A decline in the US dollar exchange rate is extremely undesirable for the Chinese – the biggest holder of US debt in the world. Nevertheless, over the past few months, China repeatedly attacked the status of the USD as the world reserve currency.

• World financial/economic crisis may have culminated and greatest risks have been averted but it is still very far from over
• US dollar continues in its multi-year downtrend
• World governments are committed to issue huge volume of government debt for many years to come
• Quantitative easing – debt monetization – are becoming a routine practice of the Fed
• President Obama’s plans for government spending are making Bush deficits seem like child’s play

The list goes on and on. Most of gold bugs’ economic projections made years ago have come true, but gold has been stuck at a seemingly impregnable level of $1000 for almost 18 months. Will this level be overcome and when?

The 10-year yield is now approaching 4.0% while less than half a year ago it was only at around 2.0%. Short end yields also soared last week. 3-month T-bill yields rose by more than 40%, while 2-year yields appreciated by 37% and are now yielding 1.32%.

The banking sector has been the unquestionable leader in the rebound over the past six week. The sector has outperformed not only the S&P 500 but the NASDAQ 100 by a wide margin.

Despite making loud headlines about stimulating the economy, the US government has been unable to raise the level of optimism among the general public, while the stock market seemed to drop into a deep state of apathy.

January Performance

Friday, the last trading day with the Bush Administration in command, was marked by new lows in the terribly ill banking sector. The Troubled Assets Relief Program [TARP] became law on October 3, 2008. Since then, the Philadelphia Bank Index [$BKX] has declined by an astonishing 55%.

Since the USD and gold are inversely correlated, the bears conclude that the gold bull market is over given that we have entered into a severe deflationary period.

Gold price action in the past half a year can best be characterized (especially after the recent rally) as consolidation. Such a consolidation is reasonable after a huge spike last year into early 2008, where gold exploded from $650 to over $1000 per ounce.

In the short term, in order to avoid seeing gold close below $700, it must move above resistances of $780-810 relatively quickly and stabilize close to that range.

However, when looking at the past 80-year history, there are a number of bear markets that carry some similar characteristics to the crash of 2008. The following six bear markets saw very significant corrections in mining stocks:

Today, nobody fully understands what really happened in the past few weeks. These events will be analyzed and re-analyzed in the future and a greater understanding will be gained.

A popular mantra among many gold bugs is: “the Fed is printing money.” Any actions by the Fed to support liquidity in the markets are touted as “money creation” and consequently “monetary inflation” which causes gold appreciation. If gold does not rise, they proclaim that there is “manipulation” and “conspiracy”.

It is fair to say that we do not see the picture in such black and white colors.

We believe the market is mistaken in anticipating that the worst for Wall Street is behind us and that the Fed is about to shift its priorities from preventing a recession to fighting inflation.  

Rising production costs, aggressive feasibility study assumptions, a worrisome number of start-up productions problems and even resource data falsification have all greatly contributed to the Credibility Crisis in the junior mining sector. At the same time, the Credit Crisis is exacerbating the situation by making funding for even the best projects unavailable. 

A common view of the Federal Reserve is that it is some sort of a nearly omnipotent being standing on guard of healthy economic expansion maintaining a delicate balance between growth and inflation in the way of regulating money supply and the cost of borrowing. This view may be correct, but only theoretically so.

Shorter term bills and notes led the way and as a result, the yield curve flattened significantly. 

The latest bull run in gold, which started in August 2007, was not due to the fears of inflation but due to a panic related to a financial crisis. Gold bull markets that are based on inflation occur during the rising long-term yield environment, similar to the 1970s and early 1980s. But that was not the case in the past nine months. Yields have been falling, but yield spreads have been rising, indicating increasing risk aversion among investors. Gold, like the T-Bills, was playing the role of a safe-haven during the times of great uncertainty.

The primary reason for this euphoria was psychological. Less than 20% of the time during the 5 years was spent in a correction/consolidation mode and for over 80% of the time, investors were counting their paper gains.