22-Feb-05: From the perspective of being bullish on gold prices it is a concern that the foreign exchange value of the US dollar is falling faster than its gold value, and accordingly that the foreign currency price of gold has been weak. The reason is, gold cycles tend to start and finish with the foreign currency price of gold.
Weekly Gold Market Outlook
A Gold & Currency Digest
USd POG / Foreign POG Drives FX
-to the extent it reflects changes in real values-
(an excerpt from Weekly Report reserved for Subscribers)
Ed Bugos
I really apologize for being away unexpectedly. I was trying to solve for the meaning of certain divergences - between exchange rates and gold values - and wanted to publish something fresh for you to chew on. In terms of research, my feeling is that if there is something unclear to me it might be unclear to our readers and I won't let it go unless I'm satisfied in the substance of my findings, their relevance, and that they are presented as clear as possible. This report took more than the average time to complete which I did not anticipate when I started it; but I believe we are at a critical inflection point for the gold story right now, and so I hope the extra time it took to reflect on these things turns out to be worthwhile.
Our subject of study this past two weeks was the relationship between money supplies and foreign exchange rates; foreign exchange rates and gold values; the structure and way that changes in real currency values affect the monetary system; and the usual contrasting of various conventional arguments with actual economic principles (it takes a lot of work to be right!?). However, before I reveal my observations, conclusions and hypotheses, and how they affect our gold and dollar outlooks, I want to summarize the Greenspan effect in terms of the 1990's - it is also relevant to the later discussions of what happened and is still happening to the real value of money. Greenspan deserves credit for the late nineties boom.
Not in the sense it is in recent years - for printing himself out of trouble - but for the opposite.
"…if the variations in the objective exchange value of the money occurred uniformly and simultaneously throughout the whole community then such social consequences could not appear at all. The fact that these variations always occur one after another is the sole reason for their remarkable economic effects" - Mises, Theory of Money and Credit II.12.39
The Greenspan Effect
Volcker (the prior Fed Chairman) is commonly awarded credit for establishing the disinflation of the eighties - perhaps it is warranted; if I were to concur I would not be referring to prices, but to trends in money supplies (inflation in the true sense) that determine changes in prices. And this change indeed began in his time. But it only just began, and only in the broader money categories (see chart below).
Conventional wisdom has it that money supply didn't matter, conveniently; only the fact that he was willing to crank interest rates up to the double digits is attributed credit, and that only because prices stopped rising so fast in the eighties (though they didn't quite fall). So it is thought that this was what ended the US dollar's rout.
To emphasize, the relationship everyone sees is interest rates affect currency values which in turn affect real (gold) values. The concept of money supply has left the building. The reason it is convenient of course is simply because that's exactly what the Friedman-monetarists claim, that money supply means nothing…
…Except when they want to stabilize prices!!
But the fact is, as this report will show, money supplies did and still do matter.
One of the grandest delusions of the past 20 years is that interest rates determine, or cause price trends!
Interest rates set by the central bank mainly determine the demand for credit, which is essentially how it controls money supplies - by manipulating your time preference rate (the way you value current goods relative to future goods). But it is a mistake to think that by lowering interest rates in 2001 the Fed implemented a weak dollar policy and deliberately boosted prices in order to help the economy recover. Money supplies are responsible for that con job… interest rates only contributed to the extent they affected money supplies and other variables.
To the extent that a rise in real interest rates is likely to encourage savings at the expense of consumption, and to weigh on credit inflation, it could affect increases in the real value of money; but this is not necessarily true of fiat type monetary regimes. We've seen interest rate spirals in many countries have absolutely no effect on the real value of its money - usually because the market was in the midst of rejecting it as money.
Insofar as Volcker affected such a strategy successfully he deserves credit at least for temporarily stabilizing the value of money, and reigning in some of the inflationary excess. However, it could also be argued that he had help from developments that were already under way - that the bear market in the foreign exchange value of the US dollar was already ending, and commodity prices peaked due to overcapacity (malinvestments).
Market Recap: Gold Bulls Sweep Brown Hijacking Under the Carpet
The gold shares have made a strong comeback over the past two weeks. In the past ten trading sessions the gold share averages are up almost 10 percent - most of it occurring in the last half of the week before last though. Last week was a matter of holding those gains, and they did that well too. The HUI was up ½ percent while the XAU was up 1.5% and the TSE gold sector was up about 1% in the five days ending Friday.
Next to the diversified mining company index, the gold share bourses have topped the list of S&P sector performers over the past two weeks; falling behind only the software services sector in the prior week.
Last week the steels and oil shares topped the list however. Within the stock market the sectors providing the most bullish technical support to the averages continue to be the commodity-related stocks, builders, railroads, steels, energy shares, and real estate. The drug sector looks to be making a comeback, and gold shares…
Those markets seem to be caught in a drift of sorts.
The fresh bullish prints of a recovery in commodity markets, returning dollar weakness, and the downturn in the bond markets are a bearish combination for stock market PE ratios in general. Indeed, over the past couple of weeks gold has outperformed most paper (stocks and bonds), as well as platinum… though it is still underperforming the base metals (silver and copper), energy, and the grains now.
Gold prices were up $6 last week after being up $6 the week before (they are up an additional US$3 overnight Monday - President's Day), which has been causing new trouble for the USd (FX).
The current gold rally must be threatening to the bears since the market's structure is so cleansed of bulls - thanks to Messrs. Brown, Greenspan (Sir), and the rest of the gang at the IMF and BIS roster.
The green light, technically, is a break back up through and out of the US$425-433 range.
Last week's rally stopped just over $425 and this morning's pop touched the top end of the range of resistance (US$432). The move up through US$425 Friday and the follow through Monday morning is bullish short term because it marks the last lowest high in the two month correction sequence which we see as a typical flag - and a typical 3 wave sequence. I correctly anticipated the timing of the correction but not its duration.
Nonetheless, a break through US$433 should be the green light that preps the market for the big move through $500 we've been waiting on, though which hypothesis is still close to being ruled out if it doesn't happen soon… it looks to be in progress. For the HUI the important reversal point is also a range: 214-221.
Gold is on a roll - it is up nine days in a row now (including Tuesday morning). But the gold shares are trading even better. The four day rally in both gold and the shares to last Monday was the best one since August when the bulls first broke out of a 3-month (Jun-Aug) ascending triangle formation (albeit a tricky one) to end the correction that began at the beginning of 2004.
What's more, although we use the HUI for a technical proxy, the other bourses (TSE and XAU) and many of the individual components have more clearly taken out the last lowest high in the two month correction sequence. More than half of the sector is above its 200-day moving average now. The current rally in the HUI looks like a belated bounce off the neckline of the triangle (see chart) after a full retracing, as well as a moving average crossover if you allow some room for volatility since the HUI actually fell through both the moving average and the neckline; the moving average is almost exactly at where the neckline is.
The exact reversal point for the two month correction in the HUI is 211 but I would extend that to 221 - if we get through there the next 50 points is a walk in the park!?! Nevertheless, the rally is occurring next to a bounce in gold prices off their primary trend line (and coincidentally the 200-day moving average).
So, Gold and the HUI may have completed a three-wave sequence down - from the November high - within what appears to be a normal corrective pattern (flag). Our intermediate target for the HUI remains at 265 on a gold rally through US$500. The trader that is holding cash right now and looking for a 20 percent move in something would be wise to look for a breach of $433 in gold and/or 221 in the HUI in order to signal a timely long trade (or short if you're a cynic about T.A.) if we didn't persuade them two weeks ago.
The US dollar index finished flat the prior week and down a bit last week. The big currencies (Yen, Euro, and Swiss Franc) are either lagging or matching the dollar's moves but strong gains were made in the Australian, Canadian, and British currencies.
The bullish recovery is a welcome surprise, for as we wrote in previous issues, the window for the blow-off scenario was shutting down and we were losing hope that it would occur during the first half 2005. However, now we'd like to see some resilience and follow through.
Two weeks ago Greenspan predicted that an end to the worsening trade gap was at hand; the UK's Gordon Brown's turned up the heat on an IMF gold "sales" plan; and the USd was coming on strong in sympathy with a post-FOMC relief rally in stock and bond values. But that all came to an end beginning with the release of a disappointing GDP figure in the week before last, and Bush's budget for the current fiscal year and beyond.
Conclusions & Sector Outlooks
Inflation is the most significant determinant of monetary values, and changes in foreign exchange rates aim to merely reflect its relative effects on the real value of money... inflationary or marginal currencies fall fastest (which is why the foreign currency price of gold leads the gold cycle) and the dollar system is only as strong as its weakest link… gold price variations ripple through the entire currency complex according to the monetary fundamentals… the monetary and trade facts suggest that the PACE of the decline in the foreign exchange value of the USd relative to its gold value is not sustainable, and further that the foreign currency POG is undervalued... the everything is okay syndrome is the most direct reason the foreign currency price of gold remains weak… the trade data (and intervention facts - BOJ) suggests the FX value of the US dollar has room to fall, while the monetary data suggests gold is undervalued in both currencies…
Finally, market influences are much more prominent than official suppression in explaining the divergences (the weak foreign currency price of gold), but anti-gold rhetoric always offers a good buying opportunity nonetheless. The gold sector is breaking out right now at a time when the seasonal window should be closing, which supports our view that there remains unfinished business before it peaks.
Our outlook for the USd is basically that it continues to fall in terms of both, foreign exchange and gold, but that it begins to fall faster against gold. Our FX target for the USd index is roundabout the early 1990's lows at 78; our target for the USd price of gold is for it to drive through US$500 in the first half. If this outlook is right I expect the HUI to gain 20% in that period unless our gold targets are too conservative.
We'd still rather err on the long side of this bet!
Our conclusion is to buy the gold sector on weakness, and sell stocks and bonds on strength.
The USd (FX) will give us trouble in the not so distant future but not until we see gold blow off past the US$500 mark.
I made some minor changes to our short term outlooks:
The strength in copper, wheat, energy, and the precious metals persuaded me to upgrade my short term CRB outlook to moderately bullish from marginally bullish; but I continue to believe that the best commodity gains in the near term will belong to gold & silver, but especially gold.
Stock market technicals for the TSE, FTSE, and the Nikkei look too strong to remain bearish on those trends (for the short term at any rate); but for the US and other European markets there is enough erosion in the technicals to keep us bearish. Lumber looks overbought short term but the nature of its recent advance argues for a more bullish intermediate outlook. The wheat chart looks VERY attractive here.
…if you trade commodity futures.
Finally, since we remain steadfastly bullish on the foreign currency price of gold and because of the performance of the Canadian gold sector last week, we've upgraded our short term outlook for the TSE gold and silver sector. As a final note on the US dollar, and in particular the lead role that gold has in forecasting USd trends, note that in the chart here gold has already taken out its 1996 high - could that mean to suggest the USd index is going to fall through its 1995 low??
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
February 23, 2005
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