A Wall of Worry or A Slope of Hope?

Now anent the possible ramifications of an disorderly decline in the US financial markets, there have been two opposing school of thoughts here, one is that rising risk aversion trades would possibly lead to an outflow of investments from high risk areas such as emerging markets and commodities to a “flight to safety” into the US dollar and US dollar denominated fixed income sovereign instruments “treasuries” on the account of the unwinding of leveraged “short” positions, capital outflows from subdued expectations for the yuan’s rise on China’s slowdown and possible improvement of the US current account deficits. On the other hand, the US dollar bears point towards an exodus or capital flight from the US assets into hard or real assets and international markets.

While your analyst may be inclined towards the latter, as I have shown to you the long term cyclical patterns of the US equities as well as US Treasuries both on a declining trend, (for US treasuries rising yields-to repeat, over the long term), I would have to listen to the markets to reaffirm my convictions. And thus, two other barometers are needed to support my adapted underlying theme, the Gold index and the US dollar Index.

The gold market appears to be in a long-term bullmarket as previously shown. I would like to remind you that gold’s motion has not been limited to a US dollar inverse correlation. As a matter of fact, while the US dollar climbed in 2005 against its major trading partners as measured by the US dollar trade weighted index- see figure 6, gold rose against ALL currencies. This is a significant development considering that mainstream media portrays gold as a plain vanilla inflation hedge.

When politicians and their bureaucrats on a global scale attempt to outdo each other via “beggar thy neighbor” policies of massively printing endless quantities of money and issuing grotesquely immense amount of credit to destroy the purchasing power of their currencies in order to keep their “competitive” pricing edge for export concerns, tendency is for these government mandated or “fiat currencies” to drop against gold. And this phenomenon of destroying the purchasing power of global currencies can’t go on forever....it would either lead to hyperinflation or a collapse in the world monetary system. And gold’s rise against all currencies in 2005 could be symptomatic of this stealthily progressing malaise.

Figure 6: Goldmoney.com/James Turk: US Dollar Index (Log scale)

In figure 6, we can observe of last year’s US dollar index rally. The long term chart also shows of the bullmarket of the US dollar from 1994 to 2002 marked by the green channel. The US dollar started its torrid decline following 2002 peak (marked by the red channel) and rallied steeply last year (small green channel).

Today, the lower green channel of last year’s rally serves as our guidepost (its resistance level) as to whether the US dollar index would benefit from the “flight to quality” emanating from increasing risk aversion trades.

Until manifestations that prove the “flight to quality” theme becomes evident, I remain in the camp of the US dollar bears.

Of course there is always the middle ground or the synthesis: the scenario of a soft landing, a goldilocks economy, subdued inflation and ample liquidity. As they say, bullmarkets climb on a Wall of Worry while bearmarkets slide down on a slope of hope.