Inflation or "Control"?

Summary

The article below concludes that the world's financial markets have reached a critically important juncture.

We appear to be facing a situation where the World's Central Bankers are either going to lose ultimate control over the World Economy or retain it.

Loss of control will be symptomatically manifested by rapidly increasing commodity prices, and a probable concomitant explosion in Precious Metal prices. On the other hand, retention of control will be manifested by commodity prices (including gold) pulling back from these levels, even as interest rates start to firm, and the US Dollar stabilises.

Unfortunately, no one (not even the Central Bankers) will be able to make that particular call with any degree of confidence, and the markets will do what they must.

We will need to await the markets' "final" vote before we can take any sensible investment decisions.

This article attempts to highlight to analysts what variables they should be monitoring.

The chart of the 30 year bond yield below (courtesy stockcharts.com) is giving off some warning signals:

• It has bounced up strongly from its 40 week Moving Average line
• The November 2005 high in the MACD oscillator is higher than the April 2005 high - evidencing a bullish non confirmation relative to the yield itself, and pointing to the possibility that the 30 year yield could rise from here
• The green histogram lines below the zero line on the MACD are contracting and may soon give a buy signal - which might be accompanied by a rise in the weekly chart of the 30 year yield above its 15 week Moving Average

There has recently been serious focus by some commentators on the potential for a so-called "inverted yield curve" - where the "time-value" of money is negated by the fact that the shorter dated yields are higher than longer date yields. Such an occurrence would have extremely bearish connotations because it would be pointing to a "deflationary" scenario ahead, and all that that would imply. In such a case the time value of money would become inverted.

The relative strength chart below - which shows the ratio of the 30 year yield and the 10 year yield - is showing a pattern to which I have referred before, viz a potentially bullish "falling wedge"

It is also showing an MACD oscillator which has been slowly rising from its bottom in April 2005.

When looked at from a different perspective, the 3% X 3 box reversal of this same relative strength chart seems to have reached its downside target based on the horizontal count technique.

We can conclude from these two charts that yields have now bottomed and may very well start to rise structurally from this point.

Ultimately, the most logical reason for a structural rise in yields would likely be an attempt on the part of the US Fed (aided and abetted by the other major Central Banks of the world) to protect the US Dollar. The US Dollar Index gave a sell signal a few days ago, and is looking somewhat vulnerable. Conceptually, it could go all the way back to 80 on the index chart if the 84.76 level on the chart below is penetrated on the downside, and might even penetrate below the 80 level in the fullness of time if the World's Central Banks do not move with conviction to protect it.

Another fundamental argument in favour of rising interest rates could be inflation, but here we need to be very precise in our logic.

"Inflation" refers to a ballooning of the money supply which, in turn, is typically followed by price inflation as too much money chases too few goods.

In the current economic environment, there is a surplus of manufactured goods, and so "price inflation" has been confined to commodities and other assets that have less supply elasticity - ie Supply does not flex as easily.

"Asset Price Inflation" has been with us for some time now - as the Fed has been stoking the money supply - and this Asset Price Inflation has been manifesting in rising prices of equities, real estate and bonds. Frankly, there are now too many people who believe that they can earn a living by doing nothing other than buying and selling pieces of "title" paper, and this is potentially extremely dangerous to the continuing health of the world economy.

A point has now been reached where the Central Bankers may be facing a situation where they lose control of the situation.

The chart of the $CRB index (courtesy DecisionPoint.com) is showing that commodities have been in a steep bull market for some time now.

Students of technical analysis will be fascinated by the Commodidollar index above which shows that in 1985, a breakaway gap occurred on the downside at precisely the current level - ie The gap is only now approaching a level - some 20 years after the event - where the gap may be covered in the near future

To emphasise the importance of this level - and to demonstrate that it is not just a figment of this analysts overheated imagination, the following chart focuses specifically on the level of the breakaway gap:

The horizontal dotted line shows that the commodidollar index is sitting at precisely the level where the gap manifested, and that the gap has not yet been covered.

But resistance to further upside movement of the index is also represented by the upper boundary of another trendline that has been drawn in. Note that the index is currently resting precisely at/below the point of intersection of these two lines.

Why have I drawn that particular trendline and no other? For the simple reason that this particular trendline has the highest number of points of contact, and the more points of contact, the more significant is the trendline.

Using this same logic of attempting to draw trendlines with as many points of intersection as possible, there is yet another trendline that can be drawn - trendline number 3 in the chart below:

Note how this particular trendline intersects with the other two at precisely the same point - again!!

It follows that the level of 3028 on the chart above is highly significant but, unfortunately, we will have to wait for the market to vote regarding whether this resistance level is to be overcome (and the 20 year old gap finally closed) or not.

It is important for the reader to get his/her head around a simple concept: Regardless of what technical analysts may or may not believe, the hard fact is that charting has no objectively defensible forecasting capabilities. One can use technical analysis to try to understand what is causing the current chart patterns and/or how important the patterns may be, and one can "speculate" or "guess" as to what is causing these patterns, but one cannot draw the conclusion that "therefore, such and such is going to happen". That is not what charting is about.

With technical analysis one has to wait until after the market has given its signal before one can draw any conclusions.

In this case, if the price of the commodidollar index rises to a level which is sufficient to close the gap that manifested over 20 years ago then it will, by definition, need to penetrate all three trendlines on the upside. If this happens, then we can say with virtual certainty that the market has entered a new era; and in this case, the era is likely to be one that is accompanied by rapidly rising commodity prices.

But rapidly rising commodity prices will not occur in a vacuum - because the "driver" of these rapidly rising prices will be too much money chasing too few assets. Other assets will likely also rise in price as denominated in US$ - in particular Precious Metals.

The following Point and Figure Chart is also demonstrating (from a different perspective) that the world's financial markets have reached a point of decision.

It reflects the fact that the ratio of the gold price to the commodities index has reached a "triple top" - which level represents significant resistance to further upside movement.

Objectively, what the above chart is showing - AS A MATTER OF INDISPUTABLE FACT - is that, regardless of any/all commentator's opinions to the contrary, gold has been behaving within the confines of the overall commodity set. i.e. Until the triple top is penetrated on the upside, gold cannot be argued to be anything other than a commodity.

Yes, we might have opinions and make "guesses" as to whether gold will emerge as the ultimate currency, but this has not yet happened and, more importantly, MAY NEVER HAPPEN.

By contrast, if the triple top is in fact penetrated on the upside, THEN it can be argued that gold may be emerging as the currency of last resort, but the reader is invited to contemplate the possible consequence of such a break-out.

• A strong rise in Commodity Prices
• A gold price that rises relatively faster than commodity prices in general - quite possibly an upward explosion in the gold price
• An eventual loss of confidence in the globalized world's major currency, the US Dollar
• An upward explosion of interest rates within the US, as foreign capital is pulled out of the USA
• An initial upward explosion in US equity prices as the markets start to panic regarding inflation, followed by a likely collapse in equity prices as interest rates start to rise to protect the dollar.
• A continuing upward explosion in real estate prices as surplus liquidity is mopped up, followed by a collapse as interest rates start to rise in earnest.
• Deflation and depression on a world-wide basis, as the debt mountain implodes.

On the other hand, if the Central Bankers do manage to retain control, what is likely to happen is as follows:

• A modest rise in interest rates calculated to prevent the US Dollar from falling further
• The US Dollar Index stabilises above the 80 level and preferably above the 85 level.
• Calmness starts to descend on the markets and the overbought gold price starts to pull back at a faster pace than the commodity prices - and gold once again entrenches itself as nothing other than a commodity
• Equity markets pull back modestly (Dow to the 9,000 - 10,000 level) and enter a trading range which remains for several years
• Crisis is averted.

No sane person could possibly be "hoping" that the former scenario manifests over the latter but, unfortunately, hope is merely a function of emotion. In the end analysis, the markets will vote.

This analyst is now focussing on the fact that the markets seem currently (tentatively) predisposed to vote in favour of a loss of control by the Central Banks.

The above Point and Figure Chart (3% X 3 box reversal) is showing a triple top that has not yet broken out.

But the following P&F chart is much more sensitive and shows a 1 point X 3 box reversal.

What this chart is showing is that a breakout on the upside may have already occurred!

However, there is still hope that matters will not spiral out of control. The breakout - based on a horizontal count technique - is targeting a move to 166, and 166 will not represent a buy signal on the less sensitive chart above.

Can we draw any conclusions from the gold chart itself?

This chart shows a significantly overbought "trading" position - as evidenced by the position of the PMO oscillator - and a price target of $560/ounce (as indicated by the measuring implications of the runaways gaps) that has been met.

If the Central Bankers are going to retain control over the World's Economy, I would expect to see the following manifest over the next week or two:

• A continuing (modest) rise in bond yields
• A stabilization of the US$
• A sharp pull back of the Gold Price
• A (less sharp) pull back in commodity prices, probably led by oil, as can be seen from the following chart, and an eventual closing of the gap at $61.50/barrel

Overall Conclusion

Speculation aside, a gold price that rises strongly in the near term from its current levels will have very serious implications, and will likely evidence a world economy that is starting to spiral out of the control of the Central Bankers. The consequences of this are likely to be extremely grave, if not catastrophic.

By contrast, if the Central Bankers manage in the next week to reassert control, the gold price is likely to pull back strongly from its current level in the very near term.

There is no way that anyone can make this call with any degree of confidence.

Author's note:

Ultimately, although not discussed in this analysis, but discussed ad nauseam in other of my essays, the issue will revolve around the integrity of our political leaders. Common sense dictates that if a snake is threatening to bite you, the appropriate response is to cut off the snake's head. It is not a reasonable or rational response to seek to start a forest fire that kills everything within a hundred miles.

The preposterous attempts on the part of our political leaders to tar up to a sixth of the world's population with the broad brush of "terrorism" is hugely counterproductive, and disrespectfully insulting to the intelligence of any thinking person.

"Fear" is not a sensible way to motivate acceptance by the broader community of highly questionable decisions by our political leaders. By contrast, "hope" is a much more sensible approach. What the world needs now is a positive vision of the future, and a plan of action to realise this vision with integrity and dignity.