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An update on future "inflation" and the Fed's madness

Prior to 2002 the Fed would tighten monetary policy in reaction to outward signs of rising "price inflation" and loosen monetary policy in reaction to outward signs of falling "price inflation", but beginning in 2002 the Fed became far more biased towards loose monetary policy. This bias is now so great that it seems as if the Fed has become permanently loose.

The following chart comparing the Fed Funds Rate (FFR) target set by the Fed with the Future Inflation Gauge (FIG) clearly illustrates the change in the Fed's tactics over the past two decades. The Future Inflation Gauge is calculated monthly by the Economic Cycle Research Institute (ECRI) and should really be called the Future CPI Gauge, because it is designed to lead the CPI by about 11 months.



The chart shows that prior to 2002 the FFR tended to follow the FIG. After the FIG warned of rising "price pressures" the Fed would start hiking the FFR, and after the FIG started signaling reduced upward pressure on the CPI the Fed would start cutting the FFR. (Note: Our chart begins in 1994, but the relationship between the FFR and the FIG that we just described goes back much further.) During 2002-2004, however, the Fed not only didn't hike its targeted interest rate in response to a sharp increase in the FIG, it continued to cut the FFR.

The Fed's decision to maintain an ultra-loose stance during 2002-2004 was the fuel for the real estate investment bubble and set the stage for the collapse of 2007-2009.

There was a lesson to be learned from what happened during 2002-2007, but the Fed clearly learned the wrong lesson. The lesson that should have been learned was: Don't provide monetary fuel for bubble activities, because the eventual economic fallout will be devastating. Unfortunately, the lesson that was actually learned by the Fed was: An economic bust can be avoided forever by keeping monetary policy loose forever. The result is that the divergence between the FFR and the FIG that arose during the first half of the last decade is nothing compared to the divergence that is now in progress. The FIG has been working its way higher since early-2009 and just hit a 5-year high, while the Fed's ZIRP (Zero Interest Rate Policy) remains firmly entrenched.

Zooming in on the shorter-term fluctuations, last year's small decline in the FIG suggested that there wouldn't be a significant increase in the CPI's growth rate until at least the final few months of this year, while the rise in the FIG that began late last year suggests that "price inflation" will start to become apparent in the CPI during the final quarter of this year and could be perceived as a serious problem during the first half of next year. This probably means that by early next year the T-Bond bears will start to look correct and the Fed will start to feel irresistible pressure to begin a rate-hiking program. Unfortunately, the US economy is now so rife with 'bubble activities' (businesses, projects, investments and speculations that are only viable due to artificially low interest rates and a rapid stream of new money) that a severe downturn is likely to follow an attempt by the Fed to 'normalise' its monetary policy.

By ignoring investment bubbles and erring far more in favour of "inflation" than it has ever done in the past, the Fed has set the stage for the mother-of-all economic busts. If the bust doesn't begin earlier it is likely to begin soon after the Fed starts to raise its targeted interest rate.

Ocean freight rates have collapsed, again

Up until a few years ago we used the Baltic Dry Index (BDI), an index of international ocean-going shipping rates, as an indicator of global trade and US$ turning points, but by early 2011 it had become apparent to us that the BDI's trends were being determined to a far greater extent by changes in the supply of shipping capacity than changes in the volume of international trade. We therefore didn't interpret last year's surge in the BDI as evidence that the demand for shipping was rising sharply in reaction to a sudden increase in global trade and we don't interpret this year's plunge in the BDI to the vicinity of its 2008 low as evidence of a sharp shrinkage in the volume of international trade.



The BDI's current depressed level isn't just due to an abundance of supply. It's also due to the fact that the increasing use of very large container ships has substantially reduced the average cost of transporting containers across the oceans. In other words, the supply is not only greater, but also more efficient.

The Stock Market

The following chart shows that the S&P500 Index has important support at 1890-1900. This support will probably be breached on a daily closing basis within the coming two weeks IF the decline from the July peak is either the initial decline within a crash pattern or the first decline in a cyclical bear market. If a crash pattern is unfolding, a 2-4 week rebound will begin shortly after the aforementioned support is breached.



The downside risk is high, because there have been more than enough divergences over the past few months to suggest that a substantial downturn is in the works. However, a daily close below 1890 would be the first clear evidence in the SPX's price action that something more than a routine bull-market pullback was underway.

Gold and the Dollar

Gold

The gold price needs to close above $1312 to signal an end to the correction of the past few weeks, but it will probably turn out that this Tuesday's return to the low-$1280s marked the end.



In late June of this year the silver/gold ratio's daily RSI, a short-term overbought/oversold indicator, was at its highest level since September of 2012. Although it doesn't constitute evidence that the correction is already over, the elimination of this short-term 'overbought' condition, and ideally but not necessarily its replacement with a short-term 'oversold' condition, was something that almost had to happen before the gold and silver corrections ended. As illustrated by the daily chart displayed below, this has happened.



The following chart from Kitco.com shows how gold traded during each of the past three 24-hour periods. The green line shows the 6th August trading and is the line in which we are interested.

Notice the near-vertical surge beginning at 8.00am NY Time on 6th August. This represents a sudden increase in buying from 'out of the blue'.

When this type of price action happens in the opposite direction, that is, when a sudden increase in selling pressure causes a near-vertical price drop, it is always cited by some commentators as evidence of manipulation, but when the sudden price change or price acceleration is to the upside it is never cited as evidence of manipulation. Instead, it is supposedly due to gold's bullish fundamentals coming to the fore. The logic (using the word very loosely) goes something like this:

1. Markets that are free of manipulation always move in synch with the fundamentals. (TSI: No, they don't.)
2. Gold's fundamentals are always bullish. (TSI: No, they aren't. For example, gold's fundamentals were bearish from mid-2012 through to mid-2013 and only turned unequivocally bullish in April-2014.)
3. Therefore, whenever the gold price falls it must be due to manipulation. (TSI: Two wrongs don't make a right.)



The fact is that there are just as many sudden, 'inexplicable' price rises in the gold market as there are sudden, 'inexplicable' price declines, but the manipulation-centric bloggers and newsletter writers only tell you about the latter. Also, experienced traders know that these sudden and often-unpredictable price moves happen in ALL commodity futures markets.

Gold Stocks

Our opinion about the gold-mining sector's current situation is the same as our opinion about gold's current situation. Additional price strength is needed over the days ahead to confirm an end to the correction, but time will probably tell that the correction ended on Tuesday 5th August.

With regard to GDXJ (see chart below), the price action during the first two days of this week resulted in a touch of the 50-day MA. Many individual gold stocks did something similar.

A decline to the 50-day MA is typical for a correction within an intermediate-term upward trend and is not something to get 'all jittery' about.



The Currency Market

There are signs that the German economy, the 'engine' of euro-zone economic growth, is sliding into recession. For example, a report publish earlier this week showed that German manufacturing orders fell 3.2% in June, which is the largest decline since September-2011. The year-over-year rate fell to -2.4%. Manufacturing orders are a leading indicator, so the weak Q2 performance for the German economy will probably be followed by an even weaker Q3 performance. Furthermore, the economic weakness that was already baked into the cake will be exacerbated by Russia's retaliation against the idiotic Ukraine-related economic sanctions currently being imposed upon it.

Mounting evidence of economic weakness in the euro-zone and the burgeoning trade war sparked by the economic sanctions against Russia are creating a negative sentiment backdrop for the euro. Moreover, the following chart shows that the euro's recent break below support at 135 has just been confirmed by the EURO STOXX Banks Index (SX7E) breaking below support at 140. The chart-based targets stemming from these breakdowns are 130 for the euro and 120 for the SX7E.



The euro is very 'oversold' and could soon rebound to at least 135, but we see no good reason to bet that a sustainable low is in place.

Updates on Stock Selections

Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html

Speculators who want some exposure to Rare Earth Elements (REE) and are willing to deal in illiquid microcaps should consider buying some Geomega Resources (GMA.V) near its current price in the low-C$0.20s. Over the past 6 months the stock has collapsed from around C$1.00 to just above support at C$0.20 due to an absence of news rather than negative news.

GMA should soon have some news in the form of an updated resource estimate for its huge and potentially-economic Montviel REE project in Quebec. The delay in the completion of this resource update (it was supposed to have been completed a few months ago) is part of the reason for the stock's recent dismal performance.



GMA has been briefly discussed in previous TSI commentaries and is a member of the Small Stocks Watch List, but is not a formal stock selection and is therefore not followed closely at TSI.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://bigcharts.marketwatch.com/
http://www.kitco.com/