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June 2, 2006 |
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On April 4, 2006 Cheng Siwei, a vice chief of the national parliament, suggested that China should cut its US debt holdings. While Mr. Siewei’s words have been forgotten by most (not to mention that his words were quickly attacked by the People's Bank of China as only ‘reflecting his academic view’), April 4 was nonetheless, in hindsight, memorable.
Following April 4 a series of positive developments pushed gold higher by more than $150 an ounce. These events included increased Iran tensions, suggestions that the Fed was getting ready to pause, a US dollar plunge, skyrocketing oil prices, and a new silver ETF. By the time gold took a breather it had struck $732 an ounce (June contract), while July silver reached $15.20 an ounce. May 10, 2006 – Today On May 10 the Fed raised interest rates again and suggested that more rate hikes were to come. On May 11 global stock markets were rocked, the dollar fell sharply, and gold hit $732 an ounce. On May 12 global stock markets were rocked again (the Dow dropped 100+ on May 11 and May 12), but the gold rally abruptly stopped. Exactly why the rally in precious metals hit a wall on May 12 is open for speculation. Some have claimed that the price of gold was manipulated lower by the COT/Fed. However, since these same conspiracy enthusiasts also argue that the currency markets are much too large to be successfully manipulated, the idea that the COT attacked gold at $732 an ounce is a stretch. To be sure, the USD Index reached a yearly low of 83.41 on May 12 and the 10-year Treasury bond yield hit a yearly high of 5.19%. Clearly something big happened after May 12; something that was not confined to the tiny gold market. One theory says that over the May 13-14 weekend the ‘IMF acted to avoid a market meltdown’. While plausible, what the IMF did, if anything, is, again, open to speculation. After all, the “IMF was working privately to exercise its new powers…” Conspiracy theories and IMF speculations aside, history suggests that on May 12 gold stopped being a hedge against inflation and started being a hedge against a financial crisis. This is the case because on May 12 - after years of successfully flooding the global financial markets with liquidity - the volatility genie was let out of the bottle. This volatility first showed itself in the currency markets, then in emerging markets, in commodities, and, finally, in the US equity markets. The reason why the return of volatility is important insofar as the price of gold boils down to the action in the US dollar – which has benefited from financial market volatility! Conclusions The great gold bull was severely injured when it dropped by $26 an ounce on Monday May 15 because a USD crisis was averted. And although the US dollar did not do so in stunning fashion, it did, once again, prove to be a safe haven during times of crisis: As global financial markets crashed lower capital moved into USD; As commodity prices crashed lower and economic slow down became a potential threat, capital moved out of gold. Want further proof that the conditions that made the April 3-May 12 precious metals rally possible are no longer present today? Yesterday Yu Yongding, who advises on policy as a committee member of the People's Bank of China (Bloomberg), said that China should buy gold. Gold ignored this news completely and plunged. In summary, the dollar took a break from its long-term descent last year, and it is taking another break now. The old story of central bank reserve diversification is, for the moment, dead. By contrast, US dollar hegemony is alive. As for what the future may hold, since May 12 the markets have been telling us that the threat of economic slow down is becoming almost as pronounced as the threat of inflation. Precious metals will have a difficult time doing well during a global economic slow down scenario unless a financial crisis arrives and/or the slow down is stagflationary. Yes, precious metals remain a hedge against a weakening greenback, and if GLD was optionable (to enable writing covered calls) it could soon be an excellent near-term buy (perhaps around $600 an ounce). Nevertheless, the action in the markets since May 12 is telling us that in order for gold to rally the next financial crisis must be a US Dollar crisis. If I could think of one major central bank that is in favor of a stronger currency I would speculate on when a USD crisis is going to arrive. I can’t. Therefore Bretton Woods II remains in play, central bank diversification away from USD will arrive slowly (if at all), and the US’s day of reckoning remains unpredictable beforehand. By contrast, what is predictable is that many more USD/Gold battles are ahead |
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