against inflation, the 'trend was his friend'. Here's a quote regarding inflation taken from an interview with the former Fed Chairman:

In the short term, it [inflation] is good for borrowers and not for lenders. Once a lender begins anticipating it, that equation changes, because he's going to say, "I expect inflation, so I'm going to charge you more than I would otherwise charge you." And you get higher interest rates, and the interest rates keep up with the inflation. And in fact, human nature, they see inflation rising for a while, they begin anticipating still higher inflation. So they say, "I'm not only going to make up for today's inflation, but I'm going to anticipate tomorrow's inflation."

Bonds and the Dollar

The Dollar sold off and bonds moved higher on Friday (Feb-16) even though the 'news' could have been construed as 'dollar-bullish' and 'bond-bearish'. How the market reacts to news often provides an important clue regarding the future 'path of least resistance'. For example, two week's ago we mentioned that the rally in the Dollar following the release of the January Employment Report was 'dollar-bullish' because the market chose to ignore the higher-than-expected unemployment rate and focus, instead, on the healthy job creation number. The Dollar was then able to rise over the ensuing 2 weeks. The market's reaction to Friday's news is, we think, a signal that the short-term trends are about to reverse. This conclusion is given some weight by the fact that, as illustrated in the following chart comparison, bonds and the Dollar have moved in opposite directions on almost a daily basis since late November 2000. With the Dollar approaching an 'overbought' condition and bonds approaching an 'oversold' condition we expect substantial moves (up for bonds, down for the dollar) to begin shortly (by the first week of March at the latest).

The Fed is likely to continue to cut interest rates regardless of the inflation data. They have no choice - the excesses (debt levels) are so great that a failure to keep the financial markets liquid (through the further expansion of credit) would be catastrophic. So, USD liquidity will be maintained at all costs, which is 'dollar-bearish' and 'gold-bullish' (since 'gold credit' cannot be expanded at anywhere near the pace of USD credit). It is also 'bond-bullish' until the lenders begin to anticipate tomorrow's inflation. Once the market begins to anticipate higher levels of inflation, bonds and the Dollar should decline together.

Gold Stock Bull Markets

Two weeks ago we were stopped-out of most of our trading positions in gold stocks (we have kept our 4 'core' gold stocks and two other stocks). This does not represent a change in our view, it represents risk management.

To help determine whether we should be changing our view on gold stocks from bullish to bearish, we reviewed the performance of the XAU during the only real gold stock bull markets of the past 15 years - 1986-1987 and 1992-1993. What we found was that the XAU's price action was strikingly similar during both bull markets, with the following sequence occurring: 1. An initial bounce
2. A period of downward consolidation
3. A dynamic upward move

Below are charts that illustrate this sequence.

Using 'wave parlance', the above charts show that the XAU followed a 5-wave pattern during its last two bull markets. As is usually the case, the vast majority of the gains occurred during Wave 3. In both cases, confirmation that the dynamic Wave 3 was beginning was provided by a break above the Wave 2 downtrend line.

So, does the above have any relevance to the present? Looking at the chart below, it may well do. Note that the below chart uses the TSI Gold Stock Index (TGSI), but the XAU chart looks almost identical.

The following table summarises the above discussion and charts:

Bull Market ->	1986-1987	1992-1993	2000-2001(?)
Duration of initial bounce (Wave 1)	7 weeks	10 weeks	5 weeks
Duration of downward consolidation	14 weeks	28 weeks	8 weeks and counting
Duration of dynamic up-move (Wave 3)	15 weeks	28 weeks	?
% increase during Wave 3 after Wave 2 downtrend was broken	79%	86%	?

If the present-day situation continues to unfold in the same way as the previous bull markets, then a break above the Wave 2 down-trend will lead to a rise of around 80% in the TGSI (and the XAU) over the ensuing 3-6 months. We plan to re-establish trading positions after the TGSI breaks above the Wave 2 downtrend.

It should be noted that wave patterns are generally only clear in hindsight and there is certainly no guarantee that the current consolidation will turn out to be a Wave 2 decline that leads to a dynamic Wave 3 advance. The extremely bullish fundamental backdrop means that the odds are in favour of the 'longs', but there is no need to guess since the bulk of the advance will occur after the short-term downtrend is broken.

Steve Saville
Hong Kong

21 February 2001

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sas888@netvigator.com

Regular financial market forecasts and analyses are provided at our web site:
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