- 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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