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GLOBAL CURRENCIES OUT OF BALANCE

The big hot buttons driving the financial markets today are weakness in the dollar, U.S. trade deficits, the Federal Reserve’s statement later today, and expectations for the economy, inflation and interest rates moving forward. Overall, stock prices have done gone nowhere for the last three days as is normal while the Treasury Department conducts its quarterly refunding debt auctions. By far the loudest signal I received today from the markets came with early volatility from currencies in the foreign exchange market. The U.S. dollar opened the day at new lows versus the euro at $1.3002 and Swiss franc at $.8565 with the December gold futures contract in new high ground at $438.30. The U.S. trade deficit for September was released first thing in the morning and the initial reaction sent the dollar lower, but not more than five minutes later the dollar began to strengthen while the yen headed south in a hurry. For me this was an overt signal the Bank of Japan fully intends to intervene in the currency markets in support of the dollar. It appears the BOJ is determined to weaken the yen in an effort to remain competitive versus China to support their export trade.

The real question I have to ask is, “What will the response be from the European Central Bank?” I interpret the movement in today’s currency market as Japan saying to the Europeans, “You do what you need to do, and we will do what we need to do to look after ourselves.” So far the euro has borne the brunt of the U.S. dollar decline and the officials at the ECB are voicing their disapproval. ECB President Jean-Claude Trichet said “brutal” moves in the currency market are “not welcome,” and ECB council member Guy Quaden told a Belgian newspaper yesterday that further appreciation in the euro is “undesirable.” If you take a look at the three-year daily chart of the euro/yen relationship you can get a good graphic view of what is happening. Today the falling yen forced the breakout from the consolidation that has been in process since the middle of 2003. Today’s breakout tells me Japan will fight tooth and nail to remain competitive globally. The ECB has been more focused on containing inflation with higher interest rates than the U.S. and on limiting the deficit spending of member countries. Their goal is to keep deficits below 2% of GDP while the government deficit in the U.S. is currently over 5% of GDP.

If I’m reading the charts correctly and the Bank of Japan is actively intervening to support the dollar, it means they are selling new yen into the market to buy dollars. North Korea also jumped into the picture by saying they can’t afford much more appreciation of the won, or they too will be hurt in their export industries with a strong currency. The only thing foreign governments can do to slow the appreciation of their respective currencies is to print (digitally create) more of their own, then sell them to buy dollars. They can all debase their money as all currencies globally are pure fiat…so far the Europeans have allowed the euro to strengthen, but what happens if they begin to crank up the printing press like they appear to be doing in Japan? The supply of fiat currencies can be expanded with no limit. As this process continues with central banks fully engaged in competitive currency devaluations, gold will continue to strengthen as it reasserts itself as thee timeless global currency. Another thing that makes gold look even more attractive as a currency is the simple fact that gold production is falling globally due to marginal mines that are being shut down and overall lack of investment and exploration in the mining industry over the last twenty years.

Now let’s look at gold through the lens of investors in Japan and Europe. Yen-gold is on the verge of breaking out from the ascending triangle formation that will serve as the launching pad for the yen-gold rocket when it finally takes off. According to the Encyclopedia of Chart Patterns, an ascending triangle has a 68% probability of breaking out to the upside. With continued intervention by Japan, this outcome is virtually guaranteed. To add fuel to the fire for a break out of yen-gold, it is noteworthy that the BOJ is considering the removal of insurance of bank deposits throughout their banking system. The last time the BOJ suggested they would remove deposit insurance investors in Japan became big buyers of gold. Remember that money (currencies) have two primary functions…to facilitate trade and function as a store of value. Today’s global fiat currencies have worked well to facilitate trade, but have not worked well as a store of value…gold will work more as a store of value or wealth moving forward as currencies continue their trend toward devaluation.

Similarly, look at the one-year daily chart of euro-gold and you can see the consolidation since April of this year creating a symmetrical triangle that typically represents a continuation pattern. If we open-up the time frame for euro-gold it’s easier to see where it has been and where it looks like it will go. The longer-term weekly chart shows the top in 1993 matching up to the top reached early in 2003, which forms the cup of the cup and handle formation. I see the consolidation as the handle of this formation, and when euro-gold takes out the 360.00 euro level, it should be off to the races. Should the officials at the ECB find it necessary to devalue the euro as the Bank of Japan has done for the yen, it will expedite the breakout of euro-gold to new heights as European investors seek a safe haven to preserve wealth.

In my mind it had to be intervention in the currency market because the spin on the trade deficit was weak at best. The deficit of $51.6 billion was downplayed because the number came in “better than expected.” Forecasts called for an increase in the range of $54 to $56 billion, so the number was spun as not being all that bad. In reality, it was the third largest monthly deficit on record and the fourth consecutive month the trade deficit has been above $50 billion. Americans are still buying products from overseas at an alarming rate relative to our exports. We are lining the pockets of our foreign suppliers with profits hand over fist!

Stocks and Bonds

As I said earlier, stock prices tend to go nowhere during Treasury debt auctions. This time around hasn’t been any different. Last Friday the S&P 500 closed at 1,166, Monday closed at 1,164, yesterday’s close 1,164 and today 1,162. The narrower Dow Jones Industrial Average had no change today closing at 10,385 and the NASDAQ Composite was under pressure most of the day after Cisco Systems coughed up a hairball by saying sales growth will slow this quarter. The NASDAQ Composite fell eight points to close at 2,034. Stocks rallied a bit in the early afternoon just prior to the statement from the Federal Reserve, but quickly retreated when the Fed basically left their statement unchanged from the last meeting. The market expected the 25 basis point hike to the Fed Funds target rate, but was also looking for a hint that the committee will hold off on the expected rate increase in December. The only change in the language from the Fed described the labor market as “improved” versus “improved modestly” from the last statement.

In the last twenty years the Fed has lowered interest rates seven times in the month of December while the past twenty Decembers have only seen two rate increases. Interest rate futures are still showing roughly a 75% chance of an increase in December, but my gut feel says they will hold off on the next one. By holding off in December it could work to keep a bid in the bond market reflecting the lower than anticipated rate and it will give the stock bulls a chance for two weeks of window dressing to close out the books for the year. They will continue talking of higher interest rates to come in an effort to contain inflation expectations, but in reality the Fed will most probably remain well behind the curve to raise rates since we are a debt-dependent economy. Jim Puplava has held the belief the Fed doesn’t have much room to raise rates, and just yesterday I read the following quote from Bill Gross presented by Steven Saville of www.speculative-investor.com. "My/our most certain idea, as expressed in previous Outlooks, is that real interest rates in the United States will have to be kept low, that the old Taylor rule [*] is out. Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing it leads to asset bubbles, potential inflation, and a declining currency over time." Steve Saville summed it up with, “In other words, we agree with Bill Gross that the US economy is burdened with such a huge amount of debt that it could not sustain the level of REAL short-term interest rates that would typically be associated with a normal, healthy economy, with a ramification being a declining dollar over time.”

Mr. Saville’s next paragraph gives you a glimpse of the dilemma facing the Federal Reserve. “There are, however, limits to what the Fed can do on the interest rate front and Mr. Gross doesn't address these limits, perhaps because he doesn't currently foresee a major inflation problem. The main limit is the amount of currency depreciation the bond market will tolerate before it completely falls apart, because if long-term interest rates begin to surge upward in an uncontrolled manner the Fed will be FORCED to boost the nominal Fed Funds rate to the point where the REAL Fed Funds rate becomes high. It will be forced to do this because a runaway bond market -- assuming it is running away to the downside -- would present an even greater threat to the heavily indebted US economy than would a high real short-term interest rate. Mr. Gross does see inflation as he has been under fire for saying the government statistics understate the true rate of inflation. All we can really do is watch to see how much longer the rest of the world will continue to support the deficits of the United States keeping strength in our bond market and holding the dollar artificially high.

Bond prices came down last Friday with the bigger than expected jobs number for October and came down again on Monday prior to the three-year debt auction. Yesterday bond prices were flat for the five-year auction and today prices moved lower in front of the ten-year auction. The lower bond prices moved yields higher making it easier to sell the debt paper. Typically bond prices get a bounce after the auctions are done, but with pressure for higher interest rates, it won’t be so easy to move bond prices higher. To keep longer-term rates low we will need to hear more of a weakening economy and no threat of inflation. The bond market is far more important than the stock market, especially since the real estate bubble is tied at the hip to the bubble in bond prices. The real estate market has been one of the few strong areas and I’m sure our officials do not want to see the same thing happen here as happened in Japan about a decade ago with their real estate bubble. The Mortgage Bankers Association said today their application index fell 4.5% with the purchase index declining 2.7% and the refinance index dropped 6.7% from the prior week. This is the third decline in the last five weeks for the application index…real estate is slowing. The 30-year fixed-rate mortgage moved slightly higher last week to 5.69%, still historically very low. How will real estate fare if the 30-year fixed rate moves up to the 8-9% level? There could be a world of hurt if you are over-extended on real estate with an adjustable mortgage rate.

With Veteran’s Day being tomorrow, the bond market will be closed, but stocks will be trading. With government offices closed tomorrow, the Labor Department announced that initial jobless claims rose by 2,000 to 333,000 which is better than the expected claims of 337,000. The Labor Department also said that prices of goods imported to the U.S. increased by 1.5% in October following the anticipated increase of 1.0%. Oil is claimed to be the big culprit of the increase. Excluding petroleum, import prices declined 0.2% thanks to low labor costs overseas. Just when it looked like crude would continue lower, it got a bounce today by gaining $1.48 per barrel to $48.85. I thought we might see $45 a barrel, but with the declining dollar don’t look for oil prices to go much lower. Crude has already moved lower for most other countries since their currencies are appreciating versus the dollar.

Now that the Treasury auctions are out of the way all we can really do is watch and see. I still believe stocks are fundamentally overvalued and bond prices have very little upside potential. Wealth preservation and profits are my primary focus and that’s why I like the precious metals from a long-term perspective. Gold has been dancing around the $430 to $438 area trying to break out. My stance on the battle in the gold and silver pits is be right and sit tight…just don’t be hung out there with margin. In times like this I remember a Jesse Livermore quote where he said something like one of the toughest things to do is simply to stay long in a bull market. He made more of his money by taking a position and then having the patience and fortitude to HOLD his position to realize future gains. The name of the game is patience!!

I hope you have a Great Evening!

Mike Hartman

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