Bond Yields and Markets

In 35 years of watching markets I have never seen anything quite like the three charts that follow:

• The daily yield oscillator looks like it may be bottoming out
• The weekly yield oscillator is giving a sell signal
• The monthly yield oscillator is giving a buy signal

Of course, in this case, "buy" is bearish and "sell" is bullish

(Charts courtesy decisionpoint.com)

A few months ago, I made a wrong bullish call on silver. The call was based on the daily charts which were showing gaps on the upside. One week later, I looked at the same daily charts to discover that the gaps were no longer visible. The historical information on the charts had been doctored - implying that the information as it was filtering through in real time was incorrect. It took me a few weeks of fairly deep contemplation to arrive at the conclusion that the daily charts in general are no longer trustworthy. That does not make me feel any better about my mistake, but the hard part was over for me. I was able to admit to myself that I was wrong. My mind has since shifted to accommodate that fact and fortunately I did not lose any money in the process.

Right now, my view is that there are too many people trading the markets to allow for historical patterns to manifest in an "objective" sense on the daily/short term charts. I am also concerned about the integrity of the day-to-day information - particularly if it's freely available and its suppliers are relying on advertising revenue to earn a buck from their web sites.

For me personally, the weekly and monthly charts are now what guide my thinking.

From a macro perspective - and taking an ultra high level view - it seems to me that "oil" is the key. My own models show that the rise in oil from $45 a barrel to $75 a barrel will translate into a cumulative world-wide upward (inflationary) price adjustment of 18% provided the US Dollar holds up. If the US Dollar Index falls below 80, my expectation is that the US economy will tank because inflation inside the US economy will become unmanageable.

The bottom line therefore is that the Central Banks cannot allow the US economy to tank because it is still the ultimate driver of the World Economy. To argue that "China" or "Russia" or a combination thereof will become the epicenter of the world economy is, in my view, a bit premature. The US economy accounts for 25% of the total world economy, whilst the Chinese economy - notwithstanding its highly impressive growth, probably only accounts for 4%-5% of the total. Who knows what Russia's numbers are? Maybe 1%-2%? My kitchen table common sense tells me that 6% of the world economy cannot drive the other 94%. If the US tanks, the whole show is over; and I therefore anticipate that the Central Banks will lie and cheat and steal and connive and obfuscate and do whatever else they have to do to prevent the US Dollar Index from falling below 80. That puts a floor under interest rates.

To me, a "best case" scenario is markets trading sideways for a decade or two. Values aren't there. Will the bond yields fall from here as Mr Bill Gross expects? Who am I to argue with a man of this stature? But if my oil model is correct and we move into an era of (say) 6% p.a. inflation to compensate for the rise in price in oil, then unless interest rates rise, there will be a net destruction of wealth. Yes, he may be right, but it may be a hollow victory.

As I see it, there is only one way that interest rates will not rise to compensate for inflation - AND for us to avoid deflation - and that is if the oil price falls from here AND if the velocity of money holds up.

Let's first look at deflation and get our terms right. Deflation, as I understand it, is a contraction in the available money supply. This would only happen - uncontrollably - if there was a debt implosion. In the old days, banks called in their debts. Nowadays they tend to reschedule where they can. This being the case, the issue is likely to be more related to a slowing down in the velocity of money, as opposed to deflation. If that happens then, yes, I can see a fall in interest rates as demand for money wanes and the economy slowly and - painfully - unwinds. If velocity of money slows too dramatically, we could have markets trending southwards and maybe even collapsing given that they are overvalued.

So the enemy of the Central Banks is not "deflation" as such. It is a slowing of the velocity of money.

How can they combat this? The short answer is: "I have no idea". To me this is an insoluble problem because it flows from consumers "feeling" bad about the future. It is purely subjective in nature. It is not manageable by any external force. By definition, it is an endogenous variable - endogenous to the individual consumer. People just turn conservative, and there's sweet Fanny Adams that the Central Banks can do about that if it should happen.

To me, the "key" is not so much the property markets - which are doubtlessly critically important. It is the oil price. Oil is king, and it has been for a hundred years. But the king may be getting a bit long in the tooth. The crown may be getting a bit tarnished.

The following weekly crudollar chart is important:

It shows that the rising wedge may have already been penetrated on the downside; and the next chart shows that the oil fund chart is looking toppy. These do not look to me like charts that want to go higher.

So, the $64,000 question is:

Will oil's fall be good news or bad news? Will it represent the beginning of a shift of the world economy's dependence away from oil (bullish) or a slowing down in the velocity of money (bearish)?

The chickens may be coming home to roost. I made the observation some years ago that the US's failure to sign the Kyoto Protocols may have been the most serious error of judgment in human history - not because it flew in the face of the "Greenies" but because it artificially derailed the march to market of alternative energy technologies. The oil lobby got so powerful that it may have dug its own grave as well as that of the economy as a whole. Seriously stupid decisions were taken; and that's what one can expect when the politicians lose their integrity. $100 oil? My models tell me that this will rupture the world economy. It is not "physically" possible to sustain such a price without something else going seriously wrong.

Frankly, I believe that we will be better off with inflation and rising yields, but my fear is that even at $75 the oil price may have already risen too high. Something may have already snapped. Certainly, the vested interests of the oil companies and the banks has been behaving counterproductively. One only has to look at their profits to come to that conclusion. Poor old Joe Sixpack has been taken to the cleaners, and will probably suffer for years to come - stuck with a mortgage that he can't afford to pay down, and a car that he can't afford to run.

From a personal perspective, I will be watching the chart below - which is the ratio of gold to the oil index. If the Blue Line is penetrated on the downside, I will be converting to cash (fiat money) - because its will be a sign that deflation is coming - and Mr Gross is right. There is an argument that gold is the ultimate cash. That argument may well be correct, but I am not prepared to bet the farm on it. To me cash is all about "liquidity", and I'm not sure how liquid gold will be. When times are tough you want to be flexible. You do not want to get caught in a thin market where you can't get out - where only the rich can afford to buy what you have to sell.

If the blue line holds, and gold stays in a bull market relative to the oil index, then I am afraid that those who hold Government Bonds may come to wish that they did not. Under those circumstances, you really do want to own gold.

Therein lies the real conundrum

I don't consider myself to be smart enough to outsmart the markets. Right now, I don't see how anyone can make the call. It's just too hard. But in the end analysis, common sense is all that we have going for us. And my common sense tells me that we need to remain flexible. We need to be liquid. Cash rich and asset poor is probably what most people today are not. If history is any guide, that's the Achilles heel; and markets love to go for the Achilles heel.

I think the days of the cheerleaders sitting on the stands are behind us. Its time to get down and dirty and play the game; or go home.

But, objectively, it's not yet time to think of selling gold. The chart below is certainly not yet looking bearish