Saturday, June 29, 2013

Gold, interest rates & market direction

All of the major averages had a nice bounce this week after the Bernanke induced sell off on 6/19 & 6/20.  The Fed was careful to apply ample amounts of damage control in the form of dovish talk from various Fed governors that any tapering of MBS and Treasury purchases were a long way off and that soothed the market.  The junkie got his "fix".

We now live in a world where the traditional inter market relationships we became accustomed to after the GFC (Great Financial Crisis) have gone awry as the "risk on/risk off" trade seems to be fading away.  As stated in previous commentaries, the new inter market relationship, established soon after the BoJ (Bank of Japan) announced their unprecedented QE program last October is:

Yen up - stocks down
Yen down - stocks up

 More importantly, the inverse correlation of the US Dollar to risk assets has dissolved.  The following chart is a weekly chart of the NYSE Composite Index going back to 2011 and the top panel is the correlation of that index with the US Dollar:

(click on chart for larger image)
Notice in the top panel the red line was constantly below the horizontal "0" black line except for very brief periods.  This is illustrative of the inverse correlation of the US Dollar to equities and commodities due to the "risk off" trade of the past four years.  That all started to change at the beginning of 2013. 

I've written about the change in this inter market relationship in a few commentaries earlier in the year and how it signaled a return to a normalcy financial markets have not seen since before the crash.  Historically, a country's currency would reflect the strength of its economy and financial market.

Now, I don't want anyone to think that the Dollar would not become a "safe haven" if the global financial markets were once again threatened the way that they have been over the past four years.  But it appears that the era where the Dollar was in a constant negative correlation with stocks is over.

Treasuries responded fairly appropriately to all the dovish talk by Fed governors with the yield on the Ten Year Note backing off it's intra day high of 2.657% on Monday (6/24) to close the week at 2.478%:

(click on chart for larger image)
After the Bernanke "bubble pop" news conference on 6/19, treasuries and stocks both sold off in unison, thereby violating that traditional inverse correlation.The fact that the Treasury market has, at the moment, stabilized is the reason for the levitation in equities this week, but we now have a new temporary inter market relationship:

Ten Year Note yield up - stocks down
Ten Year Note yield down - stocks up

Whether this persists is the main subject of my analysis below.

Yet, nothing has changed in the commodity market.  Industrial metals are still dead in the water and I was considering how to address the bloodbath in gold this week but then we had a nice bounce on Friday.  Here's a daily chart of the gold spot price:

(click on chart for larger image)
I've pointed to the "tails" on the candlesticks of the last two daily lows before counter trend rallies took place and these "tails" have been predictive of counter trend moves in the ongoing downtrend for the yellow metal. 
Ordinarily, I wouldn't get to excited about this move in gold given my deflation thesis but the miners also had an impressive move and actually started that move a full day before the metal.  This is a daily chart of the Market Vectors Gold Mining ETF (GDX) which consists of large cap precious metals mining stocks:
(click on chart for larger image)
The move in the miners was accompanied by very heavy volume (yellow arrow) which is often indicative of a market turn. 

Again, this is a very early call but I haven't seen this kind of price action and relationship between miners and the metal for years.  I could possibly explain Friday's bounce in gold being the result of yields backing off their highs.  But the move in the miners on heavy volume, to me, speaks to a change in mood and market perception.  If the miners continue to lead the metal this is an incredibly bullish sign for both the miners and gold.  Keep your eyes on this!


In last week's commentary I made much of the deflation thesis I've been defending in my commentaries since I started writing them three years ago.  And nothing has changed in a week other than the interesting development I identified above in the precious metals market.

As stated above, concerted and cohesive Fed speak has convinced the markets for now that the Fed will not be reducing the liquidity they've been pumping into the system any time soon.  And this may be for a reason that is not getting much notice in the financial media.  With no reportable inflation to be seen but only disinflationary pressures identifiable, the least the Fed can do is continue their 85 billion per month in Treasury and MBS asset purchases.  I actually believe that if disinflationary forces continue to gain momentum there is a fair chance they may add even more liquidity in the system. 

While the Fed has printed reams of money the following chart supports that the money is largely still sitting on banks balance sheets.  This is the latest Velocity of M2 Money Supply data out of the St. Louis Fed:

(click on chart for larger image)

The velocity of M2 money supply continues to plummet and is at it's lowest since the central bank started keeping this data in the late 1950's!  Velocity of money  can be thought of as the rate of turnover in the money supply; that is, the number of times one dollar is used to purchase final goods and services included in GDP.  Until this data starts to turn up there is still no inflation in our economy and this leaves further easing by the Fed "on the table."

The quandary for market watchers continues to be: if inflation is subdued or falling and the recovery, while gaining some momentum, is still tepid, can the financial markets thrive in a higher interest rate environment?  Or how about this question:  Why should interest rates in such an economic environment as we are in be rising at all? Add to this dilemma the impact of other global economies and how it will effect our economy: Euro zone still in a malaise of recession/depression and China noticeably slowing down.

This is one of those commentaries where I scratch my head and have no ready answers.  While it is true that any rise in interest rates is starting from lows not seen since the dark days of WWII (1942), the question still needs an answer.  Clearly, the market's message to Bernanke and company on 6/19 was that ANY change in asset purchases which would put pressure on the mid to long end of the Treasury yield curve was unacceptable.

I watch the market gurus, experts, money managers, etc. speculate that "the market" overreacted to Bernanke's comments on 6/19.  The market never overreacts!  As the representation of the sum total of all knowledge, wisdom, fear and greed of it's participants, the market is the ultimate discounting mechanism and predictor of economic conditions six to nine months out.  There was a very good reason for the reaction to Bernanke's comments on 6/19 and all market participants need to reflect on the meaning of that reaction.  And maybe gold and the miners turn late last week is also telling us something about this whole subject?

So, we are clearly at a crossroads in the financial markets.  The necessary central bank interventions and the distortions those interventions created have clouded the crystal balls of all prognosticators to the point where we need to go with our gut on where stocks are inevitably headed.  For me, I ultimately believe we are in the midst of an economic recovery that is stronger than many think and that we will see all time highs by the end of this year.  But until the questions above are answered it's going to be a rocky road for investors and traders.  The "junkie" has to go thru withdrawal first!

In the short term, because of dovish Fed speak, equities are back to the "good news is good; bad news is good" paradigm that the central bank, by its policies, has fostered.  Stocks still have to clear some key resistance areas to resume their bull run.  On Thursday I posted a blog on SPY ( and for those of you who read it here's the updated 60 minute chart:

(click on chart for larger image)
As stated on Thursday, gaps are formidable support/resistance areas.  SPY has yet to fill the gap and I'm a bit surprised that, in the face of some good economic news this week and the Fed speak, it hasn't.  I believe the chart above points to a very key level for stocks to clear.  In consideration of all that has transpired since 6/19, the moment of truth is still hovering over us.  We need to decisively clear this level in order to say that stocks will continue their inexorable march higher.

Have a great week!