The rise in crude oil demand over the last 5 years, as discussed in last week's newsletter, is largely due to growth in demand from China.

So far the Chinese economy has withstood the global slow-down, maintaining GDP growth above 10 percent per year. The Shanghai Composite index, however, has fallen more than 60 percent from its 2007 peak — an indication of what China can expect when the euphoria from the Olympics has faded. Falling crude oil demand from China would threaten long-term support at $100.

Thirty-year Fixed Mortgage rates remain at 6.0%. Rising treasury yields, however, would increase upward pressure on mortgage rates, suggesting the decline in housing prices is far from over.

Gold

The short retracement on spot gold signals a continuation of the rally. Breakout above resistance at $950 would indicate another primary advance to test of $1000; respect would signal another test of primary support at $850. A correction that ends above $850 would be a bullish sign.

Investors may wonder how the market can possibly rally when the economy resembles a punch-drunk boxer hanging on the ropes. The answer is fairly simple: the big money is not betting on the economy it is betting on inflation.

The Fed is printing money as fast as it can — in order to save the banking system from annihilation. Nobody gets up off the canvas without assistance after taking a 1 trillion dollar sock on the jaw. While the Fed can provide liquidity, there is only one way to protect banks from falling asset prices which threaten to wipe out their reserves. That is to create inflation — to reverse the fall in asset prices.

The Fear Index

The spread between the fed funds rate and 3-month T-bills reversed back into the danger area above 1 percent. The shift from long-term to short-term maturities contributed to falling T-bill yields, but the widening spread demonstrates that investors continue to shun inter-bank and commercial paper markets, preferring the safety of treasuries.

The seriousness of the housing bubble is best illustrated by the ratio of the S&P Case-Shiller Composite Housing Index to Disposable Income per capita (before adjustment for inflation). The previous high of 0.45% in the late 1980s was dwarfed by the reading of close to 0.6% in 2005/2006. There has since been a strong retracement, but the index remains well above the 0.4% level needed to motivate home-buyers.