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Steepening US Treasury Yield Curve to Ignite Gold - Stagflation Around the Corner

Commodities / Gold & Silver Sep 26, 2007 - 03:10 PM GMT

By: Jim_Willie_CB

Commodities Best Financial Markets Analysis ArticleThe face of all the world has changed, since first I heard the footsteps of your official rate cut. Sorry, borrowed a front line from a Robert Browning love poem, who wrote about ‘footsteps of your soul' to Elizabeth Barrett. On September 18th, notes were taken on a host of prices immediately before the US Federal Reserve executed its cut of 50 basis points in both the Fed Funds target and the discount rate. The reaction in the entire price structures for the financial markets generally has been profound in only one week. Stocks are up. Foreign currencies are up. Oil and natural gas are flat but now down a little. Gold and silver up, along with their precious metals mining stocks. However, the anomaly sticks out like a sore bruised discolored thumb.


The USTreasury Bond yield curve has steepened. The long-term bond yield has risen 10 to15 basis points to the 4.65% vicinity in defiance. The short-term bond yield has fallen about 10 basis points, thus causing the spread to widen by 10 to 25 basis points. This is significant. The 2-10 spread on USTreasury yield spread has risen to more than 60 basis points wide. This is significant. Thank the Lord that the moronic statements coming out of the US Federal Reserve have ceased and desisted on ‘inflation expectations' as a key to policy determination. How about avoidance of galloping economic recession, accelerating downslide in housing prices, unabated foreclosures, and the onset of credit derivative blowups??? They must deal with insolvency challenges as much as illiquidity issues. Insolvency is not fixable without huge capitulation, liquidation, and resolutions, complete with plowing under, all of which are steadfastly avoided. A nightmare comes!

FIRST, THE KNEEJERK REACTIONS

The stock market reacted in expected fashion. The Dow Jones Industrial Index and S&P500 stock index each have enjoyed a lift, the DJIA by about 2.5% and the SPX by almost 3.0% in the last week. Of course, the stock indexes are simply discounting a weaker USDollar, hardly worth the hollow hoopla by media wonks. The currency markets reacted in expected fashion. The euro lifted from the mid to upper 138 level above 141 in the last week, a true breakout, and might have stalled here. The Euro Central Bank might soon kick the USFed shins with their next and possibly last rate hike next month, which could trigger another final leg up in the euro. The British pound sterling lifted from 200 flat to above 201, in what might be regarded as a tepid move.

England has big problems with early signs of a bank run (see Northern Rock). Nonetheless, England has placed itself in monetary quicksand by essentially guaranteeing bank assets. Memories are spurred of the George Soros successful challenge against the Bank of England, resulting in billion$ in profits. The Japanese yen has done nothing, affixed with an 86 handle. My favorite darling Canadian Dollar leaped from the upper 97 cent range past 100 parity, enough to grab some significant headlines.

The USDollar DX index has remained below the key 79 level for almost a full week. My take is that foreigners continue to sell it, while the US ministries buy it with printing press phony money. The implications to higher systemic USEconomic costs are total and complete. Price inflation is locked into the next chapter. In no example of past history has the USDollar fallen a quantum level without a surge in cost inflation. Some call it price inflation. Not me! When wages do not rise in coordination, then the system does not experience price inflation in a general sense. The US$ decline ushers in higher costs for energy, food, materials, metals, and all imported product prices which comprise 16% of the USEconomy. Rising costs without pricing power (even in wages) results in squeezed profit margins and economic slowdown. The USFed will surely fight it with easy money.

ENERGY PRICES GIVE TWO SIGNALS

The crude oil price turned down at the 82 mark. In my view, a geopolitical message is hidden, murky, but decipherable in a preface. Then two clear signals can be detected. The energy market is digesting the prospects of a wider war with Iran . Three profoundly powerful geopolitical forces might interfere with yet another mindless decision to strain the imperial war machine over-reach. Russia has put its weight behind Iran, as a partner on grand energy projects, military weapon shipments, nuclear technology export, and cooperative efforts to sell oil in non-US$ denomination. China has put its weight behind Iran , as a partner on grand energy projects also. If Iran is attacked by US Military forces, or by allied MidEast forces, or by a group employing fresh paint in false markings, Russia and China might engage in temporary embargo actions against the United States , even actions joined by Venezuela . The third factor at work stands clearly as superior Sunburn missiles pointed at US warships in the Persian Gulf , likely to destroy at least one aircraft carrier. Such a loss would be a huge black eye not desired.

Two clear signals can be identified on the crude oil price front. First, the oil price shot up by 20% in less than two months, a loud gong signal that the USDollar was in danger of an imminent decline. We saw it. Hidden within this signal is the emerging threat of a broader weakening of the PetroDollar defacto standard. Saudi Arabia , Kuwait , and the UAE are each fully engaged in a movement with the Gulf Cooperative Council directed toward abandonment of the US $ peg. The brief pullback in the oil price from 82 to 79 could be only a technical retrenchment before yet higher breakout prices. The energy market without any doubt stands as the most interfered with, the most inefficiently run, and the most easily disrupted in the entire world. Crazy leaders impose their imprints with socialist policy. Brigands raid facilities. Poor investment hampers future supply, when the future appears to have arrived. USDollar supporters use it to finagle vaporous support.

The second signal is that a USEconomic recession is gaining credibility, sure to put downward pressure on the oil price. Well, if you rely on accurate statistics, remove silly gimmicks, and dish reality on a cold plate, the recession has been here for some time, with perhaps only one or two quarters out of negative growth since 2001. Deception, distortion, and doctored statistics go hand in hand in reporting economic performance, with fraud and mispricing and false ratings and opaque markets. Since early 2006, the US Gross Domestic Product has fallen steadily. If the true GDP goes to minus 4%, then the official Orwellian nonsensically hedonically elevated GDP will finally register an official recession.

One should never overlook the high jinx games played by the Knights of the Oval Table. In summer 2006, Goldman Sachs in a bold careless display reduced the weight on their GS Commodity Index for unleaded gasoline from 9% to 2%. The $100 billion invested in funds tied to the GSCI index forced $7 billion in gasoline contract sales. Gasoline prices plummeted as ordered. Of course, no insider trading and market manipulation charges ensued, not for a Knight. My guess is that last week the EIA energy inventory data was falsified bullish, since GoldSax probably helped push the crude oil price over 80. Now comes the profit taking event, as crude oil dips below 80, giving a buying opportunity to the shrewd. Lo and behold, today the EIA energy inventory data was bearish in slightly increasing supply. This game reminds me of the soldier death count from the Vietnam War. They were so bad on given weeks, that military officials smoothed the data from week to week so as to eliminate shockingly high death counts on a single week. Pushing down the crude oil price is essential for defense of the USDollar, as many arbitrage trades link the US $ with crude oil in inverse fashion. Defend the buck with a decline engineered in the crude oil price. The flip side is a surging crude oil price foretells of a serious USDollar failure.

A higher oil price will have to fight against a head wind of recessionary forces, like lower energy demand both at the industrial and consumer sectors. Higher costs will slow the USEconomy markedly. The conclusion is STAGFLATION, from the worsening recession and its growing awareness. A weaker USDollar with a slower USEconomy is precisely what has been called stagflation. Terrific money supply expansion is clearly next, coming, assured. The goal is to avert a dreaded recession, which in my view is unavoidable. Higher prices across the spectrum from a weaker USDollar are a guaranteed outcome. The housing and bond and banking problems are too deep and intractable right now, weighed down by insolvency scourges more than illiquidity challenges.

THE ANOMALY CONFIRMS STAGFLATION

The USTreasury Bond market has defied the USFed and its urgent rate cut decision. Clearly, the USFed has put defense of the economy from recession as a much higher suddenly urgent priority than fighting price inflation. This constitutes an abrupt ‘ABOUT FACE' reversal, one of consequent embarrassment! With money supply growing at over 14% annually, inflation is the policy. My title of the USFed as the Dept of Inflation, and the chairman post as the Secy of Inflation, are well deserved. They manage inflation, staff the printing press, order the emergency output, and double in service as disaster bubble bust insurance underwriters. People actually regard this as normal, when it is heretical.

When the USFed cut interest rates by 50 basis points, both for the Fed Funds (bank loans to banks), and for the Discount Rate (bank loans from the Fed itself), the USTreasury Yield Curve has responded. THE SHORT END HAS SEEN SLIGHTLY LOWER RATES, INDICATIVE OF ECONOMIC SLOWDOWN. The bond market believes the USFed sees that slowdown finally. The 2-year TBill yield fell below 4.0% for a time, but since have moved above that level, only to fall below it today again. My interpretation is that the bond market anticipates a highly likely economic recession. The other conclusion is the Treasury Bond market is making a statement that the USFed will make one more 50 basis point rate cut. The USFed official Fed Funds target is now at 4.75%, with another identical cut sending it to 4.25% next month perhaps. The 2-year TBill, if it continues under 4.0%, signals a continued rate easing cycle. We have not arrived at that point yet, yet, yet. The ratio of the 10-year TNote yield over the 2-year TBill yield is useful. While not a yield spread, the ratio indicates a clear trend. Look at the reaction after Sept 18th, which is a widening of the spread and thus a rise in the ratio.

The longer term trend is revealing also. Immediately after the official rate cut decision, the 10-year TNote yield rose. Market watchers noticed. Pundits commented upon the anomaly. Not enough attention has been brought to this anomaly. THE LONG END HAS SEEN SLIGHTLY HIGHER RATES, INDICATIVE OF THE ONSET OF WORSE PRICE INFLATION. The 10-year TNote yield has fluctuated in a tight range between 4.55% and 4.70% for the last several days. Clearly, many bond traders are shifting from long-term maturity bonds to short-term bonds, to reduce risk. My interpretation is that the bond market anticipates a highly likely trend of price inflation in the coming quarters. Another ugly implication is the housing market might not receive much assistance from the lending rate structure, in particular for fixed mortgage rates.

CONFIRMATION OF WORST OF BOTH WORLDS

Foreigners should tremble with a falling USDollar exchange rate coupled with a rising long-term bond yield. Investment funds in China or Japan or the Saudis or Arab nations face a double loss, one from bond principal and two from currency exchange. This rebellion in the 10-year and 30-year TBonds represents the ultimate nightmare in frustration for the hampered hamstrung hidebound US Federal Reserve. A steeper USTreasury yield curve is a horrible scenario, a confirmation of stagflation potential, and a failure on both ends of their policy initiatives. The USFed wants low price inflation with economic growth. STAGFLATION means the opposite on both scores, a double failure.

STAGFLATION IS THE OPTIMAL CONDITION FOR GOLD, AS THE ECONOMY STALLS, MONEY IS PUMPED INTO THE SYSTEM, BUT PRICE INFLATION RISES. The bigger picture trend can be seen with a chart over almost three years in the USTreasury Yield Curve. Notice the moving average crossover in June, when the 20-week MA traversed above the 50-week MA. Serious gyrations have been seen in August and September, in market uncertainty. After months and months of utter stupidity in economic analysis, proclaiming a strong USEconomy, the envy of the world, the haven of the downtrodden, the USFed finally acknowledges the tide has shifted toward the other side. The world sees the United States as a land of a deflating housing bubble, the site of an unspeakable asset-backed bond fraud, and the location of desperate central bank policy fully exported to other central banks. The steeper USTreasury Yield Curve, simply stated, should be regarded as a loud statement that the future prices of items of all kinds will be higher than today. Like in any other commodity market, the steeper future prices of money indicates we have entered the price inflation picture. What is true of a natural gas steep curve, or a copper metal steep curve, is true in the price of money itself also.

HOUSING CURVE BALL

A radically messy curve ball has been pitched against the policy makers at bat. The mortgage rates for fixed 30-year contracts will not likely come down. Those who wish to avoid the quicksand trap of adjustable rate mortgages (ARM) will find little satisfaction. This is the exact opposite of what the USFed officials desired. Notice their silence. The acidic time bombs known as ARMs will once again be pursued, not so much by choice, but rather by lack of alternatives. The challenges will be to find a lender willing to lend with risk to besieged borrowers, to find a lender flush with available funds to lend, to find properties properly priced whose buyers have a big enough down payment stake to withstand more equity decline. Then you have the LIBOR challenge, which is tied to about 25% of US-based ARM mortgages. Fortunately, the LIBOR rates have ratcheted down, probably as a result of some government interference, or actions taken by their Knights.

In the last few weeks, a new concept has entered the lexicon. For a few years we have read of Twin Deficits from the federal budget and the trade gap. Fresh on the billboards is the home equity deficit from under-water homeowners whose loan balances exceed their home values, the harsh reality of falling prices. The Mod Squads whose uphill task is to renegotiate the loan terms, deal with pre-payment penalties, write down loan balances, fix rates, forgive a monthly payment, will remain daunted and nearly impossible. The eventual inevitable climax of the RESCUE CORNUCOPIA will be a grandiose RESOLUTION CORPORATION to handle both asset-backed bond liquidation but also refinanced mortgages. They must enable a strong home buyer bid, but also provide some transparency on mortgage bonds. Both are crippling problems.

GOLD SOON TO TAKE CENTER STAGE

Look for housing prices to ignore the USFed and continue downward. My expectation is that the USFed and USGovt will embark on broad, deep, and significant rescue package measures, each to be futile for as much as another year. The main driving forces will be the continued relentless bear market in housing from a worsening inventory problem, and the downward momentum in the USEconomy. The existing home inventory rose to a mindboggling 10.0 months of supply in August. Foreclosures are threatening to rise year over year by 100%. No evidence of a bottom or of stability is remotely evident. The first rescue motion was the reduction in the Discount Window rate. Next was the President's remarkably hollow FHA refinance package deal. My guess is few will even qualify, unless they abandon all requirements to qualify. Then came the USFed official rate cut, coupled with another Discount Rate cut. As each rescue package measure is piled on, one after the other, gold will lift higher.

The shift in priority away from defense against price inflation will be starkly clear, in favor of preventing an unstoppable recession. Some pundits, even in the gold community, expect a USEconomic recession to be averted. With most central banks growing their money supply at 13% to 14% or greater, we are entering modern day Weimar times. Gold is gaining attention. The 735 price high for gold has been exceeded, but not convincingly. The HUI precious metal mining stock index has broken out to new highs, but again not convincingly. The USDollar defense counter maneuvers have begun, possibly centered on crude oil. One might take the technical chart manual and declare that the HUI has only retreated to the breakout level, to ensure consolidation, before the next bigger leg in the breakout. My image of a diving springboard always comes to mind. Time will tell. More weak economic news to join the weak housing data will add to the urgency for the USFed to continue in rate cuts enough to warrant calling it a NEW EASING CYCLE. That will be anathema for the USDollar but great for gold.

Lastly, a little noticed event took place. The USGovt just received early approval of a lift in the official federal debt limit. The previous limit in force has been $8965 billion. The new limit is set to become $9820 billion, another cool trillion$. The USGovt federal debt has risen by double since the current diminutive leader took office in January 2001. The higher limit will enable additional debts to be authorized by the federal government. Do foreigners have an appetite for them, or are they entrenched in the early stages of a boycott, as stated in my prediction?

Meanwhile, net foreign capital inflows have dropped from $181.9 billion in Q1 to $150.9 billion in Q2. The bad news is that this might be insufficient to cover the Current Account deficit of $190.79 billion in Q2.

The US financial balance sheet is in trouble. Can you say NATIONAL INSOLVENCY??? The historical response is for fast rising interest rates generally in defense. Increasing desperation will be very evident in the coming months. Gold will head toward $1000. In time, whether triggered by $800 gold or the passage of six weeks time for money to filter down to the junior mining niche of stocks, the HUI will be vaulting to new highs!!!

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