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    - 17 January 2001

The Long Wave

Increasing prices are not inflation and decreasing prices are not deflation. Inflation and deflation are terms that refer to changes in the total supply of money. Inflation is, purely and simply, an increase in the total supply of money. If that increase is greater than the growth in 'real economic output' (goods, services, tangible assets) then some prices will rise as a result of the inflation. Similarly, deflation is a decrease in the total supply of money and it usually results in falling prices. Falling prices are not, however, necessarily indicative of deflation. For example, asset prices in South East Asia collapsed during 1997 and 1998, a period of high inflation for that part of the world (the Tiger economies were rapidly expanding their money supplies at that time). Furthermore, rises in US consumer and producer prices during 1997-1999 were minimal, although changes in the money supply tell us that this was a period of rampant inflation. 

Some of the confusion surrounding inflation and deflation probably stems from the fact that changes in the money supply affect different asset classes in different ways at different times. For example, the inflation of the 1970s brought about substantial rises in the prices of commodities and hard assets, whereas the inflation of the 1980s and 1990s has boosted the aggregate demand for financial assets. It appears that major (secular) trends determine the focus of investment and thus how the additional money is used, with the inflation acting to reinforce whatever trend is in place. The secular trend may, in turn, be determined by the Long Wave cycle of Kondratieff (a 55-60 year cycle).

The above was a long-winded way of introducing the following extracts from an article written by Dr Tom Drake of Tenorio Research. We have previously outlined our reasons for believing that the yield on US Government 30-year bonds bottomed, for this cycle, on Jan-03 this year.  According to TD, the 1998 peak in the bond market represented the secular low for long-term interest rates and the beginning of the next UP-cycle (inflationary cycle). Although we have never looked at the Kondratieff Cycle in any detail we like TD's interpretation because it meshes with our own view that many years of Dollar-depreciation lie ahead. Further to the above discussion we don't, however, like his propensity to confuse falling prices with deflation. What may, in fact, be in the process of changing is not a shift from deflation to inflation (we already have inflation), but a change in the focus of investment from financial assets to tangible assets. 

"Markers of the Long Wave cycle of Kondratieff which have stood the test of time are: wholesale/commodity index prices, labor wages, production of basic goods, trade rates, and interest rates. 

Interest rates are the most complete series, and since they impact and are impacted by everything in the local, national or world economy, interest rates remain the best series to watch for long wave cycle inflexion points."

And...

"The peaks for interest rates were about 1812, 1866, 1920 and 1974-80.

Given the remarkable consistency of this cycle over several centuries, one would have expected long term interest rates to bottom somewhere between 1998 and 2004 with short term rates 
leading by a few years. 

Once it became clear that short term rates, from Fed Funds to the Fed Discount Rate to short  term commercial paper and all the rest had bottomed in 1992-93, it was a fairly simple matter of waiting for long term rates to bottom. 

Both the long rate rise starting in 1993 and the rise from a near double  bottom with  1993 in January 1996 seemed improbable final long rate lows since they were either too soon after the short  rate low (1993) or not uniquely lower lows (1996) as each prior long wave low had been.

However, the deflationary collapse in long rates (and prices) in the summer and fall of 1998 was a clear cut candidate for the long wave interest rate low. Those here will remember the public and private sentiment of that time. In many ways sentiment was worse than during the collapses of 1982, 1986, and the early 1990's, largely because the stock market was falling at the same time along with commodities and rates.

The passage of time confirms that the estimate was correct that 1998 was the low for long rates as 1992-93 was for short rates. Commodities continued to make new lows, on balance, until well into 1999, and some have not yet done so at all: cocoa and coffee for example.

Given the nearly equal time of up and down legs of the interest rate long wave, one can project that interest rates will trend upwards for the next several decades. This is a crucial point to understand in personal investment and in personal portfolio allocation."

And...

"If one knows what interest rates are going to do over a long period of time, it simplifies other investment decisions besides real estate and bonds. It's also important to throw away a lot of "old sayings" about higher interest rates being bad for commodities, real estate, and stocks. Higher rates *are* bad at some times and not at others. During the long disinflationary down cycle, a rally in interest rates quickly damps prices, partly because of a disinclination to hold and finance inventories anyway.

But in the up cycle, inventories appreciate in value since general prices are rising, so rising rates have little or no effect until they get to be quite high indeed. The same is true for stock prices. 
Corporations can more easily pass along their costs to buyers and see sales rise as well. This too can go on for quite a long time until it gets to be too much. Read about and think about 1949 to 1966 and 1966 to 1980 and you'll get the picture."

The US Stock Market

Our stock market view remains as outlined in the latest Weekly Market Update. The best way to describe the action so far this week is 'indecisive'. Those who bought during the late-December/early-January weakness should stay long, those who are out should stay out. 

Gold and the Dollar

The Gold/SF Relationship

At several times, during the past year, we've discussed the positive correlation that exists between the gold price (expressed in US Dollars) and the Swiss Franc (the Franc-Dollar exchange rate). We also occasionally refer to Kevin Klombies' work on inter-market relationships. Kevin prepares a daily report called the IMRA (Inter-Market Relationships Analysis) and has kindly allowed us to use the following extract from his Jan-17 report (refer to http://www.krk-imra.com for further information on the IMRA).

"Below is a comparative chart of gold futures and the Swiss franc futures. 

The idea here is that while gold will move higher when the U.S. dollar weakens off against the Swiss franc, there is enough 'stickiness' in the relationships that some time and pressure must build first. 

While the Washington Accord provided 'the news' in 1999, the chart shows that the Swiss franc began to strengthen several months earlier. We see the franc moving higher during July, August, and into September of that year while gold prices remained weak. It took close to three months before gold's price spiked up through $300. 

Looking at the current situation we can see that the Swiss franc is not only quite strong but has been that way since the end of October. As we dig deeper into January we have to allow for the fact that gold may be getting ready for an upside moon shot. However, the channel top that held the last two rallies is now cutting across around the $294 level. In any event, if the euro and Swiss franc begin to push higher in the next short while, gold could hit the channel top quite easily."

Yield Spreads and Gold Stocks

When long-term interest rates are moving higher relative to shorter-term interest rates the market is building in an inflation premium, that is, the market is discounting a reduction in the purchasing power of money. Gold stocks would be expected to benefit during a period when this was happening. In other words, gold stocks should perform best when the spreads between the yields on long-term and short-term US Government debt are rising. This sounds reasonable, but does it work in practice?

Below is a chart comparing the XAU with the yield spread between the 30-yr T-Bond and the 13-wk T-Bill, from January 1985 to the present day. The chart reveals that almost every significant rally in the XAU was immediately preceded by an up-turn in the yield spread, with the one notable exception being the XAU rally that began in early 1993. The strong up-move in the yield spread during 1991-1992 did not lead to an XAU rally until 1993, possibly because the extreme widening of the spread at that time was deliberately engineered by the Fed to rescue the banking system (the rising spread was artificial and did not reflect the 'building-in' of an inflation premium). 

With the yield spread having recently begun to rise, further evidence of an impending gold stock rally is at hand.

Current Market Situation

We have no intention of becoming cheerleaders for gold, it is just that the amount of evidence pointing towards a substantial rally (in gold stocks more so than in the bullion price) continues to build. With gold market sentiment near all-time record lows, with monetary factors and inter-market relationships extremely bullish, and with gold stocks extremely cheap relative to the bullion price, the only thing missing is the most important thing of all - price confirmation. As gold-bullish as the backdrop appears to be, it is rather meaningless unless a gold rally actually materialises. 'Price confirmation' is particularly important for short-term trading positions, which is why we have previously outlined an exit strategy involving protective stops. As at the close of trading on Wednesday our sell-stop has not been hit.

Another BOE auction is slated for next Tuesday (Jan-23). The BOE always manages to get the lowest possible price for its gold, so perhaps that means there won't be any life in the gold price until after the auction is complete. This would tie in quite nicely with our short-term view on the Dollar. We've been expecting a counter-trend bounce in the Dollar and that bounce should be complete by around the middle of next week.

If we are stopped out of short-term positions we will be very quick to get back on board at the first sign of an up-turn.

Changes to the TSI Portfolio

No changes.

 
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