De-Linkage With Gold
Philip Gotthelf
Since President Nixon closed the Gold Window before the legalization of gold ownership in the early 1970's, governing modern economic systems has been a test of theory by experimentation. Anyone attending an introductory
economics class is (or was) subjected to explanations of money supply, inflation, deflation, employment, productivity, and the inverse relationship between employment and demand-pull inflation known as the Phillips Curve.
Without becoming too technical, full employment was supposed to generate excess demand that, in turn, "pulled" prices higher. Low employment decreased demand and dropped inflation. However, too little employment was recognized as deflationary and dangerous...a lesson learned during the Great Depression following the 1929 stock market crash. These simplistic assumptions were formulated while modern economic systems were facing transition. The most notable and extraordinary change occurred with the disengagement of monetary value from fixed standards like gold and silver. The removal of currency "backing" permitted government presses to inflate through the issuance of more currency without the restriction imposed by a gold standard. Thus, the Fed has the power to manipulate monetary "targets" with little restraint.
The economic trial by experiment has encountered a few glitches along the road. After the cost-push inspired energy crisis of the early 1970's, the U.S. economy experienced "stagflation." This represented a period of no growth (stagnation) and high inflation...a seeming contradiction to the Phillips Curve where low employment is supposed to drop inflation. Obviously, high
energy prices changed the equation or a highly energy dependent economy.
When inflation outlived the energy crisis, former Fed Chairman Paul Volcker was perplexed, but afraid to take his experiment to the next step. His replacement and current Chairman Greenspan pushed the envelope by raising interest rates to unprecedented levels. The experiment realigned investments as fixed income strategies yielded more than 15% compounded
returns.
Another anomaly was witnessed during the latter Clinton years as the brief, but effective, peacetime economy created full employment with low inflation. Once again, Phillip's Curve was refuted. But, today's situation is equally interesting. Greenspan has lowered interest rates to unprecedented levels and the economy has remained unresponsive. This is not to say that higher liquidity will not eventually stimulate economic growth. It is simply an observation that our return to a wartime economy coupled with the stock market meltdown has developed a post-gold deflation.
As I pointed out in my book, The New Precious Metals Market, the last great deflation was the Depression when we adhered to a gold standard. I pointed out that purchasing power parity (PPP) reached its highest level for gold during the Depression and rationalized this by assuming gold was, in fact, money. Now, we see a selective deflation (absent energy) with rising unemployment without a gold standard. Interestingly, gold has risen in dollar parity more than the dollar has declined against global currencies. Once again, gold is achieving better value (PPP) during an alleged deflation.
The experiment is far from over. In fact, it may never end as technology and politics constantly alter the economic background. The question is whether theory dictates swapping from bonds into stocks, real estate, or other investments.
Gold has formed a solid downward channel to suggest that it remains linked to dollar parity. As my daughters would say, "Duh!" Gold is priced in dollars on the chart and the dollar is rising in value relative to the Euro and other major currencies. U.S. interest rates just took a big relative jump higher and it is logical for the dollar to follow through.
As mentioned last week, I expected to see September T-notes test 11400 support as indicated on the chart. We moved our stop down to 11601 after making 11427, but I am feeling a bit apprehensive about the speed with which we made our goal and the current distance we are from the stop. Should we expose so much?
September T-Notes
I cannot say I am surprised that 11400 held, but we need a few days to see the pattern that emerges. Will support form a consolidation flag? If so, we must interpret its eventual slope.
I was disappointed in the speed and extent of the Canadian Dollar's retreat. Based upon last week's action, it seemed the Canadian could remain within a trading range. Of course, we have reasonable premium and there is the possibility of rolling down. On the other hand, buying the dollar index or shorting futures to cover the puts might represent better strategies.
It is interesting to note that the September U.S. Dollar Index shows resistance at 9800. As this is approached, September T-notes vacillate around 11400 support. This raises the question of whether both contracts are about to stall.
The rounded "U" bottom projects to 9800, too. This adds tension to any decision to buy the dollar here. It may be best to wait for a breakout above 9800. Obviously, if not reached, you don't want to be in!
Energy Finally At a Top?
I have been thwarted several times in my attempts to pick tops in crude and heating oil. Although crude still displays a bullish pattern, it is challenging March highs and there are signs of resistance. More importantly, gasoline and heating oil indicate overbought conditions with strong reactions today.
It is hard to imagine crude exceeding 3200 when we know Iraq's production is rising and in the market. At the same time, Russia is increasing sales to Western Europe to suggest price relief should have already materialized.
Notice how September heating oil leads the price break today.
Support for last week's consolidation was broken at 8300. We are below two prior resistance levels made at this same point. With the price just ticks way from breaching the 20-day average, there is significant technical vulnerability.
Now, look at gasoline. Normally, the tightest month is August when distribution takes place for the last summer driving days moving towards Labor Day. It is too late to trade August because it expires in July.
The upward sloping flag represents a potential reversal formation. The price plunged below the consolidation and through 8750 support. This is, by far, the most bearish pattern.
Rumors of accumulating gasoline inventories and a "slow driving season" stimulated short side interest and may have contributed to the more dramatic slide. I feel we can view gasoline as the leading indicator among the energy contracts.
The Wall Street Journal published a front page article about liquid natural gas (LNG) as the potential savior of the international gas market. No doubt, LNG holds the potential for greater supply diversification. On the other hand, transporting LNG is an expensive process and I am not as convinced about the safety issues. My understanding of LNG is that it packs enough energy to equal a modest nuclear device. The article maintains that LNG is non-volatile because of the narrow fuel-to-air mixture required to ignite natural gas. In liquid form, it is too dense to achieve the appropriate mix.
Questions aside, natural gas is receiving an unusual amount of publicity. It's clean. It's efficient. It's plentiful. It can be cheap if made more accessible.
Greenspan successfully talked natural gas down below 5800 support and we just breached 5000 to set up a test of the small gap left at 4500. Perhaps the conversation is designed to keep natural gas under pressure (no pun intended).
Overall, the energy complex seems to have turned and I believe there is plenty of downside potential. After all, I need to take back some of the losses incurred in my previous short sale attempts!
What's The Fed Saying?
All ears were on the testimony of Fed Chairman Alan Greenspan as he described his perception of the U.S. economy. While the tone was reasonably upbeat and he promised to keep interest rates low over the foreseeable future, stock traders viewed the prognosis as negative...for the moment. Interest rates ratcheted up bringing bonds and notes down to new interim lows. Stocks retreated, too.
This raises the question about what the Fed is "really saying." My take is that investors believed it was time to reallocate based upon clues that deflation remains a threat and the economy is not out of trouble, yet. The Fed's stance seemed "accommodating" which generates a sense of pessimism among professionals who have finally reached the same conclusions I
expounded when we sold notes short in anticipation of this present correction. How much lower can interest rates go? Even if the Fed drops the discount rate another 1/4-point, there is simply no more room for appreciation.
There is little wonder why portfolio managers are realigning away from fixed income and back toward equities. Comparing after tax interest rates yields to stocks paints a rosy picture for stocks. Thus, even with overvaluation and an under-performing economy, stocks represent less exposure and more upside potential. As was mentioned in The Wall Street Journal yesterday, fixed income investors who bought for yield before interest rates declined are inclined to hold for maturity because they cannot achieve a better coupon. But, this logic is flawed in the sense that cashing in now provides appreciation equal to the yield and the money can be invested in other financial instruments that have better profit potential.
July 22, 2003
Philip Gotthelf
Commodity Futures Forecast
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