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Gold is Sniffing Deflation

 

By Greg Silberman             Printer Friendly Version

June 28, 2006

goldandoil.blogspot.com

Is Gold Schizophrenic?

Based on the action since May 2005 I think the answer is definitely a resounding YES!

We saw Gold rise higher than forecasted to $725. The excitement was electrifying!

Then we saw Gold become a manic depressant and Dive to $540 in the twinkle of an eye.

The fact is, this is NORMAL action for Gold.

Yip. You heard me right.

Gold is without doubt an unstable Schizo!

To be honest, I have been a little concerned with Gold’s schizoid nature. You see if we’re accumulating Gold and Gold stocks as a hedge against financial chaos then we shouldn’t be overjoyed to see Gold rally with the market.

In fact, the latest move in Gold was accompanied by almost no Fear. Zip, nudda.

Now I’m well aware of the liquidity theory. Rivers of money causing all assets classes to float up in price. I’m happy to explain away the latest move in Gold to a rise in liquidity.

But it’s the absence of fear that worries me. It’s Fear that is really needed to blast Gold Stocks into Orbit. Don’t get me wrong, I’m certainly NOT looking forward to that day. But by now, I feel it is inevitable!

Talking about Fear, I was curious to see whether the move in Gold alongside other commodities wasn’t actually a Red Herring. Is something else going on behind the scenes to raise the Blood Pressure of the Market?

Let’s start with the usual suspects:

$TSX:$IRX (10 Year Treasury Note/3-Month T-Bill Discount Rate)

Chart 1- HUI (blue) + yield curve (red and black) + Japanese yen (black) + VIX (green)

What I’m looking for here is to see if there is some kind of fear entering the market and propelling Gold higher. A fear that is masked and not readily apparent because everything else is rising as well.

We therefore begin with the HUI at the top of the chart. The HUI formed a 2-year base before breaking out in December 2005 (black line).

Interestingly, the HUI breakout coincided with a bottom in the Japanese Yen (first red line). My first instinct is that a rising Yen kills the Yen Carry trade draining away liquidity. But wouldn’t a reduction in liquidity be a signal of a slowdown in monetary growth which would be bad for Gold? Hmmm.

The next thing I see is a breakout in the VIX (lower green line) from a near 2 year triangle formation.

Sidebar:

The VIX is the implied volatility of S&P stock options. Huh?

In other words, to calculate the price of an option the option dealers use a variable called Volatility. Volatility measures the extent that prices are expected to move either up or down. The higher the volatility, the larger the expected moves in stocks. The VIX chart shows the movement in volatility over time.

The easy explanation for this breakout is that the Stock Market is tumbling and fear is rising. But interestingly enough, the VIX breakout coincided with a spike in the Yen. Is the Yen Carry trade reversing?

Furthermore, a breakdown in the Yen carry trade is causing Long Term Yields to rise faster than short term yields. The reason - Yen Carry trade players were long Bonds in order to capture yield. Now they are liquidating Bonds causing yields to rise faster than the Fed is raising short term rates.

The result, a steepening yield curve (red and black lines) since the beginning of 2006. A rising (steepening) yield curve should cause liquidity to flow back into the market because monetary conditions are easier. So why isn’t this inflow offsetting the Yen Carry Trade outflow?

Finally, we can now answer our original question. Have Gold Stocks been rising with the rising tide of liquidity or has there been another more sinister factor?

Believe it or not:

The rise in Gold Stocks is signalling that there is not enough Monetary INFLATION. In other words the unwinding of the Yen Carry is sucking too much liquidity out of the system and the FED is not providing enough EASY money to compensate. So yes, Gold Stocks have been rising because of FEAR. The fear of DEFLATION!!!

The FED isn’t helping either. By continuing to raise Rates they are causing the yield curve to flatten even more and choking off all liquidity.

Snookered:

Here’s the kicker, if the Fed started dropping rates they may cause the Dollar to drop and the Yen to strengthen even more – unwinding the Yen carry further.

Putting rates on Hold and asking the Japanese Central Bank to engineer a weaker Yen will only slow the process, not stop it. At some point Asset prices will need to correct!

Unfortunately, there is one alternative I think the US will take to engineer inflation – a bigger War! Not as far fetched as it sounds. Refer back to my piece entitled War in October ‘06.

Gold now has a headwind of Fear gathering behind it. As my 4 year old daughter would say, “Oh Pickles!”

More commentary and stock picks follow for subscribers…

Greg Silberman CA(SA), CFA

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I am an investor and newsletter writer specializing in Junior Mining and Energy Stocks.

Please visit my website for more free articles and analysis. Click here: http://goldandoil.blogspot.com/

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.