-- Weekly Market Update for the Week Commencing 29th December 2003

Big Picture View (Most recent update: 18 August 2003)

Here is a summary of our big picture view of the markets. Note that our short-term views may differ from our big picture view.

Bond yields (long-term interest rates) reached a major low in June of 2003 and will trend higher until at least mid 2004. 

The US stock market will reach a major bottom (well below the October-2002 low) during 2004.

The Dollar commenced a bear market in July 2001 and will continue its decline during 2003 and 2004.

A bull market in gold stocks commenced in November 2000 and will continue during 2003 and 2004.

Commodity prices, as represented by the CRB Index, will rally during 2003 and 2004 with most of the upside occurring in 2004.

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Bonds

So far, it looks like the typical post-bubble pattern

A market that has just reached a 'bubble peak' typically follows a sequence that begins with an initial sharp decline that bottoms about 2 months after the bubble peak. A multi-month rebound to a secondary (lower) peak then occurs, but this rebound turns out to be the calm before the storm because it is followed by a large and lengthy decline.

After bonds made what looked, to us, like a bubble peak in June of this year our expectation was that they would end up following something similar to the above-described sequence with an initial bottom most likely occurring in August and a secondary peak most likely occurring during the final quarter of 2003. In fact, in the 16th July Interim Update we compared the final run-up and subsequent collapse in the NASDAQ100 Index (NDX) during 2000 with this year's upside blow-off and subsequent collapse in the US bond market. 

There is no reason why today's post-bubble T-Bond will necessarily follow exactly the same path as that taken by the NDX during 2000 (there will always be enough differences between the current market action and prior market action to keep most traders in the dark). However, the below chart shows that the paths have, to date, been remarkably similar (in the below chart comparison the March 2000 peak in the NDX is lined up with the June 2003 peak in the T-Bond). 

Up until the past few weeks the twists and turns of the post-bubble bond price have roughly matched the twists and turns of the post-bubble NDX, but a difference is now emerging. Specifically, at this stage of its bear market the NDX had just embarked on the second leg of its bear market (the first leg being the initial sharp decline following the bubble peak) while the T-Bond is still rebounding from its initial drubbing. This difference is probably not significant, though, because there is no fixed duration for the rebound that follows the initial sharp decline. For example, the NDX rallied for about 3.5 months after reaching an initial low in May of 2000 whereas the Dow Industrials Index rallied for almost 6 months after reaching its initial bear market low during the crash of 1929. In other words, it would not be unprecedented for the rebound in the T-Bond to continue into the first quarter of 2004. What we can say, at this stage, is that the T-Bond does appear to be following the typical post-bubble pattern, which means that a break of the short-term up-trend shown on the above chart is likely to be followed by a large and lengthy decline.

Central bank support

Central banks -- mainly those of Japan and China -- have provided a great deal of support to the US bond market over the past year as a byproduct of their attempts to manage currency exchange rates. And this support is likely to continue until the inflationary effects of 'currency management' are perceived to be troublesome or until the US$ stops falling.

In the absence of the massive buying of US bonds on the part of Asian central banks that has occurred and continues to occur, the US T-Bond price would be much lower (long-term interest rates in the US would be much higher) and the Fed would most likely have already begun to hike the official interest rate. As things currently stand, though, one of the economy's built-in safety devices -- the bond market -- has been temporarily disabled. This, in turn, is making it possible for gold and commodity prices to move higher than would otherwise be the case. Why? Because the way the world has worked, up until now, is that large rallies in commodity prices have led to substantial rises in long-term interest rates and rising long-term interest rates have prompted the Fed to tighten monetary policy. Tighter monetary policy eventually brings about a reduction in the demand for commodities and commodity prices begin to fall. In this respect rising commodity prices have, during previous cycles, sown the seeds of their own downward reversal. However, in today's world the aggressive buying of US bonds by the Bank of Japan et al prevents long-term interest rates from responding to rising commodity prices in the normal way. One of the most important limiters of commodity-price rallies has therefore been temporarily removed.

We say "temporarily removed" because if commodity prices continue to rise then at some point private-sector selling of bonds will overwhelm central-bank buying or the Asian central banks will come to the realisation that the inflationary effects of their bond-buying outweigh any benefits they hope to achieve.

Now, the Bank of Japan and the other influential central-bank supporters of the US bond market are only accumulating massive holdings of US bonds as a result of their efforts to prevent their own currencies from rising relative to the US$. Foreign central bank support for US bonds would therefore evaporate -- allowing US Treasuries to trade based on their own dismal fundamentals -- if the US$ were to rebound or simply stop falling. In other words, in the current topsy-turvy financial environment the worst thing that could happen to the US bond market is a stabilisation of the Dollar. If the Dollar were to stop falling, even for just a few months, then bonds would have a lot of catching up to do (to get from their present artificially-elevated level to where they should be based on economic realities). 

Oil and Bonds

Over the past two years the T-Bond price has followed the oil price with a lag of 3-4 months. Therefore, the recent upside breakout in the oil price is a bullish omen for bonds assuming the aforementioned positive correlation between bonds and oil remains in effect. 

We expect that the positive correlation will remain in effect and that some follow-through to the upside by the oil price would eventually (after a lag of a few months) help push the bond price higher. However, we are more than a little skeptical with regard to the sustainability of oil's recent upside breakout. This is because the main driver of strength in the US$ oil price appears to be US$ weakness, which means that a rebound in the US$ would likely result in a drop in the oil price. This is significant because a US$ rebound will probably commence in the near future.

We say that the recent strength in the oil price is mostly a function of US$ weakness because there is no evidence of strength when the oil price is measured in terms of a strong currency. The below chart of the oil price in terms of the euro illustrates this point.

Now compare the above oil/euro chart with the below GYX/euro chart (GYX is an index of industrial metals prices). The industrial metals have been trending higher against the strong currencies as well as the weak currencies, so there is clearly a lot more to the bull market in the metals than just US$ weakness (meaning that the bull market won't be de-railed by a US$ recovery).

Conclusion

There are more than the usual number of crosscurrents affecting the bond market (and, therefore, interest rates) at the present time, but at this stage we don't see any need to adjust our intermediate-term bond and interest rate forecasts. Our expectation continues to be that the next big move in the bond market will be to the downside (roughly in line with the typical post-bubble pattern) and that rising long-term interest rates will force the Fed to do what they don't want to do (increase the Fed Funds Rate).

The greatest influence on US bond prices over the next several months is likely to be the US$ as further dollar weakness will result in foreign central banks absorbing a large quantity of US bonds while a US$ rebound will remove this central bank support and allow bonds to fall under the weight of their own over-valuation. If the US$ does remain weak we doubt that this weakness and the resultant central bank buying of US bonds could reverse the long-term trend in the bond market from down to up, but it could extend the current counter-trend move.

The US Stock Market

Current Market Situation

The below chart of the S&P500/gold ratio shows the downward-sloping channel that originated during the early part of 2000. S&P500/gold has successfully tested the top of this long-term channel on two occasions over the past 6 months and remains 'channel-bound'. 

While a longer-term chart of S&P500/gold shows an on-going downward trend, a 1-year chart (see below) reveals some bullish potential. In particular, the decline since the July peak looks more like a consolidation pattern within a continuing intermediate-term up-trend than the early stages of a new intermediate-term downtrend.

We are going to be watching the S&P500/gold ratio more closely than usual over the next few weeks because it would not require much movement in the S&P500 relative to gold to generate an important upside breakout or to provide some evidence that the longer-term downward trend remains in force. To be specific, a move above 2.75 would break both the short-term downward trend and the 4-year downward trend whereas a move below 2.58 would negate the bullish potential suggested by the shorter-term chart. 

The below chart needs no explanation, but we'll provide one anyway. When the stock market was moving lower during the first quarter of 2003 the NDX/Dow ratio was moving higher. As stated at TSI at the time, this divergence suggested that the S&P500's test of its October-2002 low was going to be successful. At the current time a similar divergence is on the go except that now NDX/Dow is drifting lower even though the stock market appears, on the surface, to be strong. In our view this is a sign that the market is very close to an important peak. 

The market will probably move a bit higher over the coming week because the short-term trend is up and we are in a seasonally strong time of the year. However, we will consider any strength over the next 1-2 weeks that does not eliminate the above-described divergence to be an invitation to increase the size of our bearish bet.

This week's important economic events
 

Date Description
Monday Dec 29 No significant events
Tuesday Dec 30 Consumer Confidence
Existing Home Sales
Wednesday Dec 31 No significant events
Thursday Jan 01 Markets closed for New Year
Friday Jan 02 ECRI Future Inflation Gauge
ISM Index

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