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Gold and the Ten-Year Bond

By John Cassimatis      Printer Friendly Version
Jun 6 2008 4:14PM

www.kitco.com

--I was out with a banker the other night that wanted to "assist" me in my investments. I told him that I had a few questions for him to answer first. I quickly asked him what the level of inflation was and he said, "Somewhere between 3%- 4%." Unfortunately for him, I had no more questions.

If you would have asked me late Wednesday June 4th, 2008 whether gold would hang in there or quickly head to the recent lows for a successful test, I would have expected the latter. When I awoke to prices as low as they were Thursday, I was even more sure that I would be right. The thought of buying the weakness did not seem like the right play to me. Sure silver had been strong for days, but gold had a clear weight on its shoulders: it was the weight of just having broken major uptrend support beginning from the May 1, 2008 bottom after some tough talk by the Fed. It wasn’t until silver had run close to 70 cents, firmly breaking out of its $16.52-$17 range to the upside that I started to rethink my thesis. Oil was up strong, and other commodities such as soybeans had broken out of reasonably lengthy consolidations to the north. In the end, I was tired. I had some light shorts that had misbehaved (always against a mass of physical metal I never sell). I began to think about the first piece I ever wrote for Kitco entitled "Caution Still Warranted" which should be a must read for nearly everyone. I thought about my own points about this lengthy consolidation we very well may be facing, of buying them at the low end of the range and selling them at the high end (the range of 845-865/930-955). Looking back, maybe I shouldn’t have been as surprised.

Anyhow, in this piece I would like to put the short term technical stuff aside and go back to some longer-term considerations. Let’s suffice to say that gold can easily bounce up to the $910-$918 level on the August contract with little, almost no resistance. At that point, it will have some tougher decisions to make. A break of $920 would be intermediate term positive even though, going back to the point aforementioned above, gold will still have to contend with this band of stiff resistance between $930-$955. We will have to see how it all shakes out, but certainly a high above the recent $935 would probably get me to buy the next down move with more fervor. Silver’s resistance has moved down to $17.88.

One of the main questions that has been running through my mind since gold bottomed in early May concerns this notion of a longer-term consolidation with potentially lower lows than the ones recently put in. I continually wonder to myself: Are you going to be right that fresh highs are well over a year off, or should you actively be looking for entry points for an imminent rally into the $1000s? A part of me thinks it responsible to take a break and relax as the metal churns its way nowhere for a while, and the other side, again, keeps thinking about all of the reasons I originally loved this investment in metals. Like most Kitco readers, I became interested in gold and silver because I was concerned about a deteriorating unit of paper money. The monetary base was expanding rapidly and I had no way to prevent it. I could only respond to it, and I did so by buying, like many of you, metals of all kinds. Obviously there were other concerns such as credit troubles and potential of major bank failures. When I think these concerns now, I realize that nothing has really changed. Most of these worries are still at the forefront of investor’s minds. If that’s true, should I be more aggressively looking for entry points here?  Or have the concerns, to the extent that they are going to materialize over the intermediate term, already been priced in? That is always the question.

There is obviously a great advantage to sitting out a lengthy consolidation. First there is a cap on just how successful you can be, and being largely successful takes a great deal of work. You will undoubtedly be caught off guard from time to time and take your fair share of pain. Some nights you will not sleep well, turning in bed with confusion and fear. In consolidations, gold can break fairly strong technical support levels to the downside and bounce as we just witnessed yesterday and today. In truth, the best way to play them is by paying a constant heed to the RSI, relative strength indexIt is during consolidations that the RSI more often than not, respects it’s overbought and oversold readings to a "tradeable tee." Yes, this notion of whether we are facing a lengthy consolidation period is of great importance, for no other reason than it mandates a certain style of trading. Again, in “Caution Still Warranted,? a deeper discussion of this is laid out.

What would make the near/intermediate term not be a consolidation, or, more specifically, what would make us rally strongly to fresh highs? Major rallies need reasons. Whether the reasons end up being valid or not, rallies just don’t "happen."  Let’s look back to our May 1, 2008 high. It came on the day that the Fed had brokered a deal between JP Morgan and Bear Sterns that save the entire financial system from a ripple effect of defaults. Gold clearly had been pricing in such a bank crisis when trading around $1000 and smartly sold off on news of the bail-out. The government had essentially softened that particular problem, mitigated its potential impact, and the metals then needed to price that in. It is clear now, that it is going to take a series of multiple bank failures, potentially to the point that the Fed can no longer figure out a way to save the entire boat, for this "bank issue" to propel gold sharply higher. While this could be around the corner (Lehman and Wachovia and others can’t make it out of the news), we are simply not there yet, and the chances of such a fatal occurrence still needs to be measured with unemotional reason.

The main force that will ultimately drive gold and silver higher is inflation. The United States is not the only country that has been inflating its currency. This is a process that has been going on worldwide. What’s interesting about gold’s sharp push higher today is that it comes on the back of tough talk from the Euro Zone. While such talk has clearly strengthened the Euro, it has done so after similar comments about the Fed’s intention to pause in its cutting campaign. One would think such moves run counter to an explosive upside move in gold as they suggest, at the very least, a moderation in the pace of global liquidity increases. If you remember back six or so months ago, to when there was suspicion that the Euro Zone would have to follow the Fed with lower rates at some point, the knee-jerk conclusion was that such a move would strengthen the USD relative to the Euro and consequently hit gold. I can remember talking to a friend that is quite proficient in his understanding of economics, and he had suggested at that time, a very different outcome: namely that the market would ultimately see a more international cutting of rates as precisely the formula to ignite further inflation on a global scale and that gold would actually rise dramatically despite a potential steadying of the dollar versus its rivals. I marked his point in my head as interesting. At this point in time, however, we are hearing (not seeing yet, as it remains jawboning until someone actually raises a rate) the exact opposite. This is precisely why gold’s strong move up today is a little strange here, but it highlights why a good deal of my writing pertains to the technicals. I am firmly of the belief that gold trades in accordance to overbought/oversold readings and technical trend lines most of the time at the expense of the news flow over the short/intermediate term.  Because there are usually multiple takes on the same news, gold can interpret the headlines as it wishes. I have often said:  "Gold does what it wants to do, and then it fits the news in." This is why we must always stay flexible in our interpretation of news and always respect the price action.

But back to this inflation concept. I continually find myself amazed by how much respect the Federal Reserve continues to get from market participants. If the Fed were to start raising rates in a timely fashion (obviously not AFTER a full blown inflation scare), it would be logical that gold would be pressured.  Most investors continue to believe that the Fed will be successful in fighting whichever battle it wages. Obviously, when the Fed chose to fight the growth battle in Sept of 2007, equities quickly exploded, relieved that the Fed had come to the rescue. There was great joy in the air. Similarly, investors also pay great attention to the battles the Fed is not choosing to fight. During that time, gold also moved up sharply as it was clear the inflation battle was to be sacrificed. Whether the Fed will win the growth battle it has waged remains to be seen, but, for the purposes of this article, I am more concerned about the battle, or lack thereof, on the inflation front. Should the Fed, and now the Euro Zone, change their stance for real and begin raising rates, many market participants will begin to place bets that will pre-assume a success in staving off inflation because, like I just said, these Central Banks get far too much credit. In such a scenario, gold and silver should face a pressure commensurate to just how far behind the inflation curve the markets thinks the fed sits coupled with the markets interpretation of the genuineness of the campaign. At this point in time, it is clear by looking at longer dated bonds, that inflation expectations are still in check. Obviously, both the 10 year and 30 year bonds have been benefitting from a shift by investors toward capital preservation and safety. But the 10 year bond has a yield below 4%. Just how high can we think market inflation expectations are with a 10 year note priced like this!  (Obviously, it is priced as such due to flight to safety concerns, misperceived inflation expectation as well as contained domestic growth predictions. But, in the end, I promise you, it will reflect the true level of inflation!) True, many investors in such bonds accept that their real rate of return is negative, but likely not by much. I would be shocked to learn the inclination towards capital preservation were strong enough for investors to accept, let’s say, a 4% negative real rate of return. No, most investors in long term bonds probably think inflation is at the most 5% or 6% and that they will lose a shaving or two to protect themselves.

Do you think the inflation rate is 5% or 6%? I certainly don’t. Food, gas, tuition, health care. I don’t even want to get started on how foolishly the CPI is calculated and more than that, for just how long we threw out the increases of food and energy—two commodities in raging bull markets! It is already well documented, though I find it amazing. In any event, the real question here is when does the market "wake up" to the fact that there is a serious and growing inflation problem in the United States and, quite frankly, in almost every nation of the world. Unfortunately, this is a question I cannot answer. I suspect it is a process. Gold’s running from $640 to $1035 was a nice start. Even now, if one looks at Large Spec Future’s longs for both gold and silver, they are running at a much higher level than after big down moves in the past. This can, of course, suggest two things. That either gold and silver still have a good deal to go down before more historic position levels return, or that the metal’s space has fundamentally changed—that the new increase in investor appetite for metals is here to stay. This is obviously a key component on the path to higher pricing. This is what the metals struggled with late 2006 to early/mid 2007, that there just wasn’t that commitment by investors to holding metal. To me, it seems like it could be a little bit of both. The large COT (commitment of traders) readings by large speculators probably indicates an overhang that keeps us from fresh highs, but that investors worldwide are wanting more and more protection from the growing threat of monetary devaluation.

While we cannot necessarily predict just when investors, on a more widespread basis, will refuse to accept as true what will be the government’s chronic underreporting of inflation, things like soaring oil can only help. What’s more, there will be a big sign that lights up and tells us that the process is underway:  the 10-year note. Clearly, one would anticipate a rather sharp drop in long-term bond prices (higher yields) at some point here. We are seeing just the opposite today. The longer the Fed keeps rates at levels so dramatically below the level of real inflation, the more behind the inflation curve we will be. This will determine the magnitude of what the eventual drop in long-term bond prices will be. Such a drop will signify a major change in investor perceptions. The investor (maybe even some nations as China and Japan dominate bond activity at the long end, though that’s far more complicated a matter) will finally say enough is enough: "I will no longer accept this ever-growing negative real rate of return." They will finally begin to respect the true rate of inflation and not foolishly discount it based on softening domestic economic perceptions in a world with not one, but two billion person economies that are exploding--economies that are buying most every resource for the next fifty years! It is then that a real inflation scare will be underway. Long term bonds will only have one place to go, and, what’s more, on a flight to safety basis, gold will lose its biggest competitor. Gold will be the primary beneficiary of such selling in bonds. In my mind, some breakdown in long bonds must couple a significant gold advance from these levels towards the lofty predictions that get flung around all over this site. Only then. Gold cannot drive itself to $2000 and beyond without a concurrent sharp rise in long-term bond yields! We are just not seeing this yet.

One final point. We all understand that markets anticipate. We know we simply cannot wait for all of the data to come out and then jump in because prices will already be largely reflecting the news flow. We would then run the risk of trading like a Jim Cramer—assuming a ton of risk to catch the ninth inning of a particular move (or, in most cases, just the just the top). Consequently, it is understood that we must use diligence to evaluate these powerful forces and perceptions and be well positioned before such an occurrence. We must do so being likewise mindful of risk and downside potential. This is particularly why buying oversold entities in bull markets is my favored investment method. Many times, my biggest gains come as a result of initiating apposition during a period of substantial weakness, and quickly adding to position on the position’s first accomplishment (i.e. the breaking of the first down trend line of technical importance—last night that was $880 gold though I failed to surmise the energy). Then, in a position of strength, I can give the market a chance to accomplish more. Often times, large gains are things a sharp trader "walks into." Make no mistake, yesterday was a day we should not have bounced intra-day. I am not surprised often and I was yesterday. That is usually the recipe for a pretty good rally--when something has every reason and every look to go down and doesn’t! This was the case yesterday morning. It wasn’t until gold clawed above three-day mini down trend resistance at $880, that it joined the soybeans and the oil and the silver and headed off to the races. It a tough life, being a gold trader. There’s a lot to do. One small piercing of prices can change one’s entire near-term outlook in a flash. Heck, I can’t even get these articles out to you fast enough as the situations change. But, that’s the way it is. It’s important to be flexible.

Bigger picture though. My thought is that you will see something from the bond market first. Maybe a quick selloff at the long end, panic style, one that gets reversed quickly before resuming anew. I don’t know, but something. Right now the long end of the yield curve is just too well behaved for me to think that inflation expectations are sufficient to send gold to fresh highs. And as for the banks, the Fed already bailed out one of them, why not two? These are the risks, along with lofty long positions and perhaps a more disciplined Fed, possibly preventing record breaking move in gold to the upside near-term. And yet as we well know, the gold market is constantly attempting to price in the persistent fears in these domains.  With oil at fresh highs now, the metal’s are finding good reason to be concerned. This is why, in oversold markets like we had yesterday, with prices at the low end of the stated range, perhaps I should have been more aggressive. With the current state of misgovernment, I am putting a great deal of faith into my thesis that we simply aren’t ready for the big one. Nonetheless, if I had to predict, my bet is that the Fed tightens before gold breaks its recent high igniting a sizeable down move. Unfortunately for the Fed, the inflation damage will have largely been done; they will find themselves well behind the curve. They are already. It will be out of that unwinding of longs as investors overrate the Fed’s chances for success, that the great buys, the buys you don’t want to sell in $60 or $70 will be born. I sure hope I’m right about this.  Now that sounds like something worth trading for!

John Cassimatis

 

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John Cassimatis has been managing his own capital for 14 years in various markets.