Why The Fed Must Allow Gold to Rise

A good Snooker player is a sign of misspent youth. One tactic commonly used is to block your opponent’s ability to make a clear shot, otherwise known as the snooker. The Free Urban Dictionary defines snookered as - To lead (another) into a situation in which all possible choices are undesirable; trap.

Hey, sounds like the position the Fed is in.

Let’s recap:

Housing stocks have taken a decidedly bearish tinge as it looks like the next down leg is underway:

Chart 1 - Centex (weekly) broken support

Centex has recently moved below its July ’06 lows ushering in the next down leg in housing stocks (Fibonacci target – $30). Below is the 10-yr bond price. Housing stocks and bonds are very closely correlated.

[The housing stocks preceded weakness in the real estate industry by about 6-months. If the above chart is anything to go by, late Fall and Winter are going to be panic months in housing.]

Due to its enormous size, a bursting Real Estate bubble has the potential to sink the economy. The Fed cannot allow this, so what are they to do?

The obvious – cut interest rates and give away free money.

But there is one major problem. Lower short-term interest rates will play havoc with an already weak US Dollar:

Chart 2 – US$ trending lower (blue lines); bottom 10-yr treasuries 2 month time lag.

The USD (top chart) has been in a downtrend for much of the 1st quarter 2007. During this time short-term rates (not shown) have topped out which implies the Dollar has been discounting future Fed rate cuts. In fact the Dollar has been making lower tops for over a year (not shown).

Here’s the Snooker:

There is an interesting correlation between the Dollar and Bonds. By offsetting the 10-yr Treasury Note against the US Dollar by 2 months, the inter-market picture becomes apparent.

• The Dollar topped out in mid-October 2006 and fell until the beginning of December - Bonds topped out 1.5 months later and fell until late January.

• The Dollar bottomed in December and rallied until late January - Bonds rallied for much of February and into early March.

• The Dollar has been weak since February and the above chart suggests Bond weakness may follow for at least the next 2 months (maybe more if the Dollar weakens further).

So cutting rates may not be much of an option. It will weaken the Dollar and cause long-term rates to rise (Bonds to fall) which will knock on an already collapsing housing market.

In the absence of sufficient ammo, the Fed will continue to talk tough for as long as possible, trying to convince the market that the economy is strong. But the economy is not strong, manufacturing and services are slowing whilst Oil and Food prices are rising.

Whilst the Fed talks empty words, inflation fears are increasing. When the Fed is finally forced to cut rates to prevent an all out housing collapse, Gold will soar as a combination of massive monetary creation collides with mounting price inflation.

Gold is the steal of the century at these levels!

Comments

[akindman]

"The Free Urban Dictionary"? What?

[francomcd]

Hi Greg: IMHO applying the word 'must' to the Fed is beyond reality. Also to conclude that our 'perpetual paper money creating machine' Fed is going to support gold has to be a joke. Fractional reserve system & gold are oxymorons.

For gold to make a significant rally, the new 'buyers' must be free from the usual market controls; like maybe China spending a few billion of its dollar collection for gold. But why should they buy such a controversial commodity as gold when they have many other more agreeable choices. As long as we have the Fed, gold will be severely handicapped. Silver anyone? Well, then an exchange can change the rules; remember the Hunt Brothers?

IMHO, if you want a set of rules and also have fun while investing [gambling, that is], Las Vegas is the place to be. There one can know the odds and be aware of their inflation [shaved odds] and bet with lady luck by observing the lucky rollers... just like Wall Street but with fabulous entertainment. Win or lose, you can eat, drink & be merry !!! Who could ask for more?

[Malkiel]

There's absolutely no objective reason to believe gold will "soar", or even hold its current levels. If nothing else, the market is ruled by us baby-boomers who lived through REAL double-digit inflation in the '70's and aren't the least bit afraid of what passes for inflation at current levels (what didn't kill us made us stronger). Gold had nothing but mystique going for it as an inflation hedge and that bubble burst over the last couple of months when it failed to rise on a market downturn, an oil upturn, and a war scare. What catalysts are left for gold if these didn't jump-start it?

The real inflation hedge of the current market is commodities other than gold that have real industrial application, oil and its related products in particular.

[francomcd]

Your conclusion is generally correct IF we have a free market. In a controlled market, one has to view the motives of those in control. Watch for trading ranges and caps.

[Mr Mister]

So how exactltly is the Fed holding down Gold prices?

PS. I'm long on gold.

[Quaker]

Hey Greg, whenever I read something like your post, which is very logical and straightforward, I ask myself "what am I missing here?. John Hussman (quoted on SA a lot) agrees with you wholeheartedly. His BOND FUND carries a 20%!!!!! gold holding. Hussman is the best bear market fund manager in the country.

So what, if anything are we missing? One thing is certain. Like those oil guys who stare relentlessly at WTI, many US managers think America's inflation rate matters. In case nobody notices, gold doubled while inflation stayed at 2%. As you state, the relationship between Gold and the Dollar seems pretty strong. Gold stocks are lagging cold considerably, which tells me, like oil, money managers still simply don't get it. Late to get in with the first move and having lost HEAVILY they're now going to be even later getting in, but when they do, it's going to the mother of all parabolas.

I think one thing we're missing is that we're going to have the mother of all bear markets in bonds.

The week after 9-11, Bush told America to show their patriotism by spending money like it's going out of style. Greenspan obliged. It's payback time.

[J Harris]

Sorry, Greg, but I don't buy into a housing "collapse".

Unlike the stock market, bond market, commodities,etc. these are markets that are in some ways tied together. One could melt done & effect another. Real estate, on the other hand, is regional, if not outright individual.

Your house has utility- you don't have to sell your home if area housing "declines". And although most Americans have too much of their financial assets in their home, there are no quotes in the WSJ on yesterday's value of your home that make you lose sleep every night.

R.E. tends to rise/fall in a rolling regional fashion over certain areas. And though I cannot speak for tomorrow, today there is no slowdown (certainly no collapse) in my part of the country when you talk about housing here in Texas.

Of course, if we all carp enough we can probably talk down R.E. here, too despite a good statewide economy.