Watchmen or Transfomers - Who Will Rule?


By Jon Nadler

Jul 24 2009 4:26PM


A small overnight dip to $945 in gold prices gave way to a fairly quick recovery in same, as the US dollar took a more substantial 0.34 point hit on Friday morning and fell to 78.63 on the trade-weighted index. The yellow metal and the greenback have been executing a cheek-to-cheek close tango for the past couple of weeks now, and weakness in the latter has translated into persistent bumping-ups against the $957 resistance area in the former.

The weekly Bloomberg price survey reveals that polled opinion is positive for bullion as we turn towards closing out the month of July, next week. Thus, gold might test towards the $975 level if conditions continue to be less than favourable for the US currency. That's the part that remains to be seen. Our short-term small crystal ball is in the shop for routine summer service, so we cannot help you there.

New York spot gold dealings started the final session of the week with a $3.30 gain per ounce, and were quoted at $951.30 this morning. The afternoon hours offered no more, and also no less in terms of price action – the metal appeared stuck in a freeze-frame mode and was ahead by…$3.70 at $951.70 per ounce at 3:30 NY time. In the background, the dollar was still mired near 78.70 but crude oil managed to rise another 78 cents to $67.94 per barrel, after its small drop earlier in the day.

Book-squaring ahead of the weekend appeared to hold things back somewhat, price wise, in the final stretch of today’s session, but the developing pattern cold imply a new range for the metal - from $930 to $975- one that is about $25 higher than what we had gotten used to recently. Just as oil will, gold will still close out the week posting a net gain.

Silver added 6 cents on the open, to start the day at $13.76 an ounce, and then proceeded to trade near $13.85 (showing a 15-cent gain) by the afternoon. Traders do see possible tests of the $14 level in the cards, but we do not have a polled participant survey result to offer for the white metal. Or, the aforementioned crystal ball, either.

In other markets, the Dow was stalled just above the 9K level, and consumer sentiment fell for the first time in five months (mainly on jobs worries). A connection? Probably. However, the main culprits for the lack of forward progress in stocks were thought to be Microsoft and Amazon – the shares of both of which were hit following not-so-hot earnings reports.

Platinum rose $11 to $1186.00 and palladium climbed $3 to $259 as the trading day started to wind down. America's version of 'cash for clunkers' begins now, and US car dealers are hoping to turn the turning in of junky cars into some kind of sales revival for their dust-laden new product that is still choking the lots all over the place. Wonder how much platinum might be recycled from said clunkers in coming months, and how much the program will mean to new car sales. If nothing else, the removal of cars that pollute a lot more than the current generation from the roads has to be something to cheer about.

Growing risk appetite among investors has sapped a couple of full points off of the US dollar index, however there is no consensus yet on what next week's GDP numbers and Treasury auctions might bring in the way of fresh impact factors to this market. As well, short-term technical indicators are flashing: overbought. Thus, we cannot rule out a quick retrace to the $930s before a resumption of the push to higher ground reignites.

Also worth noting is that such upward pressures in the metals have been more directly related to dollar trading and not so much coming as a result of fresh waves of retail investment buying. Historically speaking, trading gold strictly as an against the dollar gamble results in a 73% chance of making the wrong bet. Odd as it may seem to many, the correlation of bullion to the US currency has been -0.27, even if certain years offer exceptions that bring that correlation as high as -0.85 (such as was the case in 2005).

At a time when everyone and their cousin is screaming 'inflation!' (No, make that: hyperinflation!) in this crowded market theatre, it is also worth reminding them that gold and the long-term CPI show but a 10% correlation. Not exactly the kind of number one attaches to the 'prefect inflation hedge' product label. But, that is old news to all but the newsletter vending trade.

Finally, the newest precious metal silver ETF baby on the block saw its umbilical cord being cut yesterday, and was slated to greet the world today. This, at a time when silver's fundamentals are not as healthy as one would wish for a newborn. The market finds itself amid a substantial surplus and has also (like gold) become heavily (some say exclusively) hooked on the investment formula bottle in order to keep adding weight. Have a cigar, if you are so inclined. The question of the day/week/month/quarter/year is fast becoming: can X (insert gold, silver, copper, oil, platinum, etc.) keep up the momentum? Better ask momentum funds that sticky question, we say.

Another question to ask is will the Fed be able to implement the blueprint which was in part outlined by its Chief in the Wall Street Journal at the beginning of this week? Doubters are not hard to find, even if they do not print the ‘hard money guru’ or “senior metals analyst’ occupational title on their business cards. Basically, they rely on historical precedent and try to paint a picture of a Fed that is reactive, and significantly behind the curve. Bloomberg quotes Bernanke plan non-believers as follows:

“Now that the U.S. economy shows tentative signs of recovery, James Bullard, president of the Federal Reserve Bank of St. Louis, wants the Fed to adopt a plan for taming the inflation he expects may follow the end of the recession. Unless the central bank puts a strategy in place and presents it to the public, inflation expectations may run rampant, Bullard says. He’s pessimistic such a plan will be forthcoming. “I think I’m an army of one on that,” Bullard said in an interview after a speech in Philadelphia on June 30.

The Fed always faces a hard choice as recessions run their course (this one began in December 2007): It can keep pushing to revive growth and avoid deflation -- an extended drop in prices like the one that devastated the U.S. economy in the early 1930s -- or it can take aim at inflation and risk strangling the recovery before it takes hold.

The unprecedented steps the central bank has taken to battle the credit crunch, especially its purchases of mortgage- backed securities, pose an inflation risk that’s trickier than in previous recessions, says Joseph Mason, a banking professor at Louisiana State University in Baton Rouge, Louisiana.

Don’t count on the Fed to get it right, says economist Allan Meltzer of Carnegie Mellon University in Pittsburgh. The central bank has often lacked the resolve to pursue unpopular policies to keep prices in check, says Meltzer, who’s the author of two volumes chronicling the Fed from 1913 to 1986.
“The Fed throughout its history has carried out a strategy of taking care of today’s problems, not looking to the future,” Meltzer says.

So far, inflation has shown no signs of heating up -- nor has deflation reared its head. The U.S. core inflation rate, which excludes food and energy costs, fell to 1.7 percent as of June from 2.4 percent at the beginning of the recession. In the Great Depression, consumer prices fell for more than three years, at an annual pace as high as 10 percent.

Federal Reserve Chairman Ben S. Bernanke, who has published academic research on the Depression’s causes, is wary. He said in June that the Fed continues to watch for deflation, and he testified to Congress this week that the economy still needs support to recover, especially in light of rising unemployment. The central bank has the tools it needs to reverse its monetary easing when it’s time to fight inflation, he said.

Among the Fed governors and reserve bank presidents who oversee monetary policy, most see slow growth and deflation as a bigger risk than inflation, based on speeches they have delivered in recent months. Bullard, among the minority worrying more about inflation, says the real risk is simmering on the central bank’s balance sheet. By making loans and buying securities to unfreeze the credit markets, the Fed has doubled its balance sheet assets to $2 trillion in the past year.

About half of that expansion came through short-term lending to financial institutions. The Fed is scaling back those facilities. It’s the rest of the balance sheet growth that concerns Bullard -- especially $661 billion of MBSs acquired to push down rates on home loans. The Fed has said it may buy as much as $589 billion more.

“I call those the politically toxic assets,” says Benn Steil, a senior fellow at the Council on Foreign Relations in New York. Selling those bonds would boost home buyers’ borrowing costs and stall the recovery of the housing market. Traditionally, the work of a central banker has been simpler: lower your benchmark rate to counter a recession and raise it when the economy recovers to prevent inflation.

The current crisis shows the limits of that approach. Even after the U.S. federal funds rate was cut to zero late last year, the economic slide worsened. U.S. gross domestic product fell at a 5.5 percent annual rate in the first quarter of 2009. Bernanke responded with the loans and the purchases of MBSs, an approach known as quantitative easing.

One way to counteract the easy credit the Fed has created might be to raise the interest rate on the reserves that lenders hold at the central bank, Bernanke says. U.S. financial institutions had $781 billion of such reserves as of this week, up from just $32 billion in September 2008. The central bank got authority in October to pay interest on those funds. It has been paying 0.25 percent and can change the rate at any time.

Banks will withdraw this money when they feel it’s safe and profitable to make loans. By paying higher interest, the Fed would make it less attractive for banks to pull that money out and pump it into the economy. There’s little precedent for managing the money supply with interest on reserves, so it may be impossible to figure out where to set the rates. “We don’t know what a percentage point change in the interest rate on reserves will do to lending by banks,” says Mason at Louisiana State.

Meltzer is skeptical that Fed policy makers will act, even if they figure out how. In the 1960s and 1970s when inflation was rising, the Fed set out goals to fight it at least four times only to back down under political pressure. Paul Volcker, who became Fed chairman in 1979, was the exception. He ignored politicians and pushed the benchmark fed funds rate as high as 20 percent in the early 1980s.

Central bankers tilt toward stimulating growth, Meltzer says, partly because Depression-era deflation is imprinted on their minds, while periods of deflation prior to the 1930s that didn’t wreak havoc are forgotten. The perception that a central bank won’t move against rising prices can actually contribute to inflation, says William Silber, a professor at New York University. When the public expects inflation, it’s easier for retailers to raise prices and for workers to demand wage increases, he says.

Silber is writing a book about Volcker’s fight against inflation in the 1970s, when prices rose even during recessions. The public’s view that there was a lack of will to fight inflation helped cause this phenomenon, known as stagflation. This is one reason Bullard wants the Fed to actually publish a plan for tackling inflation and not just draft it for internal purposes. To contain inflation, the battle often needs to begin before it’s visible -- never a politically pleasant task. Acting now promises to be especially unpalatable, with unemployment at 9.5 percent in June and home foreclosures coming at a record pace in the first half of this year.”

Bon Appetit. We continue to see “Volckerman” as putting on his 1980’s vintage cape and forcing his junior apprentice to swing the interest rate lightsaber, when push eventually comes to shove.

What? You’d rather have this?

Have a nice weekend, instead.

Jon Nadler
Senior Analyst
Kitco Bullion Dealers Montreal


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