The Yen

We noted in our March 19 commentary that Dollar-Yen had reached intermediate-term resistance (at around 123) and that a pullback (a rally in the Yen) was therefore likely (see chart below). Resistance at around the 123 level has held thus far, although there is no evidence of a reversal at this time. If 123-124 can continue to hold during the next week then a sharp pullback in Dollar-Yen is likely over the coming 1-2 months before the primary trend (the Yen falling relative to the Dollar) reasserts itself.

There is one external influence that could have a dramatic effect on the Yen over the next few months, and that is the potential for heightened earthquake and volcanic activity in Japan (there are 86 active volcanoes in Japan). In particular, reliable long-term cycles pinpointed 2001 as being a high-risk time for earth-related activity and recent monitoring of Mount Fuji (situated only 60 miles from Tokyo) has identified some stirring within the long-dormant volcano. Also, an earthquake of magnitude 6.4 hit Hiroshima last Saturday.

Japan has been exporting capital to the US for the past 6 years. This has been an obvious and rational decision by Japanese investors since the US economy has been much stronger than the Japanese economy, US interest rates have been much higher than Japanese interest rates, and the US$ has been appreciating relative to the Yen (investing in the US has been a win-win-win situation for the Japanese). However, a natural disaster in Japan that causes massive destruction would not only curtail the export of capital from Japan, it would probably lead to the large-scale repatriation of capital in order to finance the re-construction effort.

We wouldn't normally even consider anything as unpredictable as future earth-related activity in our financial analysis, but with last week's quake occurring at a time when cycles suggest the potential for heightened activity we thought it was worth mentioning. There is a good chance that speculators have been piling into the Yen carry trade during recent months, so the potential for a sharp up-move in the Yen already exists if these speculators are forced to unwind their positions. However, the extent of a Yen rally would be magnified by anything that reverses, or even just slows, the rate at which capital is being exported from Japan to the US.

Gold and the Swiss Franc

The currencies with which gold has the strongest positive correlation are the Swiss Franc and the euro. Since the euro is still more of an index than a currency, we'll focus on the SF.

The below chart shows that:
a) The SF broke out of a 2-yr downtrend last December
b) Since the beginning of this year the SF has re-traced about 60% of its previous rally (a normal retracement following a sharp rally)
c) The SF has remained above its previous downtrend line during its 3-month consolidation
d) In 1998 the SF did not begin to rally until the US stock market bottomed in late-August. 6 weeks later the US stock market re-tested its Aug-31 bottom. During that 6-week period the SF rallied 15%.

Our view is that the Q4 2000 rally in the SF represented the beginning of a bull market (a new medium-term trend), rather than just a short-term counter-trend bounce. We have, to date, seen no technical evidence to invalidate that view.

Gold - what would make us bearish?

Most people who have a particular view on the markets tend to latch onto any information that supports their view and to find reasons to ignore/discard any information that supports an opposing view. We almost always have a view on the markets, but try very hard not to be married to that view. We have no interest in being bullish or bearish, only in being right.

Where we run the greatest risk of letting our views influence our interpretation of the facts, rather than letting the facts influence our views, is the gold market. We have a natural bias in favour of gold that stems from having some knowledge of monetary history and the inherent flaws in the present monetary system. As such, we will always find it difficult to be downright bearish on gold.

One thing that would make us long-term bearish on gold would be a realisation that the US was headed into a prolonged period of deflation. We see the probability of such an outcome as only marginally greater than zero and our inflationist views are constantly being solidified by the behaviour of the US monetary agents. However, if something happened that altered our forecast from an inflationary to a deflationary future we would become bearish on gold. For those who are new to our writings, deflation is a contraction in the total supply of money. Falling prices are not deflation, although they can be a result of deflation.

As far as the short-term is concerned, the following would shake our confidence in a gold rally:
a) The Commercial traders becoming net-short COMEX gold futures before the gold price had established a solid up-trend.
b) The US$ failing to break lower by the end of the first week in April

Gold and the Dollar - Current Market Situation

There is a distinct possibility that last Thursday (Mar-22) gave us the peak for the counter-trend rally in the Dollar that began on Jan-03. The Dollar is overbought, the Yen appears likely to rally over the near-term as discussed above, the SF has completed a normal retracement, and the traders' commitments for most currencies (with the exception of the euro) are bullish. Now we wait for some price confirmation. Note that a re-test of last Thursday's high, at some point over the next week, would not be surprising.

Gold should begin its long-awaited rally when the US$ turns down in earnest. We were encouraged to see that the Commercial net-long position increased from a modest 14000 contracts the previous week to a healthy 32000 contracts last week. The traders' commitments for silver are also relatively bullish (the Commercials are always net-short silver, but they have recently reduced their short position).

We can provide logical arguments until the cows come home as to why the Dollar should fall and the gold price should rise, but the final arbiter is always the market. Logical arguments are worthless unless they are confirmed by price action. The next 1-2 weeks are going to be extremely interesting (perhaps even exciting) as we wait for the all-important price confirmation.

Steve Saville
Hong Kong

29 March 2001

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