Something is in the Wind!

Imagination was given to man to compensate him for what he is not, and a sense of humor was provided to console him for what he is.

— Oscar Wilde

This week the IMF released a study evaluating QE and it comes at a time when the Federal Reserve is considering whether and how to exit. Without a doubt it will add to the debate around the still-controversial practice. The IMF found the bond-buying efforts of the Fed, the Bank of England, the European Central Bank and the Bank of Japan were able to restore the functioning of financial markets and provide accommodation with interest rates at near zero levels. The IMF also found that asset prices benefited globally, though capital flows increased to emerging markets. “While additional unconventional measures may be appropriate in some circumstances, there may be diminishing returns, and benefits will need to be balanced against potential costs,” the IMF study said.

Some of the risks include greater risk-taking behavior that may undermine stability, delayed reforms and potentially volatile capital flows. The IMF, like the Fed, also is worried about the impact on financial markets once central banks begin to sell assets. The IMF also sees the possibility of “political inference” should profits drop or diminish altogether during the tightening cycle. The IMF study comes as Fed officials debate the current $85 billion per month asset purchase program.

In the US the drumbeat to reduce the rate of bond purchases by the Federal Reserve grew louder Thursday, with a dovish voice joining the group. John Williams, the San Francisco Fed president, indicated the $85 billion per month of bond purchases can be reduced soon, and that the whole program may be halted this year. He pointed out the pace of job growth has picked up since the program was launched in September, with an average pace of job growth of 200,000 over the last six months. “Assuming my economic forecast holds true and various labor-market indicators continue to register appreciable improvement in coming months, we could reduce somewhat the pace of our securities purchases, perhaps as early as this summer. Then, if all goes as hoped, we could end the purchase program sometime late this year,” said Williams in a speech in Portland, Ore.

While Williams doesn’t have a vote this year on the Federal Open Market Committee, he joins other Federal Reserve officials this week calling for a slowdown in the program. But unlike Richard Fisher of the Dallas Fed and Charles Plosser of the Philadelphia Fed, Williams is decidedly in the so-called “dovish” camp. Williams made clear that even if the bond purchases slow down, they could be ramped backed up if the economy flounders. He went on to say that even when the Fed halts bond purchases it will still have trillions of dollars of Treasury and mortgage-backed securities (around $3.4 trillion to be precise) on its balance sheet, Williams pointed out.

It’s believed that Williams’s voice carries weight, as he is close in “intellectual framework” to Chairman Ben Bernanke and Vice Chairman Janet Yellen. It’s also worth noting that Williams gave little space to discussing inflation, and certainly did not express any sense of alarm about the recent decline in the inflation measures. Finally, this isn’t the first time Williams has mentioned the prospect of the Fed winding down bond purchases, but his comments were more explicit than before. In February, he had said bond purchases would be needed “well into the second half of the year” — which implies the purchases would be halted by the end of the year. Now he’s implying that they could begin the winding down process now.

So what exactly is the Fed trying to do? On Thursday I saw that the Empire State manufacturing survey fell into negative territory in May for the first time since January, this according to the New York Fed. The general conditions index fell to a negative 1.4 in May from positive 3.1 in April. The new-orders index also fell into negative territory, falling to negative 1.2 from positive 2.2 in April, as did the average employee work week, which fell to negative 1.1 from 5.7 in April. Then in a separate report the U.S. wholesale prices sank in April for the second straight month as the cost of gasoline and vegetables fell sharply. The producer-price index declined by a seasonally adjusted 0.7% to mark the biggest drop in more than three years, the Labor Department said Wednesday. Waning price pressures in April lowered the increase in wholesale costs over the past 12 months to 0.6% from 1.1% and that’s the lowest level since last summer.

So why does the Fed want to cut back when the economy is slowing? Perhaps it’s having a crisis of conscience as it comes to the realization that QE is in fact a failed policy? The Fed has blown its balance sheet up from US $600 billion to US $3.4 trillion and it seems that the law of diminishing returns is setting in. My concern runs even deeper as I fear the law of negative returns may be setting in!  That could also explain why the Fed is now engaging in the blame game, saying that a lack of fiscal policy on the part of the Congress limits the effect of the Fed’s monetary policy.

Lately there’s bee a lot of talk that Fed policy is responsible for reviving the housing market. On Thursday it was announced that privately owned housing starts in April were at a seasonally adjusted annual rate of 853,000. This is 16.5 percent below the revised March estimate of 1,021,000, and was quietly swept under the rug by the press. Here you can see the recent “recovery” and the dip at the end:

  

For those investors out there pinning their hopes on a housing revival, there is problem. These charts of the housing starts are a lagging indicator while the following chart of the price of lumber is a forward-looking indicator. If you look closely at this chart, you’ll see that the price turned up two months before housing started to improve, and you’ll see that it turned down almost three months ago:

 

Lumber is a primary ingredient in US housing and the sudden decline in price is more than a coincidence, it’s a warning.

There are other signs of change in the wind. The US dollar has been on the rise for several months as you can see here:

 

The US dollar is on the rise for a number of reasons. The Japanese, UK and Europeans are on a printing binge and the Chinese aren’t all that far behind. Europe now has six straight quarters of negative growth while China will be lucky to have 3% growth this year. India’s economy has stalled and Brazil isn’t any better so old habits, like a move into dollars, are hard to break. Perhaps more importantly the dollar smells and end to QE!

Another sign that we’re about to see a change in strategy is the continued decline in bond prices. As you’ll see here, bond prices have been declining for ten months:

 

Of course lower bond prices mean higher interest rates and that will also affect the housing market.Aside from that it means the cost of servicing US debt rises with the interest rate. If you look closely at the chart you’ll see a series of lower highs with price currently below both the 50-dma as well as the 200-dma, and the 50-dma has crossed under the 200-dma.

Another sign of problems in bond paradise involves the down turn in the very interest sensitive Utility Average Index:

 

Quite often a down turn in bonds will be preceded by a top and decline in the Utility Index. Here we see not only a decline but also a break below the bottom band of the trend line and a test of the 50-dma. Since bond prices have now begun a new leg down, I wouldn’t be surprised to see the Utility Index break below the 50-dma early this week.

Right now it’s hard enough to place bonds, and in spite of the Fed purchasing close to 70% of all emissions, we see bond prices falling and interest rates rising. Some months ago I concluded that the bond market is to be sold short and any attempt to exit QE will turn a decline into a crash. Nothing has changed as the Fed painted itself into a corner by establishing itself as the buyer of last resort, and now the Fed will go to its grave as the buyer of last resort. This Friday the June bond futures contract was down another 1.15 at 143.31, a new closing low for this move down. People don’t “get” that bond prices can fall even though the Fed continues to buy. Simply put they fall because supply overwhelms demand and that is a situation that will only worsen over time. That’s why I sell the bonds short for my clients. It’s simply one of the best investments they can make in 2013!

As far as bubbles are concerned if the Fed doesn’t have housing, all that’s left is the Dow. So far the Dow has not disappointed as it cranks out one new all-time closing high after the other. On Friday the Dow closed out the week up 121 points at 15,344, the seventh new all-time closing high out of the last eleven sessions:

 

You can see that the Dow has been in rally mode for six months, with no more than a four-day decline along the way. Aside from that we’re seeing new all-time highs in both the S & P 500 as well as the Transportation Index. As you can see in the following chart, the Transports arrived late to the party, but they’re there nonetheless:

 

Friday was no exception as the Transports closed up 81 points at 6,549, another new all-time closing high.

If you look under the surface there’s very little weakness to be found. The percentage of NYSE stocks holding above their 50-day moving averages remained impressive at 76.99% as you can see here:

 

If I were to post charts of the percentage of stocks trading above their respective 200-dma’s, or the NYSE High Low Index, you would see the same positive picture. Finally, if there’s been one consistency throughout the advance in the Dow, it’s the fact that absolutely no one is worried:

 

The current level of complacency matches what we saw heading into the October 2007 top and exceeds what we saw in March 2000 as the tech wreck unfolded. For those of you who think this time is different because the Fed supports the market, you would be wise to rethink your position. Finally, if you’re long the Dow I would use a tight stop at this point.

Now let’s move on to gold. In last Sunday’s report I said that “given everything that’s developed over the last couple of months, and in particular over the last four weeks, I see four possible outcomes”:

•    i.) May 10th’s dip was a fluke and the bottom is in and we’ll move up from here through the critical 1,522.00 area and eventually a lot higher, or

•    ii.) Gold continues lower on Monday or Tuesday to test good support at 1,402.90, a 50% retracement of the gains from the 1,321.50 low to the recent 1,487.20 high. We’ll hold the support and eventually start to rally up and through the resistance at 1,469.50 and keep grinding higher throughout the year, or

•    iii.) Gold will break below the 1,402.90 support and we’ll run down to retest the 1,321.50 April low. Gold will hold at or slightly above the April low and then begin a journey up to much higher levels.

•    iv.) The last case scenario is where gold falls down to 1,321.50, breaks below it and falls all the way down to 1,100.00 in a volatile, fast break (no more than two or three weeks, followed by a sharp recovery and an eventual move to much higher highs.

I then went on to say that “I believe we’ll more than likely see either the second or third scenario play out, and I would give either one the same chance of happening.” Given everything that’s happened this week we can now rule out the first and second scenario since spot gold closed out the week at 1,359.10.

While the primary trend in gold’s bull market remains intact it is important to understand that there are several factors contributing to lower gold prices right now, and they are cumulative:

•    The fact that everybody is printing and that supports the US dollar,

•    Real interest rates are negative or at zero so bonds and have no place to go but up,

•    There is a paper (futures) market for gold that allows the bullion banks to pressure the physical market for gold lower,

•    The Dow is recording new all-time highs every week so its an attractive alternative, and

•    There is a media blitz against gold.

This combination of events has gold heading lower for the moment and that benefits the central banks and smart money that want to buy cheaper gold. 

Like other analysts I thought that the bottom was already in and the strong support at 1,522.10 was impenetrable, and I was wrong. Making a mistake doesn’t bother because I treat it as a learning experience, but repeating the same mistake is inexcusable. So now when everybody rushes out to say that the April 16th low of 1,321.50 is the low, I’ll have to pass on that for the moment and here’s why:

 

This is a Point & Figure chart that I published back in early April and is the work of John Strebler. At that time gold was at 1,580 and many were looking for a breakout to the upside. I noted back then that a break below the critical 1,522 support would leave gold in a big vacuum with nothing really to support it until it hit 1,089. That’s why I took my clients short as soon as price dipped below 1,522.00 and didn’t cover until it hit 1,345. Furthermore I only covered because RSI on the weekly and monthly charts hit 15.00 and I had never seen that before, in gold or anything else other than Dutch tulips. As it turned out the plunge stopped at 1,321 almost one month ago, rallied up to the 1,468 resistance

 

marking a 50% retracement from the point where it turned down and then it stopped. More than a half dozen attempts to punch through that resistance failed. As I type the spot gold is back down at 1,359 and has traded as low as 1,350. That is well below both the 1,426 and 1,404 support levels I have mentioned in previously.

I know that some very intelligent people like Richard Russell believe the bottom is in, and I know that Jim Sinclair published a piece saying that we would see a secondary low in gold and silver between May 9th and 12th, but that didn’t turn out so well. That empty void I pointed out in Strebler’s Point & Figure chart is huge and it literally jumps out at you. Then I take into consideration that the Fed needs lower prices right now to support the dollar, eliminate alternatives to the Dow and maintain credibility, so I have my doubts. That’s why I’m short paper gold from 1,471, looking for a test of the April 16th bottom at 1,321 at the very least. 

In conclusion, I hope gold holds here but my experience is that hope only disappears right after the margin call arrives. Even if gold breaks down here I do look for a bottom in gold over the next couple of weeks and I am convinced a decline to 1,100, should it occur, will be swift and violent. I am also sure that we’ll be at the bottom for a few minutes, and the bounce that follows will also be quite strong as the desire for physical gold completely overwhelms the paper market. Finally, in the event that 1,321 holds here, and it’s possible, I’ll take in my short position and go long. In the mean time I have physical gold and silver that I’ve accumulated over the years that I never touch, and I have no doubt that it will come in handy once the wheels fall off of the fiat machine. In conclusion it really doesn’t matter which of the two remaining scenarios plays out because both end with a move to much higher (new all-time) highs, the only difference is the amount of pain we need to suffer in order to get to those new highs.

CONCLUSION

When Nixon was took the oath of office for the second time in January 1973, the seeds planted during the first four years were supposed to yield a lot of fruit. In stead scandal brought his administration down. The nation ground to a halt as America sat glued to its television sets to watch the impeachment hearings. Now President Obama may be headed down that same road with not one, but three scandals. The IRS scandal is the most serious, and the most likely to bring back a genuine whiff of Nixon who used the IRS as a weapon against his enemies.

In this case, IRS workers were filtering a wave of applications for tax-exempt status by political organizations during the run-up to the 2012 election - casting an unacceptable and possibly illegal eye towards whether they had the phrases like "Tea Party" or "Patriot" in their name. While none of the conservative applicants were ultimately denied tax-exempt status, the intrusive inquiries delayed their advocacy and cast a chill on the political process. After the scandal broke last week, President Obama denounced the actions as "outrageous" and fired the acting IRS director along with a top deputy.

We’re supposed to believe that hearings from an inept Congress will help determine how widespread this blatantly biased practice was, but the initial investigation report found no orders coming from outside the agency. Did they just decide to do this on their own? Not likely! New regulations need to be put in place to ensure this abuse cannot happen again while also ensuring that explosive growth of partisan groups pretending to be non-partisan non-profits is properly monitored.

The second scandal came when the Associated Press was told by the Justice Department that reporters' phone records had been secretly subpoenaed as part of an investigation into a leak concerning national security, most likely related to a story that compromised a field agent's identity. Some of the conversations tapped were in Congressional cloakrooms where politicians meet for informal reunions and had nothing to do with the investigation! All of a sudden privacy issues and concerns over the excesses of the Patriot Act became personal to the press corps and they reacted with understandable outrage in a series of brutal press conferences. On the surface, this new version of the old struggle between freedom and security might recall Nixon-era fights over the Pentagon Papers. But the ugliness of this particular inquiry is really a reminder of how far technology has outpaced our laws, putting privacy under assault for individuals and the press.

Finally, there is the continuing inquiry into the killing of four Americans in Benghazi. After damning congressional testimony from former deputy chief Libya diplomat Greg Hicks, the White House belatedly released a barrage of emails - which showed that the editing of the now-infamous "talking points" used by officials in television interviews was largely the product of a bureaucratic turf war between the CIA and the State Department. Only now is the White House forthcoming with some documents related to this scandal.

All of this comes at a time when both the White House and Congress should be focusing their attention on a slowing economy, high unemployment and massive debt. Instead we’ll be watching Congressional hearings run by the same political hacks we’ve been watching for twenty years, anxious to win brownie points with the public. Maybe even laying the groundwork for a run at the White House! The only thing you can be certain about is that they don’t have the public’s best interest at heart.

These scandals will surely occupy the news for the weeks and months to come, meaning that nothing will be done about the debt ceiling and deficits that face us here and now. What nobody seems to get is that these scandals are just part and parcel of a continual erosion of the rights of Americans. Much like the movie Wag The Dog a lot of this is a concerted effort to keep Americans from focusing on what matters. In the end nothing will be resolved and the inquiries will fade in September as football season heats up. Once the Super Bowl is played, they’ll have to come up with something else… maybe a good war!