Inflation Update

It's official - inflation is not a problem!

Here are extracts from a 4th June Bloomberg article, with our comments shown in brackets:

"Inflation is not a significant problem," Greenspan told delegates at the International Monetary Conference in Singapore. Inflation among the 12 nations sharing the euro is likely to drop below 2 percent next year, from 2.9 percent in April, Duisenberg said at the same conference.

[As we've said before, there will be no reason for us to stop focusing on inflation until the central bankers start focusing on it. As long as they are ignoring inflation and putting all their efforts into stimulating growth, the markets will most likely continue to 'bid up' the investments that benefit from higher inflation.]

The euro region's inflation rate has been above the ECB's 2 percent ceiling for 11 consecutive months, reaching 2.9 percent in April. Economists expect a report on June 18 to show inflation rose above 3 percent in May. Inflation will probably ease in the second half of the year, economists said. 

[Who are these economists and why do they think that? With inflation clearly trending higher, on what objective evidence are they basing this conclusion?]

The strength of the dollar is evidence that inflation is not a short-term concern in the U.S., Greenspan said. The Fed's trade- weighted dollar index, which measures the dollar against a basket of currencies from the country's largest trading partners, is at its highest level in two months. 

"Obviously our exchange rate is firm and rising and that is not the type of thing one would ordinarily envisage in the context of inflationary pressures," Greenspan said. 

[We certainly agree that a rising exchange rate is not the type of thing one would ordinarily envisage in the context of inflationary pressures, but there is nothing ordinary about the greatest credit bubble in the history of the world. Greenspan's willingness to continually switch indicators until he finds one that supports his argument is almost laughable. Two year's ago the change in labour costs included within each quarter's productivity report was one of Greenspan's favourite measures of inflationary pressures. However, now that labour costs are rising at the annualised rate of 6.3%, the highest rate of increase in more than 10 years, this indicator has apparently disappeared from the Fed Chief's radar screen. In fact, now that almost all the US Government's own inflation indicators are finally revealing worrisome price increases we should, according to Greenspan's latest words of wisdom, ignore them. We should, instead, consider the Dollar's exchange rate to be proof that inflation is not a problem.]

The Big Easy

This is how things have worked in the past: The money supply growth rate rises to a level that causes the market to anticipate an inflation problem and, after a delay, prompts the Fed to hike the Fed Funds Rate (FFR). The Fed keeps raising the FFR until it figures out that inflationary pressures have subsided, a realisation that tends to occur after the money supply growth rate has plunged and the economy has entered a recession. It then begins to cut rates in an attempt to rejuvenate growth. When the difference between the M3 growth rate and the FFR is strongly positive and moving higher it is a sign that the Fed is pursuing an 'easy' monetary policy. When the difference between the M3 growth rate and the FFR is contracting it is a sign that the Fed is pursuing a 'tight' monetary policy. In the past, tightening cycles typically haven't ended and easing cycles haven't begun until the FFR was higher than the M3 growth rate.

Below is a chart showing the M3 growth rate minus the FFR. The chart only goes back to the mid-80's, but the current difference between the money supply growth rate and the official interest rate is the highest it has been since the early-1970s. Unlike rate-reduction cycles of the past, the current 'easing' began while the M3 growth rate minus the FFR was already quite high. With inflation currently not a problem (chuckle, chuckle), Greenspan may be about to go for the record - the 'easiest' monetary policy in the history of the Federal Reserve.

We've mentioned in prior commentary that we expect the first decade of the new millennium to have more in common with the 1970s than with either the 1980s or 1990s. As well as a high average level of money supply growth, the 1970s were characterised by huge swings in the rate of money supply growth. Huge swings may be in store for the US over the next 3 years, with this year's explosion in the money supply growth rate being followed by a sharp slowdown next year that will, in turn, be followed by another 'ramp job' during 2003-2004.

The US Stock Market

Current Market Situation

The April/May rally - the first up-leg of this cyclical bull market - ended on May-21. Since that time the market has been in a 'raggedy' correction that we expect will continue for another two weeks or so. 

From the May-28 WMU: "If we could ignore valuations and just look at the market action, the sentiment picture and the monetary environment, we would be very confident that the coming correction will be shallow with the greatest risks, in the medium-term, being on the upside." Although valuations are still a concern we are becoming increasingly confident that this correction is going to be shallow, primarily because a very supportive 'sentiment platform' is being built under the market. By some measures the market has already reached an extremely oversold condition, despite the fact that yesterday's S&P500 close was only about 3% below the May-21 peak. For example, the following chart (provided courtesy of www.decisionpoint.com) shows that the Arms Index has already hit a level normally associated with an important bottom (the Arms Index measures the volume in advancing issues relative to the volume in declining issues and becomes oversold when declining volume is high relative to the number of declining stocks).

With the market being as oversold as it is we expect to see some spirited rallies interspersed amongst the on-going erosion. However, lower levels are likely before the next sustainable up-move gets underway. As far as the next 2-3 months are concerned, the major risk is firmly on the upside.

Gold and the Dollar

The Trend

The underlying trend for gold has been positive since last November, although on some days it certainly doesn't feel like it. Around November 2000 the following trend changes occurred:

a) Gold stocks, as represented by the XAU, bottomed and began trending higher.

b) The XAU, which had been dramatically under-performing the S&P500 up until that time, began to dramatically out-perform the S&P500.

c) Long-term interest rates began trending higher relative to short-term interest rates, indicating that the market's expectations for future inflation were increasing relative to its expectations for future growth.

d) The European currencies stopped falling relative to the US$ (for this to continue to be the case the SF and the euro need to hold above their October-2000 lows).

The below chart illustrates the changes that occurred during the final quarter of last year. This chart paints a picture of an environment that is conducive to a rising gold price. The gold price itself, of course, has barely moved, but the pressure continues to build.

Gold Price Manipulation

Many gold bulls not only believe that the gold market is manipulated, but that manipulation is the major determinant of the gold price. Whilst it is clear to us that the gold price has been and continues to be manipulated, we do not believe that market manipulation can create a trend or change a trend. The reason that attempts to suppress the gold price have been successful in the past is that the manipulators were, in a sense, swimming with the current. Gold was in a bear market and, as such, the trend was the friend of those who desired to limit the upside. As noted above, the underlying trend for gold appears to have changed, meaning that those who attempt to suppress the gold price in the future will be swimming against a very strong current. Most likely they will either drown or reverse course.

Current Market Situation

As outlined in the latest WMU, the first two trading days of June presented an ideal time frame for a Dollar peak and downward reversal. This is all well and good, but the Dollar has so far given no indication that it is about to embark on a substantial decline. A preliminary sign that a top is in place would be a daily close below 118.70 (basis June). If this doesn't occur by the end of this week then the Dollar will likely remain firm until the final week of June as discussed below.

Below is a chart of the June Dollar Index. The Dollar has been moving counter to the stock market for the past few months, a pattern that appears to be continuing. The current up-swing in the Dollar began on May-22, the day of the stock market's intra-day high and the day after the stock market's closing high. If the stock market's correction continues for another 2 weeks, as we currently expect, then the Dollar could remain firm for another 2 weeks.

If the Dollar hangs in there for another fortnight and the stock market continues its raggedy correction, then gold and gold stocks will probably remain under pressure for the next 2 weeks. As previously noted, support for the XAU exists in the 55-57 range and we expect this support to get a thorough testing before the correction is complete.

As was the case during April and May, the next rally in gold and gold stocks should occur in parallel with the next rally in the overall stock market (we expect the pattern that was established in early-April to continue). With another FOMC Meeting (and, therefore, another official interest rate cut) scheduled for Jun-27, the period of Jun-21 through to Jun-27 provides a likely time for important turning points in the currency, stock and gold markets. With gold and gold stocks oversold and the Dollar overbought, an intervening gold/gold-stock rebound and Dollar pullback would not be surprising.

Please note that the above analysis is an attempt to explain the short-term action and finesse the turning points, but should be of academic interest only to anyone who is not a short-term trader. Our main objective is to stay in synch with the medium-term trends, which are UP for gold, gold stocks and the stock market. Our work suggests that the gold price, gold stock prices and the overall stock market are headed substantially higher over the next 2-3 months.

Changes to the TSI Portfolio

No changes.