Monetary Policy and the Dollar
This article has been written prior to the release of the Fed minutes on Wednesday, so there may be considerable volatility later on which may require a reassessment of the technical considerations presented further below (this is not very likely though).
The market's fixation on the Fed minutes remains quite baffling. While it is true that the central bank's actions are more important than ever to the financial markets – this is so because private bank credit is barely expanding, so the Fed remains the main source of monetary inflation – there is never anything new revealed in the minutes. The same people as always will object to 'QE', and even the supporters of the policy will probably be glad of any improvement in the 'data' that gives them a fig leaf to commence the much dreaded 'tapering'. After all, their preferred method of driving the car is with their eyes firmly fixed on the rear-view mirror.
On the other hand, none of them have even the foggiest idea what the long term effects of the policy will be (this much seems pretty obvious). Deep down though, many of them are probably a bit uneasy by now. As a result of all this, the majority of economists expects that a 'taper' of about $20-25 billion per month will be announced in September. Note that thereafter, 'QE infinity' will still be of the same size as 'QE2' was.
It is however not only that one can learn nothing new from the minutes why the fixation on them is useless. For one thing, the Fed's view of the economy and its economic forecasts are pretty much useless. By reading them one runs a slight risk of losing IQ points by contagion.
The main reason is however that it takes time for money to percolate through the economy. The longer term effects of 'QE' will arrive with an unknowable lag (including the inevitable crash of the current echo bubble). For the moment one must expect that numerous prices will continue to rise, as the wave of new money ripples outward (so far this year, the true US money supply has increased by about $400 billion, bringing the total increase since 2008 to roughly $4.1 trillion), although it cannot be stated with certainty which prices will do so (however, one can take a few educated guesses). As an example for the lag, consider that the price effects of the 2001-2004 inflationary push took several years to play out. Crude oil for instance topped in a blow-off rally in the summer of 2008, in spite of the fact that money supply growth had plummeted to low single digits for almost three years already.
This brings us to the US dollar. The dollar's exchange rate is perversely not held to be the 'job' of the Fed, although it is the institution that has ultimate control over the supply of dollars. For some time we thought that in the one-armed contest between different types of confetti (i.e., fiat money), the US dollar didn't look too bad actually – not least because the euro's very survival appeared and still appears uncertain. As to emerging market currencies, they are under great pressure as a result of a synchronized bust egged on by the commodities cycle, which has temporarily lost its 'story' (namely China's growth, which was previously considered limitless). It will take a little time for a new story to be concocted.
The US dollar meanwhile will likely be sought after as soon as the next deflation scare makes an appearance, but as long as things muddle on and the euro area's debt problems remain under wraps, one must keep in mind that the ECB has inflated a lot less than the Fed in recent years. This is partly due to its statutory limitations and its modus operandi, both of which tend to render the euro more deflation-prone in times of banking stress (this is not meant to indicate that there is much of a chance of genuine deflation in the euro area, but goosing money supply growth is more complicated for the ECB than the Fed and it shows in the data). The same incidentally holds for the BoJ, which is particularly inept in its attempts to produce money supply inflation, in spite of the fact that it would be easier for it to alter its modus operandi than for the ECB.
Assuming that the effects of the Fed's inflationary policy have yet to fully play out, it doesn't take a big leap of the imagination to be a bit wary about the US dollar over the next year or two. One reason why we are thinking about a weaker dollar scenario and what might cause it to eventuate is that there is such an enormous consensus out there that the dollar will rise. With 83% of fund managers bullish on the US dollar (a record high) according to the most recent Merrill survey of institutional investors, one must consider why and how the market might confound these expectations. One thing we can think of is precisely that the lagged effects of the Fed's monetary pumping may begin to affect the US dollar with a lag. After all, the dollar is higher today than it was before the Fed printed $4.1 trillion in additional money and while all other central banks have pursued an inflationary policy as well over this time period, the Fed's efforts have clearly dwarfed theirs.
A long term continuous front month futures chart of the dollar index (DXY). It is widely assumed that it will rise, but that assumption may well be challenged over the next year or two - click to enlarge.
Gold Stocks – Possible Elliott Wave Scenarios
Our current working assumption is that the short term uptrend in gold and gold stocks is likely to continue and that quite possibly, a medium term uptrend has begun. This assumption may turn out to be wrong, but there are good reasons to think it could be correct. One reason are the previously discussed statistics on the aftermath of significant bear markets in gold stocks published by James Debevec at Minyanville a while back. As a reminder, we reproduce the table showing these examples below:
The worst gold stock bear markets since the 1960s and their aftermath. Explanation: the 'signal' is given once the ratio of gold stocks to the SPX trades 38% or more below its 252 day (one year) moving average. Note that there is a typo in the table – the last entry should read 'May 17, 2013'. The 'risk' column shows the remaining downside in gold stocks after the signal was given, the reward the size of the rally off the subsequent low.
It should be pointed out that in the recent bear market, the ratio of gold stocks to the SPX traded at the lowest level relative to its one year moving average in all of history, so it was definitely the strongest of the signals listed above. As can be seen from the table, the bigger the decline after the signal was first received became, the bigger the subsequent rally tended to be. It should be pointed out that there is no guarantee that the same thing will happen again, but chances are that whatever rally develops will turn out to be 'above average'. Note that this does not mean that there can not be a retest of the lows before the rally gets going for good. If we assume that the bear market was wave C of a 3-3-5 primary degree ABC correction, we can still not rule out with certainty that there won't be a fifth wave down to new lows (this was discussed in some detail in previous updates, see here and here).
Below is a recent chart showing our friend B.A.'s latest update of the wave count of the XAU's decline. This is so to speak the 'bullish version' that assumes that the final low of wave C is already in (you will notice that wave 5 of C has received a question mark, reflecting the fact that we cannot yet be certain that this was 'it').
B.A.'s proposed wave count for the XAU's recent bear market. Note the classical RSI/MACD/price divergences, as well as the new MACD buy signal – click to enlarge.
Obviously, the XAU has broken out above its weekly downtrend channel, and the same bullish divergences we have frequently discussed in the context of the HUI's daily chart are present on the weekly charts as well. This bodes well for the bullish case, regardless of the potential for additional near term volatility.
The next chart is a monthly chart that compares the recent low to the 2008 low, and there are quite a few similarities in the patterns – the current one looks like a smaller, somewhat less volatile repetition of the 2008 pattern. This is to be expected, as post crash volatility is usually especially elevated.
The 2008 low and the recent low in the XAU compared, monthly candles – click to enlarge.
The main near term uncertainty factor is the fact that we cannot yet tell whether the recent advance will become an impulse wave or will merely remain a three wave corrective structure. This bearish alternative is shown below; it is a possibility we cannot rule out, even though it is not our preferred view (if it turns out to be correct though, then it will mean that the next wave down will be the final wave 5 of C).
Given the well known sentiment situation (speculators have only very recently begun to turn less bearish on COMEX gold futures and surveys show a great deal of skepticism about the rally), the fact that GOFO remains in negative territory 6 months out and the fact that the seasonally strongest period for gold is underway, we are inclined to believe that the rally has more legs than this wave count alternative would allow for.
A possible bearish wave count alternative of the HUI's recent advance. This is not our preferred view, but one must be aware of the possibility - click to enlarge.
A recent chart of 3 month GOFO (gold forward rate = LIBOR minus gold lease rate). While the decline in GOFO is mainly a function of very low interest rates, the recent turn into negative territory is still remarkable, as administered dollar interest rates have not changed in recent years – the Fed Funds rate remains pegged at a 0%-0.25% target. Normally, GOFO should remain slightly in positive territory as has been the case in previous years.
Assuming that wave C is indeed done (i.e., the primary bear market is over), what might the future progression of the HUI look like? There is an obvious resistance level that is likely to be the end point of wave 1, which should ideally be reached near the end of the seasonally strong period. The sequence could look approximately like this:
A possible bullish progression, assuming the recent advance is part of an impulse wave 1. Note that in gold and gold stocks the 5th wave is often the longest and wave 3 only the second longest - click to enlarge.
There is also a short term bullish possibility which would still lead to a medium term bearish outcome (and a long term bullish one), namely the idea that the current wave up is indeed wave c of 4 of C (as indicated in the a-b-c count of the advance presented further above), but assuming that wave c is still going to subdivide further, i.e., is not complete yet. There would be no difference in the short term (i.e. over the next several weeks), as wave c would likely travel a similar distance as wave 1 in the above example, but this rally would then be followed by a 5th wave down that would likely 'retest' the low made in late June, or may even slightly undercut it (note that sometimes 5th waves are also truncated and make a slightly higher low than the preceding 3rd wave low).
That possibility could look as follows (as an aside, note that there are of course a number of uncertainties regarding the precise timing and extent of the waves in these 'future progression' guesses. Both charts present only a rough outline):
The 'short term bullish, medium term bearish, long term bullish' alternative, assuming that wave c has further to go and that wave 5 of C is still ahead of us - click to enlarge.
The next question is of course: how will we know which scenario is playing out? It won't be possible to tell for a while yet, since both the more bullish and the more bearish alternate courses are looking for a rally in the near term of similarly shape and size. We will therefore have to wait for the beginning of the next major correction to determine whether or not the first or second alternative is the correct one (this is always assuming that the more bearish alternative that an a-b-c correction is already finished is not applicable). At the time we will have to use sentiment and positioning data as well as the type (shape) of the decline as our guides. What one can however do, is use the above outlines as a means of helping to manage risk.
Long term investors could conceivable opt to ignore the possible near term scenarios altogether, but it cannot hurt to reduce exposure a bit once the market approaches obvious resistance levels and increase it again once prices have pulled back. For shorter term traders the precise progression is of course highly relevant and possible scenarios such as the ones presented above can be integrated into a trading plan.
Addendum: Fed Minutes
In the meantime the minutes have been released, and according to a Reuters article, 'offer few clues'. In other words, waiting for the minutes was even more useless than it normally is.
“A few Federal Reserve officials thought last month it would soon be time to slow the pace of their bond buying "somewhat" but others counseled patience, according to meeting minutes that offered little hint on when the U.S. central bank might reduce its purchases.
The minutes of the Fed's July 30-31 meeting, released on Wednesday, showed that almost all of the 12 members of the policy-making Federal Open Market Committee agreed changing the stimulus was not yet appropriate.
Investors are anxiously waiting to see when the Fed will start to slow its $85 billion monthly asset purchases, with most predicting September as the beginning of the end of the quantitative easing program, known as QE3. The minutes provided few clues on the potential timing for a reduction but did little to dissuade people expecting a policy change next month.
"A few members emphasized the importance of being patient and evaluating additional information on the economy before deciding on any changes to the pace of asset purchases," the minutes said. "At the same time, a few others pointed to the contingent plan that had been articulated on behalf of the committee the previous month, and suggested that it might soon be time to slow somewhat the pace of purchases as outlined in that plan."
New information gleaned: precisely zero.
Charts by: Bloomberg, StockCharts, BarCharts