Fed Rate Cut: Good For the Dollar, Gold

I posted here about how the Fed’s actions regarding the dollar in the immediate future will dictate action in the months ahead. In this post, I will tackle a different angle of this idea: the prices end of the equation.

One major driver of the emerging markets has been global liquidity – in short, it has been plentiful. The moves in gold over the past four years have represented this plentiful level of liquidity responding to rising asset prices and more risky asset moves in general globally. This move in the likes of Corn, Crude and Rubber have lead to higher levels of inflation and put the likes of the ECB and Fed on notice. With this notice came hawkish rhetoric and rate hikes to off set this move in prices.

As the chart shows, the “price” end of this trade is sinking so the central banks have achieved their goal to some extent. The prices index, as I mentioned previously, is now negative – this indicates that pricing pressures are now waning and the central banks of the world have achieved their goal of stemming the rise in inflation.

In a period when the index has moved into negative territory, as the chart shows, gold prices have waned as well generally. This shows a clear connection between inflationary pressures in the marketplace (via the pricing index) and gold. Taking this a step further; since the prices index has been a leading indicator of the core CPI for the most part, this means gold is thus a leading indicator for the CPI.

Thus, let’s reexamine what I said in regards to the dollar. A rate cut by the Fed at this point would not be harmful to the inflation story and helpful to the economy. It would help the sub prime sector get some legs (though I think it will help those with arms feel a bit better about their budget more than anything).

It will also steepen the treasury curve which will allow the banks to make a dime. Finally, it will stabilize the dollar because dollar bulls at this point want to see some growth in the US economy to offset the bulging trade deficit. It would also, in theory, stabilize prices to some extent – helpful for the gold market! So there lies the connection. If the Fed cuts rates, gold will find support as prices will find support. If the Fed decides that such a move is risky, gold will be hurt as well as most assets for that matter.

The one other variable to consider here is liquidity. I measure liquidity in two ways; First, via a measure using MZM and M2 from the St Louis Fed (call it a Money Measure); the other being the action between the Aussie Dollar and the Swiss Franc. If you look at the money measure versus the prices index on the chart, you will see that when the money measure is moving down, it puts good pressure on assets and prices (2000 through 2002). When it is stable and there is growth, assets rise (2002 to 2006). Now, it is beginning to move lower as liquidity is drained and guess what; prices are coming down. You can see this on the gold chart as well with gold now rolling over as the money trend tightens.

The reason gold has not collapsed though relates to the global environment. In looking at the Swiss Franc versus the Aussie Dollar, you determine a penchant for risk and for global growth. If the Swissy is rallying relative to the Swissie, traders are getting cautious – short term normally relates to some event whereas longer term generally relegates to growth. If you look at the chart between these two currencies, using a weekly view of things, you will notice that the AUD/CHF spread is shrinking with the CHF quickly playing catch-up to the AUD. This represents a tightening of liquidity conditions. Further, since the CHF is part of the “carry trade,” assets in general could be in for pain in the months ahead if this trend continues.

The bottom-line here is simple. The fundamentals at the moment are becoming more of a drag on gold. This could keep a lid on the 655 level (the breakout point) in gold and support my short position down to the bottom of the trading range in the months ahead, around 575. Of course, if the Fed were to cut rates…perhaps this would loosen the conditions and keep gold from going substantially lower. I guess again, it is up to the Fed.