The money supply is either stagnant or declining, depending on how you measure it, in spite of a 1% fed funds rate here in the U.S. and aggressive interventions on behalf of the dollar by other central banks. The year-over-year growth of M2 is down to 4.5%, just above the 4.3% growth of GDP. So I thought I should check my own money supply to see how things were holding up.
I am talking about quality, not the more-often checked quantity. I pulled a dollar bill out of my wallet and checked the design on the back carefully to see whether those redesign maniacs at the Treasury, the same ones who keep enlarging Andrew Jackson's head, had messed with the Great Seal on the back. No, they had not; underneath the unfinished pyramid with the disembodied Eye of Providence is the Latin motto
novus ordo seclorum
, meaning "A new order of the ages." (By the way, the history of the Great Seal is an amazing one; you can read about it
The timing of this inquiry was propitious, no doubt, for the nature of the
Federal Open Market Committee's
policy pronouncement last Wednesday may be rightfully construed as the first step of a secular change in monetary policy. It was a warning to the carry traders and others who have been feasting on cheap credit to get their affairs in order if they care anything at all about their next of kin.
Gold, interestingly enough, anticipated this change by nearly two weeks. Cash gold hit its intraday high on Jan. 6, shortly after Fed Governor Bernanke's New Year's weekend speech, which was interpreted by many as a promise to continue pumping out money regardless of the consequences, and it has been in retreat since Jan. 12. The euro hit its high against the dollar on the same day; the linked movements are hardly coincidental.
Gold is an exquisite barometer of monetary policy. Its movements depend on both the exchange value of the dollar and the relationship between short-term interest rates and expected inflation. Let's revisit an analysis of the gold market from
last May, when talk of deflation was upon the land, to see where the gold market may be heading now.
Now, as then, I will begin by taking an annualized yield spread between two Treasury notes with similar maturities, a 4.25% TIPS due Jan. 15, 2010, and a 6.5% note due Feb. 15, 2010. As is always the case with TIPS, please be mindful of their two embedded long options: a call on the higher all-urban consumer price index and a put on the price index itself. Should deflation materialize, the principal of the TIPS at maturity will not be adjusted downward.
In addition, while the maturities of these two notes are nearly equal, their risks are not. The TIPS has a modified duration, or percentage-price change for a given change in yield of 2.65, while the regular note has a modified duration of 4.95. You would need to trade 10,000 TIPS to have the same risk as 5,354 normal notes.
The annualized inflation gauge derived from this spread, which I dubbed the AIG, had been making a series of lower highs from May 2000 -- the date of the Fed's last and most ill-considered rate hike of the 1999-2000 cycle -- to July 2003. It then broke higher out of this downtrend, retested it in late September 2003, and then began moving higher. Moreover, the AIG as a percentage of the 6.25% note's yield has continued the climb it began in late 2001. On the surface, this looks to be nothing more than a continuation of gold's strong fundamentals.
However, gold trades not off inflation alone but off the spread between expected inflation and the short-term cost of carry, which will be represented by the annualized three-month repurchase rate. Here the picture starts to look different. Even though the spread between the AIG and the annualized repo is 1.28%, the highest in the history between these two notes, the rate of growth clearly has stalled. Any increase in short-term rates will contract the spread sharply and place downward pressure on gold.
Bucking the Buck's Trend
Some correlations are spurious, while others walk up to you and introduce themselves with a flourish. The latter is the case for the dollar and gold; more dollars lower the value of each one in relation to both gold, an absolute standard, and to a basket of foreign currencies, a relative standard.
If the Fed starts to tighten credit and foreign central banks end their manic interventions on the dollar's behalf, it will not take a great deal of imagination to see a reversal of both trends. This will be true unless -- and this is a very important unless -- expected inflation rises at a faster pace than short-term interest rates do.
A New Lease on Life
Just as stocks have their negative indicators such as the VIX, put/call ratios, short interest and adviser sentiment, the gold market has the lease rate. This is the difference between the London Inter-Bank Offer Rate and the gold swap rate; heavy demand to borrow the metal for short sales creates a future demand to cover those shorts. Jumps in the lease rate often precede jumps in the price of gold itself.
Gold lease rates plummeted into early January, and even though they have since rebounded slightly, they remain at multiyear lows. Sellers basically have backed away from the market, a condition associated commonly with a capitulation top.
The stocks of commodity producers relative to the market as a whole often trace the path of a call option on the underlying commodity. We expect them to rise earlier and faster than the commodity itself, and then fall more slowly when the commodity price itself falls as the producers close down higher-cost facilities. This was the case for gold stocks for years.
The recent rally in gold has provided an exception to this expectation, however. The Philadelphia Gold and Silver index's performance relative to the broad Russell 3000 has failed to match the move higher in bullion prices. These stocks have been major underperformers during the biggest gold rally in more than two decades, and that confirms once again that if you want to trade commodities, trade commodities and not commodity-linked equities.
Oh, that phrase
on the Great Seal translates to "God has favored our efforts." I doubt that will buy you much time with your compliance department or risk managers, so if you are planning to go short gold, use a buy stop.
Howard L. Simons is a special academic adviser at NQLX, a trading consultant and the author of
The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. The views expressed in this article are those of Howard Simons and not necessarily those of NQLX. As a matter of policy, NQLX disclaims the private publication of materials by its employees. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to
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