COMMODITY FUTURES FORECAST WEEKLY REPORT
Gold And Silver Hold Up
Philip Gotthelf
(October 27, 2005) Last week's dip in gold came in conjunction with a drop in oil prices. Silver responded in tandem and I was tempted into the short side of both after making long-side profits a week earlier. Alas, it was the wrong strategy.
It looked like December gold could challenge 46200 support as seen on the chart. A breach of this support level implied a retracement from the September breakout down to 45400. I believed it was worth a shot when considering weakness in December crude oil.
Crude oil appeared to be challenging 5800 support. While I like to think I was the first to go public with a bearish sentiment on crude, the bandwagon seems to be rolling down the street. Now, even Merrill Lynch is putting out the possibility crude can drop into the 40's. Unlike gold, crude has not moved back above the 20-day and 40-day averages. It is still in a downward channel and needs to breakout above 6400 resistance that formerly offered support before the October bust.
Some chartists claim crude has put in a rounded top as I have tried to illustrate. Others claim there is a head & shoulders top within my outlined area. Both reference 6400 support that remains broken...for now.
Silver has had a nice run from the 67000 bottom made in September to the double-top at 79500. All the bulls are awaiting a breakout above 80000 to set the "roaring" market in motion. The problem is that both silver and gold are headlined as responding to inflation. If crude cannot support the advance, I am concerned that the metals will stall or even retrace their autumn advances.
Strategically, I would wait for the penetration above 79500 in December silver before jumping back into the long side. The 40-day average is too distant to rely upon for a reversal signal unless one wants to sacrifice 45¢. The 20-day is hugging the price with a propensity for being whip-sawed. The chart shows some support at 78000 which was probed 3 times, and also at 77000. We need a bust below 77000 to venture back into the short position...even at the risk of being premature relative to the 40-day average.
Is Crude Going Up Or Down?
All media eyes are focused upon crude oil for economic and political reasons. High energy prices are considered a Bush failure by his opponents and even Republicans are feeling pressure as temperatures dip and heating bills begin to accumulate. So far, major broadcast media is still playing the bull-horn for rising prices with the same continuum of experts yakking about China and India. I referenced Bill Clinton's interview on FOX News where he said higher energy prices are inevitable using the same reasoning.
I went on CNBC with a different perspective as oil reached above $70 during the summer. When I said prices would fall below $60 before year end, the nasty phone calls and emails poured in. I have been vindicated...if only by a few points.
With 19 days left until December crude options expire, the chart looks like prices can stall above 5800 support and below 6500 resistance. The 58/2x57 December put ratio spread was posted at a 40¢ credit towards Thursday's close (10/27) while the 65/2x66 call ratio spread showed 30¢. Given the pattern, I would venture into these for the bold and wealthy. Margin should be reduced by the balance between the two spreads. We collect approximately 70¢ while having an additional opportunity to gain $1 between each of the strikes.
We have been successful with this strategy since early summer. However, we were biased toward the short side and only executed the call ratios. Last week we took a $1,950.00 profit. Not bad!
New Fed Raises Old Fears
When Paul Volcker took his cigar and packed his bags to turn the Federal Reserve over to Alan Greenspan, markets gasped. After all, no one could do as good a job as Paul! More importantly, Alan Greenspan was a known gold advocate who frequently wrote and spoke about monetary restraint and the need to preserve monetary integrity, i.e. some form of currency standard. How could such an individual dovetail into the new world of floating foreign exchange and currency volatility?
If there was ever a story of adaptability, Alan Greenspan epitomizes it. Reading his papers from the 1960's, it is almost impossible to believe the Greenspan of then is the Greenspan of now...who quickly uses interest rate policy as a fine pitched tuning fork that creates a perfect cord between interest rates, reserve requirements, and monetary velocity. Gone is his gold advocacy. Gone are his reservations about freely floating exchange rates. At least, this is what we see from Greenspan's tenure as Fed Head.
Enter Ben Bernanke, a monetary conservative who is allegedly similar to the departing Chairman. However, Mr. Bernanke's background is strikingly dissimilar when comparing his writings to the early opinions of Alan Greenspan. Mr. Bernanke's perspective is drawn from a much shorter historical perspective since he is only 51 years old. This means the new Fed Chairman was still an undergraduate when U.S. gold ownership was reintroduced and the standard lifted. While Greenspan could draw upon two distinctively different global monetary standards, Mr. Bernanke can only recall one.
For this reason, many gold enthusiasts are predicting a positive shine on the yellow metal as the Fed transition takes place. Gold bugs espouse a change for the worse in the new Chairman's attitude toward trade deficits and interest rate policy. After all, Bernanke has lived through a consistent period of growing U.S. deficits without adversity. He is likely to be from the school of, "deficits don't matter as long as the economy grows." Rumors suggest that the new Fed will incorporate foreign investment in U.S. debt as a positive GDP inflow, thus, altering the entire perspective on trade deficit expansion.
Economic Evolution
Since subscribers pay for my opinion, I'll give you one. I have grown up parallel with the new Fed Chairman. In fact, I best him by a year...something we stop appreciating once we pass the age of 45! All I know of the Great Depression is what I have read in books and chronicles. I did not live through it and my existence (like the majority of our population) has not spanned either a world conflict like the Great Wars, nor a global contraction similar to post 1929.
Certainly, there have been threats. But to date, no horrific alteration in the nation's lifestyle has been experienced for more than 60 years. This is not to say that there has not been an enormous economic "evolution" since the Great Depression that includes the transition from a global bimetallic monetary system to one of international "full faith and trust." Western Europe has consolidated most of its major currencies while the United States has reprinted its paper twice...with a third design already in the wings.
A good deal of this discussion is carried in two of my books, Trading Precious Metals (Wiley) and Currency Trading (Wiley). I have touched upon the morphed thinking from a time when Goldman Sachs' economist, Henry Kauffman emphasized the money supply and trade deficits to our present techno-analytical correlation between relative interest rates and currency values. In the "old days," the belief was that a nation with a trade deficit would lose currency parity as it bid for foreign exchange to cover its bills for foreign goods and services. Yet, the dollar remained dominant as the world's "reserve currency" despite large and growing deficits with countries like Japan, Korea, and OPEC members. Since traditional logic failed to explain reality, the explanation needed to be altered.
Keep in mind that markets did, in fact, react to M1, M2, and M3 during the time when money supply was assumed to be a controlling factor in setting interest rates and the equity market environment. However, the reactions were not consistent. Few economists seem to have commented on the 180 degree about face market analysis has taken whereby interest rates are now assumed to be the controlling factor with currency values, trade, and other economic conditions following. Thus, if the Fed raised interest rates, the dollar gains strength relative to nations that have a lower interest rate. Why? Because an investor can achieve a higher return from the currency that has the higher government guaranteed yield.
In reality, the new logic is counterintuitive because interest rates are usually raised in response to inflation. Inflation, by definition, is a deterioration in purchasing power. Shouldn't inflation decrease a currency's relative strength?
The argument is that the proactive raising of rates is a sign of strength and, further, markets are anticipatory...they discount the prospective consequences of increasing rates in the present for lower inflation in the future. The problem with the new logic is that it circumvents the assumption of a hedged rate of return. Currency futures, forwards, and options were founded upon the premise that they could be used to hedge against adverse fluctuations. Reading initial literature describing the use of currency hedges, we find the example where a country like Australia might raise interest relative to the U.S. To earn the higher rate, an investor would buy Australian bonds. Once purchased, there is a risk that the Australian Dollar can fall relative to the U.S. Dollar. The protective position would be a short sale of Australian Dollar futures.
With the short in place, the math says that any increase in the Aussie currency would result in a loss on the futures and a concurrent gain on the Aussie bonds. If the Aussie Dollar falls against the Greenback, the deterioration in the bonds is offset by the futures position profit. It is as a hedge should be! With the futures position in place, the higher rate on the Aussie bonds can be achieved without commensurate currency exposure.
Ah...If only it worked that way! What we find under the evolved logic is that currency demand increases when a higher guaranteed yield is available. This demand raises parity. Hence, the hedge would automatically lose money on rising rates. Even worse, an increase in Aussie interest rates would have a corresponding decrease in principle values. Not only would the hedge lose money, but also the cash position.
As we see from these few examples, monetary thinking has evolved along with the abandonment of a hard currency standard. Ask yourself the question, "What can I exchange my dollars for?" Obviously, we can go to any store and buy goods with dollars. But, the government offers absolutely nothing now whereas it offered fixed amounts of gold and silver before. As governments exhibit more and more corruption, there is a possibility the general public...the consuming public...can become disillusioned with non-backed paper money and electronic credit memos.
Herein lies an argument for a return to a metallic system that was advocated by Alan Greenspan during the 1960's! It there any wonder why we are seeing an increasing number of gold and silver ads in newspapers and magazines. It almost feels like the late 70's!
October 29, 2005
Philip Gotthelf
Commodity Futures Forecast
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