Research Pit

[Jagman]

Monetary Cap on Gold to Be Lifted!

By Mike Swanson
June 15, 2005

wallstreetwindow.com


Gold is going up again, but it is no surprise. The commitment of traders report for the end of May showed that commercial traders covered 8,846 short positions and went long 10,552 contracts in the final week of that month. They also closed May by being net short only 60,463 contracts. They have probably even covered more since then. We’ll know for sure when the next report comes out. Remember, each major gold bottom in the past five years has come when the commercials were net short only 40-60k contracts.

The best news though is that the macro picture is lining up for gold. The biggest factor that has kept gold stocks down over the past year and a half is the Federal Reserve’s cycle of interest rate hikes that has given strength to the dollar. There are signs that we are seeing the end of this cycle, and once the cycle ends the next bull rally in gold stocks will be in full force.

According to political columnist Robert Novak, Chairman Greenspan “is described by close onlookers as confused by the economic data... The army of number crunchers at the Fed does not give Greenspan the statistical security blanket he craves. The Consumer Price Index's warning of inflation ahead is regarded by one Federal Reserve governor as ‘phony.’ Nevertheless, inflation concerns were rising at the Fed until weaker economic news prevailed going into last Tuesday's meeting of the Federal Open Market Committee. Three days later, gains in employment reported on Friday suggested greater inflationary danger,” writes Novak.

Novak’s sources tell him that the Fed plans to continue to raise interest rates by a quarter a point “every time the open market committee meets, no matter what the economy looks like.”

I wouldn’t bet the farm on that. Eventually the Fed is going to stop raising interest rates. Historically, the Fed has always gone overboard when it has engaged in a cycle of interest rate hikes. This happened during their last cycle of interest rate hikes. During the last cycle, the last hike came in May of 2000 two months after the stock market topped out and the economy had begun to show signs of slowing down.

There are reasons to think that the Fed will be done raising interest rates sooner than most people think. First of all, long-term rates have been falling for the past two months and actually made a new low for the year three weeks ago. This usually happens at the end of a cycle of interest rate hikes as the long-term bond yield’s forecast the end of the cycle or the start of a cycle of lower rates.

In fact, if Alan Greenspan continues to raise interest rates, he will create an inverted yield curve; a situation in which short-term rates are higher than long-term rates. As hedge fund manager and Financial Sense commentator Frank Barbera writes:

“Yet another troubling factor has been the consistent narrowing of the Treasury Yield Curve, which late in the week, nearly inverted with the 2 Year Treasury yielding 3.62 and the 10 Year Bond yielding 4.10, a razor thin spread of just .48 basis points. As a gauge of liquidity, the ultra-flat yield curve is the market's mechanism for communicating to Fed Chairman Greenspan that he should stop raising interest rates at once. Think about it, another ¼ point hike in June would lift Fed Funds to 3.25% and probably press the 2 Year Note toward 3.80%. At that point, the 2 Yr-10Yr spread could be as thin as just .20 to .25 basis points.”

When you get an inverted yield curve it means that the bond market is forecasting an economic slowdown that will force the Fed to lower interest rates in the future. The last time this happened was in the first quarter of 2000.

Bill Gross and Paul McCulley, who run the largest bond fund in the world at Pimco, believe that the bond market is forecasting just such a slowdown. This is a contrarian view. The “so-called economic fundamentalists have been bellowing ever more stridently, if not angrily, that the bond market is nuts, totally ignoring strong April employment and retail sales data which have exposed the so-called soft patch in March data to be nothing but a mirage,” says McCulley.

McCulley thinks they are wrong. He notes that the ISM manufacturing index has been declining every month since it peaked out at 62.8 in January of 2004. It now sits at 53.3. A reading below 50 is a sign of contraction in the manufacturing sector and every time the ISM has dropped below 50 the Fed has never continued to raise interest rates. McCulley projects the ISM falling below 50 by the Fall.

A slowdown in the economy is consistent with what I have been saying about the stock market for the past couple of months. Going into this year, I argued that the market would likely make a stage three top as we moved into the summer and then roll over and begin a stage four decline by August or early Fall. The rotation of the individual sectors that make up the market has also convinced me that this view is correct. The recent rally has not changed my overall view of the big picture, even though I expect it could continue a little while longer.

The Fed funds futures contracts are projecting three more interest rate hikes this year, coming this month, August, and September. After that, the futures traders expect the Fed to sit on its hands into the end of the year. Barbera thinks the Fed won’t raise rates in September, and if McCulley is correct about the ISM he may be right.

The important point is that the end of the tightening cycle will have significant implications for the global markets. Since the Fed began raising interest rates in the first quarter of 2004 the XAU gold stock index has been trapped between a range of 113 and 77. Once the Fed stops raising interest rates the dollar should drop down to its long-term 80 support level and will likely break it. The monetary cap on gold will be lifted.

To find out what gold stocks Mike Swanson holds and plans on buying subscribe to his free Weekly Gold Report at http://wallstreetwindow.com/weeklygold.htm

****