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The financial markets and the end of QE2

As everyone knows, the Fed has been aggressively buying Treasury securities since last November under the program affectionately known as "QE2". One of the touted justifications for this program was the perceived need to support the housing market by making mortgages more affordable, the idea being that the Fed's buying of Treasurys would help to lower Treasury yields and, due to the link between Treasury yields and other yields, mortgage interest rates. However, the following chart shows that the 10-year T-Note yield has risen since the introduction of QE2.

The increase in the 10-year interest rate since the beginning of QE2 is not as anomalous as it may superficially appear. Yes, the Fed's buying of Treasurys constituted a significant additional source of demand for government debt, but it also led to a significant increase in inflation expectations by pushing up the prices of commodities and equities. In general, if the lowering of interest rates is the primary goal then the monetisation of debt will be counterproductive -- even from the jaundiced perspective of a central banker -- when the additional money causes inflation expectations to rise.

It should be understood, though, that while the lowering of long-term interest rates was a publicly stated goal of QE2, it probably wasn't the actual goal (there is often a big difference between the stated and actual reasons for a policy). It's more likely that the large-scale debt monetisation was undertaken with the aim of boosting prices and strengthening the balance sheets of poorly managed banks. In this case it achieved its short-term objectives, in that: a) it effected the surreptitious transfer of wealth from the rest of the economy to the banking industry, b) the cost of living is now much higher, and c) stock prices have risen to the point where the broad stock market's future long-term performance is almost guaranteed to be sub-par. A very successful policy, indeed!

A point we wanted to make today is that while many analysts appear to be operating under the assumption that the end of QE2 will quickly lead to a rise in bond yields, it could actually bring about the opposite by causing inflation expectations to fall. Think of it this way: if the QE2-related boost to monetary inflation put irresistible upward pressure on long-term interest rates by causing commodity prices and inflation expectations to rise, why wouldn't the reduction in monetary inflation associated with the termination of QE put irresistible downward pressure on long-term interest rates by causing commodity prices and inflation expectations to fall?

At this stage there are a lot of unknowns. We don't know, for instance, if the Fed will end its QE program in June as currently scheduled. Our best guess is that it will, but will phrase any announcements in such a way that the door is kept open to the immediate resumption of the policy if deemed necessary. We also don't know what will happen to the banks' excess reserves, which is an important consideration because the banking industry now has sufficient reserves to rapidly expand the money supply without any assistance from the Fed.

What we do know is that if the Fed announces the end of QE and the markets take the announcement seriously, the result could be substantial downturns in the commodity and equity markets and a multi-month extension to the recent T-Bond rally in response to falling inflation expectations. We also know, or at least can be confident, that a substantial decline in the stock market would prompt the Fed to resume QE, although there would likely be a 2-4 month period between the end of "QE2" and the start of "QE3" during which the markets discounted slower monetary inflation. Lastly, we are confident that a bond market decline of sufficient magnitude to push the 10-year T-Note yield above 4% would prompt a large decline in the stock market, with or without additional QE.

The bottom line, then, is that as far as the next few months are concerned there is a lot more downside risk in the stock market than the bond market. There is also probably less upside potential in the stock market than the bond market.

Oil Update

The Stock Market

The following chart shows the gold/CCI ratio (gold relative to a basket of commodities). We'll now explain why we have included this chart in the stock market section of today's report, rather than in the gold section.

Gold/CCI is an indicator of economic confidence, in that it trends higher when confidence trends downward. Also, it tends to rise in response to an increasing desire to save, and, by extension, a decreasing desire to consume. The reason it behaves in this way is that even though gold is no longer money in the true meaning of the word (gold is not the general medium of exchange), in many respects it performs as if it were money.

The Fed and other central banks unwittingly support gold's monetary performance. They do this by ensuring that anyone who tries to save in terms of the official money will end up with a negative real return and a loss of purchasing power. In effect, central bankers are constantly shouting: "If you try to save in dollars (or euros or Yen or pesos), we will punish you!" This forces some large investors -- and some small investors, but the large investors have more influence -- to save in terms of a money-like asset that can't be depreciated by central banks. Consequently, an increase in the propensity to save is generally indicated by a rise in the price of gold relative to the prices of commodities that are consumed.

A rise in the propensity to save is a short- and intermediate-term negative for an over-valued stock market that relies on increasing risk aversion to maintain its elevated valuation. The recent rebound in the gold/CCI ratio should therefore be considered a warning shot that the stock market's upward trend is about to end.

Within the Oil and Gas sector, the drilling services companies generally have the most bullish earnings outlooks over every timeframe. However, evidence is emerging that the stocks of these companies peaked on an intermediate-term basis in early April. For example, the Oil Services Holders ETF (OIH) appears to have just completed a rounded topping pattern.

Ideally, the drilling services stocks will fall far enough to set up excellent buying opportunities by the final quarter of this year.

Gold and the Dollar

Gold and Silver

Current Market Situation

Market Vane's bullish consensus for silver peaked at an extraordinary 97% during the final week of April, which doesn't guarantee anything but is consistent with the idea that silver's late-April peak will hold for a long time (more than a year). The sentiment situation has since changed dramatically, with Market Vane's bullish consensus reaching 61% on Tuesday 17th May. Tuesday's bullish percentage was the lowest since August of last year, and is consistent with the idea that a meaningful rebound has either begun or will soon do so.

There is little chance that silver has made its ultimate correction low, but a counter-trend rebound to the low-$40s is a realistic possibility.

Unlike silver, there is no decisive evidence yet that gold has made a peak of intermediate-term significance. A daily close below the early-May low would constitute such evidence.

With regard to the next 2-3 weeks, one plausible scenario is that gold will rally to a new high for the year while silver rebounds to a lower high. If this scenario played out it would create an excellent short-term selling opportunity.

Incorporating silver into Mexico's monetary system

Jeff Berwick of The Dollar Vigilante did an interview earlier this week with Mexican billionaire Hugo Salinas-Price (HSP) about the latter's plan to "monetise" the one-ounce silver Libertad coin. The interview can be read HERE.

Prior to Jeff's interview we weren't clear on what HSP had in mind. It seemed as if there were moves afoot to provide silver backing to the Mexican Peso, but that's not actually the case. As explained in the interview, if HSP's proposal were adopted it would not provide the Peso with any silver backing and would not in any way limit the ability of Mexico's central bank to inflate the Peso supply. The proposal, in a nutshell, is for Mexico's central bank to quote a value for the 1-ounce Libertad coin that would always be above the current market value of the contained silver.

We are certain that HSP has good intentions, but his current plan does not appear to offer any benefits.

Gold Stocks

The following charts show that GDX (a proxy for large-cap gold mining stocks) recently tested intermediate-term support at $52.50-$54.00 and that GDXJ (a proxy for junior gold mining stocks) recently tested intermediate-term support at $33.00-$34.00. These support ranges will probably be breached before the gold sector's correction comes to an end, but we suspect that GDX and GDXJ will consolidate/rebound for a couple of weeks before resuming their declines. $57-$59 and $37-$38 are reasonable upside targets for near-term rebounds in GDX and GDXJ, respectively.

This week's modest strength in the major gold stocks relative to gold bullion probably means that our HUI/Gold Oscillator (HGO) will not generate a buy signal. At this stage it looks like HUI/gold's decline reached its momentum extreme last Thursday (12th May).

We maintain our own index of major gold stocks, known as the TGSI. The following chart shows that with the exception of the 2008 panic (August-October of 2008), at the end of last week the major gold stocks, as a group, were at their lowest level relative to gold bullion in more than 10 years.

We don't know what to make of this. It means that the major gold stocks are relatively cheap, but it doesn't mean that they aren't going to become a lot cheaper. During the 1970s the major gold stocks became progressively cheaper in terms of gold until they finally bottomed-out in January of 1980.

Currency Market Update

Over the past 25 years, intermediate-term US$ bottoms have usually involved a multi-week rally followed by a decline to test the low. If the current bottoming process follows this pattern then the Dollar Index probably won't do any better, over the next few weeks, than rise to around 79 before embarking on a decline that eventually takes it back to the vicinity of its early May low. The area just below the 200-day moving average (77-78) is the most likely place for a short-term peak.

Update 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)

Orvana Minerals (TSX: ORV). Shares: 117M issued, 120M fully diluted. Recent price: C$2.59

We confirmed ORV's addition to the TSI List in Stock Selection Update #65, which was sent to subscribers after Tuesday's trading session.

The following chart shows that ORV has resistance at C$2.70-$2.75 and support at C$2.25.

ORV has the potential to rise to C$6 within the next 12 months, but there will be significant execution risk as it brings its two main projects into production. 'Teething problems' during the production ramp-up combined with the continuation of the sector-wide correction could result in the stock trading below this week's low before the next intermediate-term advance gets underway.

    Jaguar Mining (NYSE and TSX: JAG). Shares: 84M issued, 88M fully diluted. Recent price: US$5.31

JAG's price action over the past month has been bizarre. The stock price surged from $5 to $6 in mid April in response to a press release confirming that the company's planned operational turnaround was on track, then dropped relentlessly for about 4 weeks to new multi-year lows in the $4.10-$4.30 range, and then, on Wednesday of this week, jumped 23% on heavy volume in response to a press release that essentially provided the same information as the mid-April press release. The stock market is many things, but it ain't efficient.

If JAG is able to achieve its 2011 production and cost forecasts then at the current gold price the stock would, in our opinion, be fairly valued at around US$10/share. Given the historical record this is a big "if", but the mid-April and mid-May press releases indicate that the company was on track as at the end of Q1.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html