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(May 18, 2006) I appeared on CNBC's early morning "Squawk Box" about two months ago to discuss precious metals, as usual. The question was, "Why gold?" When I brought up the "I" word (inflation), I was immediately confronted with the fact that the Consumer Price Index (CPI) did not reflect my alleged inflation. My only response was, "Have you been to the supermarket lately?" The point is that inflation has been talked around, disguised, dismissed, and even ridiculed as recently as March...yet, the cost of living has taken a rapid track towards the moon. If $4.00 copper is not indicative of inflation, what is?

So, stocks have been merrily trekking higher based upon the media and government deception that Bush's growth plan has miraculously avoided the historical consequence...inflation. In the meantime, I have been calling attention to the commodity-led cycle since last summer. Admittedly, I missed a few marks when shock and awe overtook my thinking as copper moved to unthinkable new highs. So, I sold some non-existent tops for which I apologize. As I have always said, "If I was as good as subscribers wished I was, I would not be writing a newsletter every week!"

April's inflation data should not have come as a surprise. Anyone who read The Wall Street Journal in February had to know that retailers were adjusting spring pricing in accordance with newly imposed fuel surcharges and other cost hikes. I find in interesting that our world of 1-minute sound bites and day-by-day news articles never cover analytical aspects of developing news. So many experts, so little expertise!

For example, the Postal Service raised First Class rates from 37 cents to 39 cents and increased bulk rates charged for distributing catalogues and other promotional mail. When you mail one million catalogues, a few pennies can make a big difference. Add the extra 2¢ needed to send bills and other mail. The amount adds up for businesses that operated on razor thin margins and depend upon large volumes. Major metropolitan areas were granted electric rate increases that surged by as much as 62%. Rural rates have equally gone up.

This translates into higher costs that must be transferred to consumers. Thus, the Department of Labor revelation should not have been a surprise that jolted the market so severely this week. Further, stocks were not the only investment sector to take it on the chin. Commodities took a plunge right in tandem to suggest that the mere prospect of higher interest rates can control rising prices.

Consider that oil dropped below $70/bbl. in the midst of the stock market selling spree. Gold dipped below $700 and the U.S. Dollar gave a sign of stabilizing. Contrary to popular opinion and market logic, bonds have rallied. Is there something wrong with this picture?

Take a step back and a deep breath. Let reality sink in. Inflation is not new. Look at the CRB Index chart and take a hint. Prices of practically all raw commodities have been moving higher and energy prices have been in the lead. Use your power of observation rather than the "spin" of television, radio, and print media. If it costs more in the store, that's inflation. The question at hand is, "Why inflation?" Is it driven by demand, supply, or both?

Subscribers should recall my frequent references to cost-push versus demand-pull inflation. You see, there are some things that sink in after taking college economics. Cost-push results from rising costs that are generally associated with shortages. For example, a shortage of labor can drive wages higher. A drought can drive grains higher. Demand can be static or even declining as prices rise. A balance comes when the price of the commodity or service confronts inelasticity...ie., it's too expensive.

In comparison, demand-pull represents an increase in demand that is generally associated with too much money chasing too few goods. This implies loose monetary policy or relaxed fiscal policy. Under such circumstances, the solution is to remove money from the system. That's where monetary and fiscal policy work. But, neither monetary nor fiscal policy addresses a hurricane that knocks out refineries or a drought that destroys crops. In fact, raising interest rates during a cost-push inflation can exacerbate the problem by pushing borrowing costs higher. Higher interest is passed along to consumers, too.

Indeed, the Fed is challenged by current conditions because the biggest source of wealth remains real estate. We already see signs of falling real estate values as the National Association of Realtors releases average home sales statistics along with mortgage default rates. While it is not a bursting bubble, weakening real estate is a precursor for a cooling economy.

In my opinion, the figures represent nothing new. The reaction should have been expected and I feel the downside is limited. Overall, the economy is doing very well and we can endure another 25 basis point rise in fed funds. I do not believe the Fed should, or will become more aggressive after increasing rates in June. If I read Bernanke correctly, he will allow the summer to run its course.

Today's Wall Street Journal Section D carried the headline, "Bond Market Has A New View On The Economy." As if to sum up the entire market based upon a day of trading, the article argues that the reversion of the yield curve indicates inflation rather than recession. This is what I mean by sound bite media. To fill pages and waste ink, the article regurgitates statistics that we already know and observations we can all see.

Where is the substance? Missing from the article is the possibility that investors might be tempted into bonds as a flight to safety. Isn't this a typical pattern when stocks falter? Also, bonds offer a good relative return when yields exceed 5%. Finally, take a look at the chart. Bonds actually rallied through the news.

Technically, June bonds are testing 106'00 resistance again. A breakout above this level points to a test of 108'00. Alternatively, 106'00 can hold and we would see a repeat of the pattern observed in April when 108'00 was resistance. But, a move beyond 106'00 and 108'00 sets the stage for a rally all the way to 110'00. This is the farthest thing from trader's minds if you look at call option values for July.

Seasonally, we are ready for a rally, too. Bonds tend to gain value as interest rates stabilize into the summer. Again, I sense that Bernanke does not have a hair trigger. He knows interest rates take time to work their way into the system. It is better to wait and see how real estate fairs through the hot months than to rile markets with too much tightening.

This is why I opted to sell the June 107/106 strangle rather than jump into the long or short side of bonds. While I am leaning toward a long-side bias, 106'00 resistance is a major obstacle as is 108'00. With the June hike in sight, these areas are not easily overcome.

I view 110'00 as the stopping point for the early summer rally. When correlating bond movement with the interest rate trend, it is hard to see bonds rallying over 110'00 unless we see a further deterioration in stocks that forces the flight to quality. More bad news in real estate could also be a catalyst for a pop above 110'00.

Interim bond movements appear to be limited to 5 full-point increments. Notice the drop from September through November was from 118'00 down to 111'00... 7 full points. The rally from November into January went from 110'15 to 115'15...5 full points. The drop from January into March was from 115'00 to 110'00...5 full points. The March bust from 110'15 bottomed at 105'15...5 full points. We have rallied from 105'15 to 107'00 which is only 1-1/2 points. The target would be 110'15 if we expected a 5-point correction.

Between March and the first half of April, everyone seemed to be looking for stocks to correct In particular, the S&P 500. The drop from 1320 to 1290 was viewed as a "partial correction" by the cautious and a "pivot point" by the aggressive. Still, 1325 resistance held in June futures while the consensus turned bullish. When prices overcame 1325, everyone said we were ready for the summer rally in the spring. Economic data was good. Corporate earnings were strong. Interest rates were supposed to stall after the May bump up.

But, the breakout was stumped by this week's data and the flag turned into an exhaustion rally. Once the market fell back below the support/resistance line at 1320, investors decided to take profits and run. The entire highly volatile and painful rise from the February low through the May high has been retraced in a few sessions. We see a definitive violation of the trendline which was technically worthless considering the velocity of the plunge. There was a brief test of 1285 support which failed. Now, 1267 stands as support against a further decline to 1250.

This is why an argument exists for a bond rally. Some say stocks are busted. However, ask yourself the question, "What has changed?" April's inflation stats are behind us and it is apparent that the big culprit, oil, has receded. Iran is stalling which means the news will stall, too. With calming Middle East jitters and a possible Dollar rally (in response to the likelihood of further FED tightening), oil could roll back to 6000 or lower. In turn, gold would probably correct into the mid 500s, taking silver, platinum, and palladium along for the ride. Investors will say, "Hey, it's not so bad," and the cycle will resume.

The first clue will be a rally above 1285. If we achieve this, I believe the S&P will relax for a few weeks in a range between 1285 and 1305. Unless there is significant news, why should stocks move powerfully in either direction? Just as bonds will be held under 110'00, so should the S&P 500 be confined below 1310. June will be a slow month for financials.

Wall Street calls gold "the latest rage." Gold is the nemesis of paper. The more gold attracts, the less stocks appeal. This is because stocks do not run on the same fuel...inflation. Yet, keep in mind the fact that stocks rallied as gold advanced. Currently, observe how gold has declined in tandem with the S&P 500. Where's the inverse relationship?

While I remain bullish in gold, I view 680 support in June as critical. I think it will be penetrated as the June options expire. The question is whether the market will exercise huge protection that was bought in June 675 puts, or wait for expiration to make the move.

For those wondering of gold's luster has vanished, look at the shiny side. A bust below 680 is likely to gain momentum as longs scramble to realize profits. This should bring prices into the 610-650 range. If oil falls below 5800, I expect to see a buying opportunity in gold around 590. Thereafter, the market can stall in a range between 590 and 630.

As June progresses, commodity traders will watch corn and beans...summer favorites. So far, planting has been adversely affected by too much rain. But, the season is young. Even if weather is "normal," the environmental stories about global warming and hurricanes will keep tensions high and market reactions volatile. Some traders believe soy and silver are correlated. We'll soon see.

May 22, 2006

Philip Gotthelf
Commodity Futures Forecast
P.O. Box 566, Closter, New Jersey
201-784-1235

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