Bob Hoye Looks for a Rebound in the Long Bond, and Topping Out in Commodities

While our recent recommendation to buy the Long Treasury ETF, namely the Lehman Brothers 20+ year U.S. Treasury (TLT), has not been a good move so far, I have not at all given up on this suggestion. I am encouraged by Bob Hoye's latest "Pivotal Events" letter dated March 16, in which he suggests the long bond will likely rebound significantly over a period of perhaps six weeks. At the same time, he looks for a topping out in the commodities sector.

Mr. Hoye is also suggesting that a process of widening spreads is beginning to take place in which riskier debt is beginning to be priced more in line with its risk than has been true in the recent debt bubble mania. Along with a wider spread between junk bonds and Treasuries, we will then see a decline in other assets like risky bonds and commodities, though not necessarily gold. In fact what Bob is looking for as credit spreads widen is for gold to rise, vis-à-vis commodity prices and also a steeper yield curve. These favorable events for gold should take place, according to Mr. Hoye, at the time the long treasuries stop rallying-perhaps over the next six weeks or so.

Longer term, your editor is sticking with his view that we are in a long-term bond bull market until the long-term uptrends shown in the chart below are violated. At this stage it seems obvious that the bull market in the 30-year U.S. Treasury, which began way back in 1982, is very much alive. Also, the strange long bond conundrum that Alan Greenspan spoke of may be explained by Professor Fekete, who suggests that the attempt to inflate away burdensome debt by the Fed through its open market operations and via the cooperation with the Japanese in fact is self defeating as the bulk of new money goes into the bond markets rather than the commodity markets. This is a strange view to most observers, but I for one think he may be right. The issue here is linkage between interest rates and inflation. Clearly lower rates of interest have not served to lift rates of inflation as the chart below, along with inflation charts, clearly demonstrates.

Stephen Roach Sees Commodity Speculation

I believe Hoye's expectations here over the next several weeks are very consistent with the views of Stephen Roach, who is suggesting commodity prices are now on the rise-more due to hot money flows from hedge funds and other speculators than to basic growth in demand. Remember that bubbles are created because of enormous amounts of money created out of thin air in our fiat currency environment. Meanwhile, Roach notes that the Chinese economy is slowing down and that the policy makers want it to slow more. Roach points out that while the world is now taking for granted 8% to 9% annual growth in the Chinese economy, policy makers are increasingly concerned about the quality of life in China as well as stability of the economy. And Roach points out, "From China's perspective, the stresses and strains of an overheated economy pose serious threats to stability. Last year, the Chinese economy was endangered by mounting bottlenecks and sharply rising prices of industrial materials. This year, the economy is being buffeted by sharply higher energy prices. In both cases, the materials requirements of excess growth were at odds with the overriding concerns of stability. And so the China slowdown remains very much on the minds of its leadership as it attempts to walk the fine line between its growth, reform, and stability objectives. Needless to say, the slowdown campaign has important implications for world financial markets. If China succeeds in slowing its economy, commodity prices would probably ease -- leading to a reduction in inflationary expectations in most major economies and a related easing of concerns in bond markets."

Roach goes on to say that China also is faced with the potential of a sudden loss of value from its over-weighted dollar holdings and excesses within China. Roach believes that China will be less likely to take risks required to keep its economy growing at the kind of 8% to 9% we have assumed it will continue to grow and when/if that pace subsides, we could see a nasty contraction in what is looking more and more like a commodity bubble.

Turning back to gold, your editor is in agreement with Bob Hoye that gold shares will do best when gold rises, vis-à-vis all currencies, because that is when the economics of gold-mining firms operating under various currency regimes will perform best. And as Bob sees it, we can look forward to that kind of event now that the credit spreads are widening and after the long treasuries rally over the next several weeks. Then we will see a steepening of the yield curve as people strive for liquidity at the short end of the yield curve, and of course the ultimate liquidity is gold.

In his March 16 "Pivotal Events," Bob concludes his remarks on gold by saying the following: "When it starts, the real bull market (gold) will become exciting and eventually fabulous. Investors should continue to buy the gold shares-it will be a multi-year bull market."

I think Bob Hoye is right. The cool-headed John Hathaway of the Tocqueville gold funds quietly suggests that before the current gold bull market is over, we will measure the price of gold in four digits not three. I would suggest that at the bottom of the equity market we will see the Dow and gold at parity once again, as has happened at the bottom of past equity bear markets. Whether that number is 2000/$2,000 or 5000/$5,000 doesn't really matter because a deflated equity market will bring with it bargain basement prices in the economy and in the investment world. Even if deflation places such a stranglehold on the economy that we see a 500 Dow and a $500 gold price, it won't matter because gold (and cash too) then will be so valuable in terms of purchasing power that those who own cash and gold and have no debt should be in an exceptionally strong position, financially.

A Powerful Deflation Argument

Writing in his March 17, 2005 issue of "The Macroeconomic Newsletter" Warren Pollock said the following:

" When the average Joe fund manager finally realizes that huge swaths of assets are essentially worthless-Gm Stock, for instance-funds will try to rotate to things of perceived value. Deep down, these guys must know they are perpetrating a fraud. But frauds are revealed only when they stop working.

"Therefore, on first pass, attempts will be made to rotate money stuck in stocks from sector to sector within the stock market. More and more people will come to know that little of value exists in the majority of stocks. At some point, individual investors will realized they are once again locked into the equities-based fraud.

"Recently, the individual investor has looked to the safety of the housing sector. Here, too, a bubble has been brought about by rotational money. A nasty surprise lurks quietly in the background because the financing engine that makes this fraud possible has been waning.

"The housing sector is now perilously overvalued and, due to constraints at Fannie Mae and Freddie Mac, little room exists to bull this market any further. At this stage, the only way to do it is to extend credit at still higher levels of risk. The present value of the market depends on continual expansion, and on the future availability of credit. Making loans to the feckless can and should be construed as fraud.

"There is no room for expansion in the housing stocks, mortgage companies, physical real estate, or in the companies that were picking the low-hanging fruit in those sectors.

"Thus a disaster awaits in the financial sector-and, unlike market-weighting statistics, I would put GM in that category. I wonder how many jobs are based on financial sector fraud?"

I think Warren paints an excellent picture of a bubble economy that is now approaching its optimum inflation limits. Which reminds me of the old Bazooka bubble gum we used to chew and blow bubbles with as kids. You could blow that bubble out to its optimum dimension, but then like it or not, it would slowly implode. Warren is correct about the housing market when he says, "At this stage, the only way to do(keep it growing) is to extend credit at still higher levels of risk. The present value of the market depends on continual expansion, and on the future availability of credit." What Warren implies here is that just like the bubble gum bubbles we used to blow, unless the housing bubble is expanding, it will contract. It simply can't sit in neutral because an ever-expanding source of energy is required to push the walls outward. When that force is no longer adequate to do so, the walls of the bubble being to cave in either slowly or in a very rapid implosion. The housing bubble is like all other bubbles. It is sustained by the "greater fools" theory rather than by sustainable economics. A major reason many people have been buying more and more expensive houses in addition to low borrowing costs (which are subsidized by old folks who are getting nothing for their savings) is because they are convinced they need to buy NOW because another "fool" will most certainly exist who will pay a still higher price in the near future. This is the mentality of this housing boom. I have seen it here in the New York City borough of Queens.

But I believe the deflationary handwriting is on the wall because the limits of inflation and the bubbles that result are quickly being approached. The only area where Warren and I may not agree is on the U.S. Treasury debt markets. Shortly after the 1929 crash, U.S. Treasury Bonds spiked to around 6% or 6.5% but then soon after they fell persistently until they bottomed at under 2% in 1940. The same held true for AAA corporate debt-which remained 0.5% or so higher than the U.S. Treasury Bond. Your editor believes many of the same deflationary dynamics are in place now as they were then including the dynamics Antal Fekete has discussed in this letter. In addition to the need to hold the ultimate of liquid assets, namely gold as Warren Pollock suggests, we advocate long U.S. Treasuries, at least for now.

*******************

March 26, 2005

Jay Taylor, Editor of J Taylor's Gold & Technology Stocks
www.miningstocks.com