Bonds or gold - which market is wrong?
August 20, 2004
The Prudentbear.com
by Chris Temple
As we all know, financial markets now and then send mixed signals on what the future might hold. Especially these days, with investors on edge over soaring oil prices, terrorism fears, uncertainty over the upcoming election and a growing belief that the U.S. economy’s surge since early 2003 might be flaming out, it’s hard to know whether to “zig” or “zag.”
One of the most curious anomalies of the last few weeks has been the fact that both U.S. Treasury securities and gold have been rallying. While not unprecedented, this is a situation that is inherently contradictory, and is unlikely to last. To be sure, some are arguing that the rallies in each are due, in part, to terrorism fears and the inevitable flight of some capital to traditional safe havens; on this score, both bonds and gold qualify. At the end of the day, however, both markets will be supported or shunned based on their underlying fundamentals.
Let’s start with the bond market. Virtually everyone at the beginning of the year believed that long-term interest rates had nowhere to go but up from their lowest levels in half a century. The economy and corporate earnings were strong, and it appeared inevitable that the Federal Reserve would finally have to respond at least somewhat to the extraordinary inflationary pressures it has fostered in the recent past by taking some of them away via, at last, raising short-term interest rates. Topping off an environment which was already pointing to higher rates and lower bond prices has been the inexorable rise in the price of crude oil to fresh all-time nominal highs. No matter how the Bureau of Labor Statistics tries to gloss over its implications, higher oil prices still—Fed Chairman Greenspan’s “new economy” notwithstanding—have inflationary implications. In fact, through 2004’s first half, even the substantially understated numbers from the BLS showed U.S. consumer prices rising by a 5% annualized rate during the first half.
After topping out twice around the 4.9% area, though, the yield on the government’s current bellwether 10-year note has plunged lately; it now stand at around 4.25%. Ignoring much of the above, bond traders seemingly are voting now that a weakening economy and the apparent peak in corporate earnings growth demonstrate that interest rates can’t go up much more. They ignore the inflationary pressures of rising oil prices to instead reinforce their belief that this additional “tax” on the economy means that the Fed will neither have the ability or the nerve to raise rates much farther. Combined, this suggests to them that we have already seen what rise we’re going to in long-term market rates; and that, before much longer, we’ll be fretting over recession/deflation anew.
Longer-term, that is certainly where we’re heading to some extent (though whether everything goes down in price or, in the alternative, at least some items such as commodities buck the coming unwinding is yet to be determined.) For the time being, however, gold is begging to differ with some of this hypothesis. Gold traders also see soaring energy costs; they realize to some extent, however, that such an event has always meant higher eventual inflation.
In addition, those tiptoeing back into the yellow metal with increasing conviction seem to recognize something stock traders and the cheerleaders on financial television incredibly continue to dismiss; and that is—terrorist premium or not—high (and rising) energy costs are here to stay. Now, there’s no question that at least some of the rise in oil’s price (and today was a good example, as a barrel of black gold closed at $48.75, up $1.48 on the day) does indeed owe itself to speculators. And I’ll even concede here that, if peace suddenly broke out in the world, oil’s price would likely plunge, as some speculators exit their recent bets.
However, listening to the shills for Greenspan and the Bush Administration, you’d think that under this scenario oil would go back to $25 per barrel and stay there. This is nothing but fantasy. There is nothing “transitory,” to use one of Greenspan’s favorite words, about countries like China and India having embarked on major growth trends not unlike that of the United States at the beginning of our own Industrial Revolution. If and when oil does settle down for a while, it will later be looked back on as nothing but an interlude in what is otherwise a long trend to substantially higher U.S. dollar prices for crude.
I stress U.S. dollar prices because that’s another thing seemingly understood by those re-entering gold that is utterly lost on those again willing to loan money to Uncle Sam for 10 years at 4.22%, as of today’s close. Though the greenback has spent most of 2004 successfully holding its own against most other currencies, it’s inevitable that its secular bear market will soon resume (if it in fact has not done so already.) Our nation’s external debts continue to mount. Eventually, a trade deficit now running in excess of $600 billion annually and a combined current account deficit of even more means that the currency with which that “nut” must be serviced has to go down in value.
The disconnect between bonds and gold was especially stark when it was announced a few days ago, in fact, that the U.S. trade deficit for June had surged to a new record of $55.8 billion, smashing the old mark. The dollar sank, gold rose—and bonds yawned.
Smug bond traders, out in front of their belief that, like they did in Japan, long-term interest rates have to decline ultimately to even new lows as the U.S. economy weakens further, are taking a heck of a gamble on two fronts. First, they’re betting we’re headed straight to that outcome; and that, in between here and there, nothing will cause long-term rates to, at the least, challenge their old highs (on yields) first. I respectfully disagree.
Secondly, they fail to realize that there is at least one clear, HUGE difference between the U.S. today and the Japan of the 1990’s; namely, that they cut interest rates to the bone from a position of having current account and foreign exchange surpluses. In short, nobody from the outside had to “ratify” their policy of massively inflating their monetary base and taking rates down to virtually nothing, in order to cushion their long unwinding. America is not in such a position, but instead has the largest external debts of any country in recorded history. In spite of what remains a large appetite for U.S. paper around the world, at some point our creditors will decide that their excess savings might better (and more safely) be put elsewhere. The long-term implications for interest rates, therefore, is much less sanguine than bond traders seem to grasp; and could hit us sooner rather than later, depending (among other things) on how quickly China moves to revalue its currency.
For our present purposes, in addition to betting that bond traders are wrong in the near term, I’m increasingly willing to bet that gold traders are correct. Gold has managed to move above $400.00 per ounce again and, in the last couple days, has additionally moved above a down trending resistance line in place since its peak around April 1. The most leveraged basket of gold stocks, as measured by the HUI Index of the American Stock Exchange, has today managed to close sufficiently above overhead resistance in the 200-202 area to mark an important breakout point as well.
Unlike the false starts of late May and late June/early July, this last few days has seen volume increase smartly as well. In fact, even in the last week, it was typical to see volumes for most gold stocks traded on the major exchanges remain below their 30-day averages even on days they were rising. Today, as this apparent breakout was occurring, those I follow were not only up strongly, but traded on average DOUBLE their recent normal volume.
At the least, we are on a course to shortly challenge the April high in the gold price, and last December’s high in the HUI. In the end, I have to take sides with either the bond bulls or the gold bugs; and for the time being, I’m choosing the latter.
One of the most curious anomalies of the last few weeks has been the fact that both U.S. Treasury securities and gold have been rallying. While not unprecedented, this is a situation that is inherently contradictory, and is unlikely to last. To be sure, some are arguing that the rallies in each are due, in part, to terrorism fears and the inevitable flight of some capital to traditional safe havens; on this score, both bonds and gold qualify. At the end of the day, however, both markets will be supported or shunned based on their underlying fundamentals.
Let’s start with the bond market. Virtually everyone at the beginning of the year believed that long-term interest rates had nowhere to go but up from their lowest levels in half a century. The economy and corporate earnings were strong, and it appeared inevitable that the Federal Reserve would finally have to respond at least somewhat to the extraordinary inflationary pressures it has fostered in the recent past by taking some of them away via, at last, raising short-term interest rates. Topping off an environment which was already pointing to higher rates and lower bond prices has been the inexorable rise in the price of crude oil to fresh all-time nominal highs. No matter how the Bureau of Labor Statistics tries to gloss over its implications, higher oil prices still—Fed Chairman Greenspan’s “new economy” notwithstanding—have inflationary implications. In fact, through 2004’s first half, even the substantially understated numbers from the BLS showed U.S. consumer prices rising by a 5% annualized rate during the first half.
After topping out twice around the 4.9% area, though, the yield on the government’s current bellwether 10-year note has plunged lately; it now stand at around 4.25%. Ignoring much of the above, bond traders seemingly are voting now that a weakening economy and the apparent peak in corporate earnings growth demonstrate that interest rates can’t go up much more. They ignore the inflationary pressures of rising oil prices to instead reinforce their belief that this additional “tax” on the economy means that the Fed will neither have the ability or the nerve to raise rates much farther. Combined, this suggests to them that we have already seen what rise we’re going to in long-term market rates; and that, before much longer, we’ll be fretting over recession/deflation anew.
Longer-term, that is certainly where we’re heading to some extent (though whether everything goes down in price or, in the alternative, at least some items such as commodities buck the coming unwinding is yet to be determined.) For the time being, however, gold is begging to differ with some of this hypothesis. Gold traders also see soaring energy costs; they realize to some extent, however, that such an event has always meant higher eventual inflation.
In addition, those tiptoeing back into the yellow metal with increasing conviction seem to recognize something stock traders and the cheerleaders on financial television incredibly continue to dismiss; and that is—terrorist premium or not—high (and rising) energy costs are here to stay. Now, there’s no question that at least some of the rise in oil’s price (and today was a good example, as a barrel of black gold closed at $48.75, up $1.48 on the day) does indeed owe itself to speculators. And I’ll even concede here that, if peace suddenly broke out in the world, oil’s price would likely plunge, as some speculators exit their recent bets.
However, listening to the shills for Greenspan and the Bush Administration, you’d think that under this scenario oil would go back to $25 per barrel and stay there. This is nothing but fantasy. There is nothing “transitory,” to use one of Greenspan’s favorite words, about countries like China and India having embarked on major growth trends not unlike that of the United States at the beginning of our own Industrial Revolution. If and when oil does settle down for a while, it will later be looked back on as nothing but an interlude in what is otherwise a long trend to substantially higher U.S. dollar prices for crude.
I stress U.S. dollar prices because that’s another thing seemingly understood by those re-entering gold that is utterly lost on those again willing to loan money to Uncle Sam for 10 years at 4.22%, as of today’s close. Though the greenback has spent most of 2004 successfully holding its own against most other currencies, it’s inevitable that its secular bear market will soon resume (if it in fact has not done so already.) Our nation’s external debts continue to mount. Eventually, a trade deficit now running in excess of $600 billion annually and a combined current account deficit of even more means that the currency with which that “nut” must be serviced has to go down in value.
The disconnect between bonds and gold was especially stark when it was announced a few days ago, in fact, that the U.S. trade deficit for June had surged to a new record of $55.8 billion, smashing the old mark. The dollar sank, gold rose—and bonds yawned.
Smug bond traders, out in front of their belief that, like they did in Japan, long-term interest rates have to decline ultimately to even new lows as the U.S. economy weakens further, are taking a heck of a gamble on two fronts. First, they’re betting we’re headed straight to that outcome; and that, in between here and there, nothing will cause long-term rates to, at the least, challenge their old highs (on yields) first. I respectfully disagree.
Secondly, they fail to realize that there is at least one clear, HUGE difference between the U.S. today and the Japan of the 1990’s; namely, that they cut interest rates to the bone from a position of having current account and foreign exchange surpluses. In short, nobody from the outside had to “ratify” their policy of massively inflating their monetary base and taking rates down to virtually nothing, in order to cushion their long unwinding. America is not in such a position, but instead has the largest external debts of any country in recorded history. In spite of what remains a large appetite for U.S. paper around the world, at some point our creditors will decide that their excess savings might better (and more safely) be put elsewhere. The long-term implications for interest rates, therefore, is much less sanguine than bond traders seem to grasp; and could hit us sooner rather than later, depending (among other things) on how quickly China moves to revalue its currency.
For our present purposes, in addition to betting that bond traders are wrong in the near term, I’m increasingly willing to bet that gold traders are correct. Gold has managed to move above $400.00 per ounce again and, in the last couple days, has additionally moved above a down trending resistance line in place since its peak around April 1. The most leveraged basket of gold stocks, as measured by the HUI Index of the American Stock Exchange, has today managed to close sufficiently above overhead resistance in the 200-202 area to mark an important breakout point as well.
Unlike the false starts of late May and late June/early July, this last few days has seen volume increase smartly as well. In fact, even in the last week, it was typical to see volumes for most gold stocks traded on the major exchanges remain below their 30-day averages even on days they were rising. Today, as this apparent breakout was occurring, those I follow were not only up strongly, but traded on average DOUBLE their recent normal volume.
At the least, we are on a course to shortly challenge the April high in the gold price, and last December’s high in the HUI. In the end, I have to take sides with either the bond bulls or the gold bugs; and for the time being, I’m choosing the latter.
Chris Temple is editor of The National Investor newsletter and founder of The Foundation for American Renewal.
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