Gold: False Signals & Rays of Hope

In the last 18 to 24 months, two key "False GO Signals" lifted the gold price from its low in 2003 of $320 per ounce to its recent high of $455 in December 2004. The markets finally figured it out though, and the gold price has languished. In the recent history, certain signals were highly reliable for a powerful rise in the gold price. However, in the age of Chinese renaissance the signals might not be so reliable anymore. Few in the gold community seem to have identified either signal as anything but a major bullish indication for much higher gold prices and strong continuation of its bull market, even after several failed gold rallies. This here analyst does not share such a view, and my analysis has elaborated in much detail as to why much of the banking system's inflationary machinery has been operating in a reverse gear, in quiet subtle support of the secular deflation underway. Even Greenspan acknowledged this week how the bond conundrum might be answered by globalization and the unleash of cheap Asian labor. Most new money goes to dreaded new debt, unproductive dead end destinations to be sure. The fundamental force behind the false GO signals is Chinese industrialization, and their interference with the US Federal Reserve reflation initiative.

The two signals, which to date have not succeeded in generating systemic price inflation inside the US Economy are:

1. fast rising USDollar money supply growth
2. negative short-term real interest rates

The key is whether the US Economy is a CLOSED SYSTEM. By any reasonable rational open- eyed definition and assessment made by a person with a pulse, the US Economy is a highly open system, replete with one-way global trade, massive outsourcing to both China and India, and staggering trade deficits to prove it with almost every single nation on earth. Closed system? Get serious. Don't insult my intelligence. Let's examine why each signal is false. Finally, rays of hope are offered on changes to the signals themselves, and how they might finally turn positive. Don't be too heartened and warmed. The rays of hope owe mainly to increasing strain with China politically (possible trade war), and strain internal to China on profit prospects (stagnant profits).

LACK OF PARALLEL STILL IN PLACE

In my earlier article "Lack of Parallel with 1970 Decade" an argument was made that passing along higher costs, while China pours exports into our back yard, is next to impossible. While China blocks the "cost push" on the manufacturing side, India interferes effectively on the service side. This much is clear. Unlike decades ago, the United States now has massive trade gaps financed by consumer debt for the purpose of buying foreign worker output. What used to be an "alarming" $100 billion trade gap is now a "no big deal" $600 billion gap. Consumption used to be tame and unremarkable. Now retail sales and omnipresent spending make up the central pillars of the US Economy, a sure signal of trouble. Debt service has become an indication of total economic suffocation, as almost 78% of all transactional flow for goods & services is devoted to payment of principal and interest.

The North American Free Trade Agreement brought the offshore manufacturing movement to our continent in 1994. NAFTA lowered costs for participating corporations, and developed free trade zones in Mexico (since shuttered as workshops went to China). The 1999 Most Favored Nation status was granted to China, surrounded by controversy and strident objection by the AFL/CIO. Global trade would never be the same again. Worse still, with the aid of technological advances in broadband transmission, computer networking, and fiberoptic connectivity, the service sector was laid vulnerable to outsourcing of knowledge output. That trend is accelerating. On the domestic front, the prevalence of "Big Box Superstores" has changed the retail front. Supplied largely by Asian goods, they reinforce the trade gap and abandonment of US workers. New jobs are of shabby quality, but in the eyes of the Bureau of Labor Statistics, a job is a job!!! The end result of all these undeniable changes has been the profound engrained structural absence of pricing power and wage pressure.

The gold community must come to grips with its mediocre analysis as far as inflation is concerned. If the standard key signals for a gold bull market have failed to lift the gold price, then one must ask what went wrong. Too much blame is placed on the gold cartel. If the signals were valid, the gold cartel would have been steamrolled long ago. Perhaps the key signals are just premature on that long awaited gold price explosion. Perhaps. China must be subdued. Its blockage of the customary inflationary machinery outcomes must be removed. With the large powerful Chinese arm, the gear shift is firmly in reverse for the US powerful inflationary engines. That strong Chinese arm must be removed, so that a forward gear is engaged.

MONEY SUPPLY GROWTH

The wider M3 money supply has grown from $7.3 trillion at the start of 2001 to $9.6 trillion through March 2005. "That is a lot of chicken!!!" Just where did it go? Did the USA use it constructively? NO. Did we build something advantageous with it? NO. Did we waste it? YES. Did we gamble it away? YES. Did we blow it like a drunken sailor on shore leave? YES. Did we buy trinkets, gadgets, and junk with it? YES. Did we try to keep up with the Joneses in lifestyle and designer clothes? YES. Did we buy into the moronic notion that US consumers should power the world economy in yet another sick New Paradigm? YES. Is it any wonder that all this occurred when Viagra sales shot through the roof? NO. Is it any wonder that all this occurred when piggish Sport Utility Vehicle sales shot through the roof? NO. Is it any wonder that all this occurred when obesity blossomed across our land? NO. Is it any wonder that all this occurred when the illiteracy rate rose across our land? NO.

Newly minted crisp money simply does not come easy into gold in order to push a major bull market. Not yet. In 2002 and 2003 and 2004, the process was a snap to flow into gold and miner stocks, the annual spring swoon corrections notwithstanding. The unspoken foundation premise behind the flow into gold from fresh funds was the expectation of systemic price inflation, since that was the stated objective of the US Federal Reserve. They publicly stated intentions to inflate the debts away, to reflate, to generate inflation throughout the economic system. We have witnessed the exact opposite, more debts, puny wage gains, and little inflation except in costs.

The implied assumption was that, just like in the famed 1970 decade, a virtuous cycle of higher supply costs (for energy) would be passed along to customers. Households and businesses could afford to pay the higher prices. Worker wages would rise in lockstep. Companies would receive more for their products, as profits rose. It was a relatively easy process on the drawing board, once it got started, which required a three-year wait. Almost no factor from that 1970 decade is similar today across numerous categories. We have price inflation nowadays, but in checked fashion. Most notably, it is sorely missing in jobs and wages, the biggest failure zone.

From 2002 to 2004, China and India interfered with the reflation initiative on a truly MASSIVE basis. The evidence is lackluster job growth inside the United States (with porous boundaries) which has barely kept up with population growth yet is called robust by politicians. The evidence is a truly MASSIVE trade deficit with Asia.

Where did all the easy money go? We are tired of hearing it, but we must. It went into broad consumption of retail stuff. It went into new cars. It went into new and ever larger houses and second homes. It went into house appliances, expensive home electronics, and luxuries. It went into sustenance of a ripe lifestyle. Almost nothing of these unproductive destinations is a constructive avenue to generate rising wages for US citizens. Unfortunately, the USFed stimulated Asian economic growth, truly MASSIVE Asian industrial base building, Asian job hiring, Asian wage growth. This Fed Reflation initiative will go down in history as the most wasteful, most unproductive, most destructive, most counter-productive in US history. It has built up China first as a supplier and partner, second as an emerging competitor, ultimately our next formidable geopolitical adversary.

NEGATIVE REAL INTEREST RATES The argument goes like this. If short-term interest rates cannot keep pace with price inflation, then an investor in the 3-month Treasury Bill yield falls behind on a practical basis, even moves backwards. One is better off investing in gold, the ancient store of ultimate value. With the Fed Funds rate held fixed at 1% for 18 months, the path for gold was laid out in plain fashion. The Consumer Price Inflation, although suppressed by telltale tricky techniques, rose at a tame 2% to 3% for all those months, well above the yield of 1% of bond. Negative real rates were the original foundation for the gold bull market. However, something went awry. The foundation shifted. The foundation was subjected to the powerful erosion of global trade with China.

In the shadow of this unstable foundation of sand, the USFed encouraged the only price inflation possible within our shores, namely in financial instruments, our aberrant strong suit. Since 1980, our manufacturing base has been abandoned, discarded, dismantled, and permitted to rot and waste while US firms eagerly invested in Asia. Great advantages existed in Asia, so WHY NOT? Lower labor costs, lower taxes, lower regulation, lower payroll mandates, and so on ad nauseum.

So the USFed accomplished asset inflation from the last remnant bulkhead remaining in the US Economy, the financial sector. Can you say BONDS? The Treasury bond bull has given steroids, after already having taken long-term rates from the mid-teens in 1980 to 6% in 2000. Mortgage backed securities followed suit. In response, stocks rose due to the screwball sham known as the Fed Valuation Model, which calls for price/earning ratios to rise inversely to long-dated bond yields. In response, housing prices rose. This is the ballyhooed Asset Economy financed by Asian credit in boasted flexibility. Put this Economics Chapter in a textbook Appendix whose leading description begins with insanity, desperation, deception, heresy, disinformation, and propaganda.

The outcome is rather tragic trade deficits and the hemorrhage of current account deficits. In a stark example of Orwellian language distortion which would impress even George Orwell, our bloodletting is described by both the Federal Reserve officials and Wall Street leaders as a sign of strength. If that is strength, then a prone cadaver drained of blood is vibrant and fully prepared to sprint.

RAYS OF HOPE, TROUBLE WITH CHINA

The gold price is like the speedometer on a souped-up turbocharged Ferrari race car. In the first 18 months on the track, the first gear which powered the sleek race car was clearly the euro currency. A 35% rise in the euro versus the USDollar gave lift to gold, pushing it from $265 lows to $430 in the winter of 2003 and $455 in the winter of 2004. THE SECOND GEAR MUST NEXT OFFER GOLD ITS POWER FROM THE ASIAN CURRENCIES. TO DATE, THE FOREX CLUTCH HAS SLIPPED, AND INTERFERES WITH SMOOTH MOVEMENT TO THE SECOND GOLD GEAR. The next move is from China, whose leaders are under pressure the world over. Their labor costs advantage is monumental, between 10 and 30 times that of the US labor, depending upon whether skilled or unskilled.

Beijing leaders insist on the maintenance of a rigid yuan peg regime, fixed at 8.3 Chinese yuan to the USDollar. Unless and until the Asian currencies realize a fully justified considerable rise, gold will continue to struggle. Like with a car whose clutch cannot find the next gear, aggravated by the shrill sound of grinded gears, speeds stutter, and the car slows down. Gold will find its next gear and make great strides in price. However, to conclude that it did so easily in the 1970 decade and therefore will again, such is evidence of shallow economic analysis. Almost every conceivable factor worked in its favor back then, and now many powerful factors work to provide a stiff headwind of resistance.

Next up is resolution of imbalance by means of currency adjustment. If it proceeds in orderly fashion, the Chinese yuan currency will be reset to something besides the tight tether ratio to the USDollar. If reallocation of their $620 billion of foreign reserves by the Peoples Bank of China is any indication, the new pegged regime is likely to be a fixed basket of the euro, the yen, gold, and the USDollar. Look for all of Asia to follow suit in what could develop into a rout of the USDollar even if it begins in orderly fashion. If the process breaks down, with trade tariffs and other assorted protectionist levies and obstacles, followed by retaliation, then expect disruption and perhaps chaos. The trouble is, with such extreme imbalances, the hidden forces are an order of magnitude greater than the seeming calm foretells. Even a constructive start could degrade into rampant disorder over time.

Gold will absolutely love the changes, whether orderly or disruptive. The change will permit higher Asian import prices, greater pricing power, puffed profit margins, and likely even a wave of hiring or at least wage gains. The loser might be US Treasury Bonds, since consumer prices will show up as on the rise, led by import prices. Could we be seeing an engineered USTBond rally as a preface for exactly this development? Methinks YES. These and many other related topics and difficult issues are discussed in detail in my HAT TRICK LETTER. The outcome is unclear, but the changes are certain. The rays of hope for the gold community are wrapped tight around the Asian currency becoming released and unlocked. The golden race car requires a shift into the next FOREX gear for renewed acceleration of a higher quality price inflation. Gold demands it, and will almost certainly see it, regardless of how the process begins. The important requirement is that it begin. Depending upon the level of cooperation, maturity, and wisdom, order will rise or fall, be maintained or deteriorate. Get me my ringside seat.

Oh yes, by the way. Almost nothing has been accomplished to rectify imbalances inside the US Economy during the three years of USDollar devaluation. Import growth has greatly exceeded export growth. The USDollar has recently risen, not from economic strength, but from a queer combination of favorable interest rate differential with Europe, and faltering imports to the USA. As the USFed continues its rate hikes, it applies stress to the US Economy even while encouraging bond speculation in the euro carry trade. That chapter is coming to an end soon, if not already. The lion share of the narrower trade gap came from reduced imports, which in April fell 2.5% even as exports gained 1.5% from a much lower base. Could we be seeing an engineered USDollar rally as a preface for a resumed bear market and Chinese currency adjustment? Methinks YES. Could backroom deals have been cut with the stubborn Chinese in order to convince them to budge? Methinks YES. These and many other related topics and difficult issues are discussed in detail in my private newsletter. Get me my ringside seat.

THE SIMPLEST SIGNAL FOR RESUMPTION OF THE GOLD BULL MARKET IS FOR THE 10-YR TREASURY NOTE YIELD (TNX) MOVING ABOVE 4.0% AS BONDS COMPETE WITH GOLD IN A STABLE STORE OF VALUE. The TNX moved well below 4.0% last week and remains below it still. Its upward move will accurately signal trouble with China and an actual currency adjustment, which will release price inflation finally inside the distorted, dependent, and debilitated US Economy.

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.