Bonds and Inflation

Bond Market Update

We have been medium-term bearish on bonds since the beginning of this year on the basis that the huge on-going increase in the money supply (inflation) and the absence of economic 'slack' (energy prices remain high) will put irresistible upward pressure on long-term interest rates. We turned short-term bearish on bonds at the end of February on the basis that a pullback was likely (the T-bond price has subsequently fallen from 106 to 102.4, pushing the yield from 5.31% to 5.62%).

While we remain short-term bearish at this time, our expectation has been that one final surge to new highs would occur before the rot sets in (the chart projection included in the Mar-26 WMU showed a drop in the bond price during the first half of April, an upward spike in late-April/early-May, and then a major sell-off). This expectation (for one final surge) was based on a) the relationship between T-Bonds and the A$ (the A$ and US bond yields consistently move in the same direction, with the A$ leading at major turning points), and b) a belief that a combination of weak economic data and a jittery stock market would provide some support to bond prices until early May.

A few things are, however, casting some doubt as to whether new highs for bond prices (new lows for bond yields) will actually materialise. 

Firstly, the move to new lows by the A$ during March was followed by marginal new lows in the T-Bond yield. It could therefore be argued that bonds have already fulfilled their potential as forecast by this inter-market relationship.

Secondly, the oil price has held important support during pullbacks and has just broken out above its short-term downtrend. Below is an updated version of the chart included in last week's IU that shows yesterday's upside breakout. Since the oil price and the bond price tend to move in opposite directions, new highs in bonds are less likely to occur when the oil price is strong. 

Thirdly, an official (inter-meeting) rate cut in the near-term, something that appears quite likely, would potentially put a concrete floor under the equity market and cause long-term market interest rates to move higher (as the market discounts future inflation).

Fourthly, although the recent decline in bonds has been in-line with our short-term forecast, bonds have reached an area of critical support and must reverse higher very soon if they are to have any chance of moving to new highs over the next month. The following chart indicates the T-Bond's trading range since the beginning of this year. A weekly close below the bottom of this range would strongly suggest that the peak is in place.

Bonds still have the potential to rally during the second half of April, but until we see some evidence that a rally has commenced we will retain our short-term bearish view. Regardless of whether or not we get an upward spike over the coming month, we are confident that bond prices will move substantially lower over the coming 6-12 months.

Inflation

Regular readers would be well aware that we have been consistent in our view that US inflation is in a major up-trend. The only question, as far as we are concerned, is whether the trend towards higher inflation began in 1995 (when the year-over-year M2 growth rate bottomed and began moving higher) or in 1998 (when bond prices peaked). The surge in the money supply growth over the past several months is just another stage in this inflationary trend.

At some point the effects of this inflation, such as a reduction in the purchasing power of the Dollar, will begin to be factored into market interest rates (the inability of T-Bond futures to achieve a daily close above their Jan-03 high may mean that the market has already begun to factor-in these effects). However, although the results of high inflation always include reduced real economic growth and high unemployment, we don't see any other politically-acceptable path for the US. Consumer and corporate debt levels are so high that the short-term effects of inflation will always be preferred over the short-term effects of any substantial slowdown in the rate of money-supply growth (in the political arena the short-term is all that matters).

The US Stock Market

Current Market Situation

Since late-March we have been recommending that subscribers average-into the market during weakness. From the Mar-28 IU: 

"Whether the bottom is reached in April or May, it is our belief that we are approaching the first investment-grade buying opportunity in years. By 'investment-grade' we mean an opportunity to buy stocks with the idea of holding for at least 6 months rather than for just a quick trade."

And...

"Since buying at THE bottom will require more good luck than good judgement, we think the best approach to this unfolding investment-grade buying opportunity is to scale-in over the next 6 weeks. The lowest-risk way to do this is to accumulate the NASDAQ100 tracking stock (QQQ) during weakness over the next several weeks."

At this stage we have made two purchases of QQQ for an average cost of about $36. We also purchased Corning (GLW) at $20. We plan to continue accumulating QQQ on pullbacks into the $33-$37 range and to purchase North American Palladium (PDL.TO) if it becomes available under C$11. Palladium producer PDL fits nicely into our 'higher inflation' theme, particularly since there is a long-term shortage of palladium. 

We are yet to see the evidence we have been watching for to confirm that a major bottom is in place. In particular, we doubt that a major bottom will occur until after a dramatic loss of confidence is signaled by a sharp fall in the Dollar and rise in the gold price. Furthermore, although long-term market interest rates moved up quite sharply on Tuesday we have not yet seen an upward reversal in short-term rates (as discussed in the latest WMU this is something we expect to see as soon as the crisis ends). Until we do see such evidence we will assume that any rally is of the 'counter-trend' variety. However, counter-trend rallies can sometimes extend for many months and generate large percentage gains.

Gold and the Dollar

Current Market Situation

After a market has confirmed strength or weakness it will often immediately make a brief move in the opposite direction. This is just the market doing what it does best - act in a way that confuses the greatest number of people. As such, traders who react to mechanical signals and buy as soon as a market confirms strength, or sell as soon as a market confirms weakness, will regularly find themselves buying at short-term peaks or selling at short-term troughs.

The bounce in the Dollar Index during the first 2 days of this week looks, to us, like the sort of 'curve ball' the market will often throw after confirming weakness (the Dollar confirmed weakness by closing below 114.92 last week). If this is the case we should see the Dollar reverse lower either today or tomorrow. A daily close below 114.51 (basis the June contract) would provide strong evidence that at least a short-term downtrend is underway. 

As far as our bearish view on the Dollar is concerned, we are encouraged by the strength in the A$ since the beginning of last week. For the first time since the Greenback peaked in October of last year we may be about to see all the major currencies moving higher versus the Dollar (the Dollar's initial decline into its Jan-03 bottom was lessened by the impact of a weak Yen and the extent of any pullback over the past 3 months has been reduced by weakness in the commodity currencies (the A$ and the C$) and the Yen).

One piece of news that will have a near-term effect on the currency markets is the ECB's decision on interest rates due later today. By the time you read this the decision will probably be known, so we won't bother speculating on what they will do. Judging by the reaction to previous non-moves by the ECB, the market seems to believe that a rate cut is warranted in order to stimulate economic growth. If the ECB decides against reducing rates, the euro will probably take another quick dip before returning to its upward path.

An inherent problem with the euro, and one of the main reasons we remain long-term bearish on this currency, is that the ECB cannot possibly fix official interest rates at a level that suits the requirements of all the economically-disparate participants in the monetary union. This problem is magnified by the fact that ECB monetary policy is determined by the consensus of an 18-member committee, with most members no doubt voting along nationalistic lines. 

Gold is yet to provide us with any technical evidence that a low is in place. As previously noted a daily close above 261.50 (basis the June contract) is needed for initial confirmation of a low. Gold stocks appear to be marking time until the gold price finally takes off.

When gold eventually does rally, a large percentage of the move will probably happen within a short period of time. The short position continues to build, the money supply continues to expand at a frenetic pace, and the Dollar is showing preliminary signs that a top is in place. The spring is being coiled tighter and tighter.

For those who are interested in committing additional money to the gold sector, Durban Deep (DROOY) is set up very nicely for a short-term trade (see chart below). 

Changes to the TSI Portfolio

No changes.