|There is no more widespread meme in the world of investment and economics right now than the "rising rates recovery" meme. The spike in interest rates for long-dated Treasuries has turned into a true bull market in rising yields. However nascent and short-lived this bull market may prove to be, the plunge in Treasury prices that began in June can no longer be written off as merely a short-term reaction to the Federal Reserve's decision to back away from notions of "untraditional methods" of reflation (namely, the purchase of long-dated Treasuries in an attempt to keep long-term interest rates at historical lows). |
This is not to say that the bull market in Treasury yields is not a bona fide reaction to the Fed's stance; the point is that reaction is not short term. In other words, the bond market has not just fired a shot across the bow of the Federal Reserve Board's intentions; it has all but threatened to overtake, grapple, and board the Fed's monetary frigate.
The relationship between the Federal Reserve and the bond market increasingly reminds me of the old Richard Pryor joke about two hikers in the forest who suddenly find themselves in the presence of an angry bear. One hiker turns to the other and says: "I only want to know one thing: which way are you going to run?"
In spite of mass preoccupation with the Fed's machinations — from the dubious "Fed model" of market timing to such bromides as "Don't fight the Fed" — the fact of the matter has been that the Fed is constantly trying to handicap the market's movement. This underscores the reality that it is the market, not the Fed, that determines where the market will go. The Fed may determine the environment, the context, in which the markets will operate. But like the first hiker in Richard Pryor's joke, all the market wants to know is which way the Fed is prepared to move so it will know whether it will be running with, away from, or over the Fed in its own mad dash from danger to opportunity.
This is why calling the top in bond prices (or the bottom in bond yields) a "reaction" to the Fed's attempt to provide yet another moral hazard to bond market bulls is like calling US military mobilization in the Pacific theater in 1942 a "reaction" to the bombing of Pearl Harbor. While true enough, such a definition can actually obscure the changing sentiments among bond market participants toward the Federal Reserve.
Whether the Fed has lost credibility with the bond market — as many have suggested — remains to be seen. But clearly, it is hard to imagine the same bond traders who saw a relatively risk-free trade to the upside months ago now taking the Fed's cues on economic policy with the same commitment as they once did. Indeed, commentators ranging from Paul McCulley of Pimco to Victor Canto of La Jolla Economics have since stepped up their criticism of the Fed, imploring Fed chairman Alan Greenspan to be far more explicit in stating the central bank's objectives. Canto recently opined that it was "time for the cooks at the Fed to disclose their operating procedures."
McCulley was somewhat more generous, crediting the Greenspan Fed for securing "operational transparency," but then faulting it for not yet achieving "goal transparency." In other words: thank you for showing us how you do it. Now could you please tell us exactly what it is you are trying to do?
THE RAP ON RISING RATES
As I've suggested elsewhere (see "Gibson's Paradox"), rising interest rates in a deflationary environment tend to augur higher stock prices. Essentially, this is an inverse of the relationship between stocks and interest rates — as manifested in bond yields — that predominates in conditions of low to moderate inflation or even disinflation.
Why do rising interest rates anticipate higher stock prices in a deflationary environment? Because deflation (per Nobel Prizewinning Canadian economist Robert Mundell's vital formulation) is a decline in the monetary standard characterized by a demand for money in excess of money available, there are two ways to resolve a deflationary crisis. One is to provide enough money by way of reflation to solve the "money shortage." The other is to attack the demand for money directly by making money more expensive to obtain.
Although the first method is the one generally preferred by governments — for which the urge to inflate the currency is never long dormant — and the latter more often the route the markets themselves are inclined to take (deflation means a skyrocketing credit risk, which encourages lenders to seek additional protection for their principal), the outcome of either approach is, inevitably, higher interest rates. Either by way of excess liquidity that makes marginal investments productive (at least in nominal terms), or by restoring a security premium and simultaneously draining the system of money it doesn't need, the markets get better.
The question, however, is whether rising interest rates — in and of themselves — represent an economic recovery, particularly this "recovery." I question "recovery" because the term, at this point, is as political as it is economic. In an environment marked by increasingly fierce political partisanship over economic policy, as well as a Wall Street that has turned the previously parenthetical phrase "better than expected" into a veritable call to financial arms, it is difficult to understand just what would constitute a consensus opinion that an economic recovery has occurred.
That said, the debate over what a rising interest rate trend at this juncture means comes down to this: Are currently rising interest rates a signal of economic improvement? Or are currently rising interest rates merely a signal that while reflation has taken hold, the notion of the economy coming along for the ride is still very much undetermined?
With regard to reflation, one of the best gauges of inflation, deflation, or reflation that I've come across is not interest rate movement but the dollar price of gold. Jude Wanniski of Polyconomics, Inc., has perhaps been the chief proponent of the use of the gold price as a gauge of inflationary and deflationary pressures — so much so that Wanniski has frequently (and correctly) counseled monetary authorities with regard to the efficacy of tightening or loosening monetary policy on the basis of the gold price alone. Gold's virtues are many, as economists as diverse as Alan Greenspan and Karl Marx have asserted (Greenspan, in his seminal essay "Gold And Economic Freedom"; Marx, in his no less seminal tome Das Kapital).
But one of these virtues tends to stand above all others, and Wanniski is as eloquent on this virtue as any other:
This brings us at last to the monetary standard. For thousands of years, the reference point provided by gold has been the equivalent of Polaris in the world of everyday commerce. . . Unlike Polaris, which seems fixed immutably in the heavens, gold does have a slight wobble to it that shows up over the millennia. . . It has the smallest wobble, which has made it more valuable than all other commodities as a monetary vehicle. The advantage of a small wobble, which has made it more valuable than all other exchange goods across time and space, is self-evident. A national paper currency that has held its value against gold for a long period of time gives that country's merchants the greatest advantage, in that they do not have to spend resources insuring against the wobble.
THE WOBBLE AND THE MCTEER PUT
That "wobble" is the pull of inflation or deflation, and coping with the effects of this wobble — from the largely deflationary 19th-century US economy, which produced a social and economic ethos of thrift and debt-aversion, to the largely inflationary 20th-century US economy, which produced a social and economic ethos of consumption and debt-attraction — has been the bane of economists throughout financial history. And at the risk of sounding trivial, it is the exhortation of observers like Wanniski (not to mention economist Robert Mundell) that all monetary officials need do is watch the wobble of gold. When gold is rising significantly above a given target price, it is a signal that inflationary pressures are mounting. When gold is falling significantly below this same given target price, it is a signal that deflationary pressures are gaining strength.
Thus, it was not without a bit of chuckling that many supply-siders greeted the news that the Federal Reserve might actually have a "target price" for gold — to say nothing of the fact that the Fed's target was remarkably close to the target price suggested by Wanniski and the supply-side economists at Polyconomics. Here is Dallas Federal Reserve Bank president Richard McTeer, as quoted in Marc Auerback's transcription of McTeer's appearance on CNBC with guest host Steve Forbes:
Steve, I can't resist the temptation to tell the audience what I heard you say recently in Austin where you told the audience that a simple way to measure how the Fed is doing is to look at the price of gold; if it is over $400 an ounce we are too easy and under $300 we are too tight. I was in the audience and used my Blackberry to email my assistant and ask her what the price of gold was, and it was $349, just one dollar off the midpoint. I think it's up to $364 yesterday so a little on the easy side.
Auerback's takeaway from this exchange was that a new "put" had been created by the monetary authorities. As he comments:
We have had the "Greenspan put" for the stock market and the "Bernanke put" in the bond market. Does this exchange mark the formulation of a "McTeer" put in the gold market? The simple gauge for the Fed's future actions: the price of gold. Too high a price: $365. The right price: $350.
Auerback fears that this merely represents "yet another stage in the futile expectations management game that the Federal Reserve has continued to play over the past several years." And events may prove him right. At a minimum, the "game board" for this contest has been set, and the game board consists not just of the gold price itself, but of the massive symmetrical triangle that gold prices have been forming since 2003.
THE GOLD TRIANGLE
Technical triangles in price charts are among the more common and watched-for chart patterns. One reason for this is simple: triangles consist of a gradually narrowing range in prices, and this narrowing of range tends also to signify an appreciable decrease in volatility. Often decreases in volatility precede increases in volatility, particularly when short-term volatility drops below more normal or historical volatility trends. This thinking is part of what makes Bollinger Bands an effective price action analysis tool, and it has spawned the development of a number of volatility-based trading systems and methods. As Laurence A. Connors wrote in his book, Investment Secrets Of A Hedge Fund Manager:
Most market participants use volatility readings to trade options. Professional traders attempt to buy historically cheap options and attempt to sell historically expensive volatility options. Our approach is different. We use historical volatility readings to signal major advances and declines for equities and futures. Our research has shown that whenever a 10-day historical volatility reading reaches half or less of its 100-day historical volatility reading, a major move for that market is nearing.
Most important, Connors notes that the direction of a volatility move cannot be determined from a comparison of short-term versus long-term volatility. Thus, with many triangle patterns — particularly symmetrical triangle patterns — it can be difficult to anticipate whether volatility will push prices up or down. This is equally true with the symmetrical triangle in gold, which only recently has begun to show signs that prices are ready to move to the upside.
Figure 1: The upside from a successful breakout from this symmetrical triangle points toward a December gold futures price above $420.
Consider, then, not only the symmetrical triangle in December gold futures in Figure 1, but also the implications of such an advance in the gold price on monetary policy. If the Federal Reserve Board has established, explicitly or implicitly, a target gold price near $350 — above which monetary policy is considered "too loose" — then what can market participants expect in the way of a monetary response should gold climb above $400? Clearly, if McTeer is accurate about the Fed's attempt to provide the sort of "goal transparency" that Pimco's McCulley desires by way of a $350 gold target price — and assuming that the Fed means what it says — then a gold price above $400 means tighter money and higher interest rates.
There are many, including noted investor and "Market Wizard" Jim Rogers, who have suggested that higher interest rates are exactly what the market needs. Higher rates will not only to weed out "zombie companies," but also prevent them from devouring the flesh of otherwise healthy companies who find it increasingly difficult to compete with "zombies" cleansed of debt through the wonders of US bankruptcy laws (for example, Worldcom/MCI).
However, there is an ominous possibility of a Fed reaction. It is quite likely that a move above $400 for gold would represent the peak in a bull market move that began in the spring of 2001, when the price of gold was trading near $275. If that $400 level for gold represented a top of some significance, then it is possible that the Fed, following a strict $350 rule, could end up tightening monetary policy at precisely the most inopportune time. Such a timing trap would be reminiscent of the Fed's decision to tighten monetary policy from the spring of 1999 to the autumn of 2000 — precisely as the major stock market averages in the US were forming historic tops.
"STUCK IN THE MIDDLE WITH YOU"
The combination of sound technical analysis and an understanding of the role of the price of gold in gauging the difference between deflationary and inflationary pressures is a godsend for those interested not only in intermarket technical analysis, but also for those looking to make sense of what is too often deliberately obscure economic rhetoric among political partisans and the mainstream financial media.
Like technical analysis, however, the gold Polaris requires not only the skills of analysis but also the fortitude of execution. It is one thing to recognize, for example, a massive eight-month symmetrical triangle on a price chart, and quite another to put on the hedged long or short trade, or to build the options straddle position in order to exploit whatever outcome the market provides. Similarly, even if the Federal Reserve has informally adopted a target gold price of $350, it remains to be seen if the Fed will drain liquidity from the financial system in response to a gold price that breaches $400 — affirming a commitment to monetary stability, yes, but quite possibly incurring the wrath of market participants who had bet on virtually permanent low short-term interest rates.
Mistakes have been made — and can be made again. As economist Jude Wanniski noted of the early to mid-1990s, there were instances in which "Fed errors" to strengthen the dollar had little effect on the dollar price of gold, but had great effects on interest rates, which ramped up 200 basis points in the autumn of 1993, precisely at a period "when the market's confidence in the Fed was at its peak."
It is perhaps no surprise that such a hubristic move would come after a period of relative price stability, as reflected in a gold price that had been trending downward since a spike in 1987. Ironically, the lesson in the mid-1990s seems to have been learned too well, as the response to the inflation of the mid-1990s was the deflation that gripped the market from, roughly, 1996 until the spring of 2001.
With 10-year Treasury note yields continuing to rally through Labor Day weekend, the interest rate markets may be primed for a pullback. And a tightening of monetary policy from the Fed — in response most obviously to the threat of an above-$400 gold price — might actually have the effect of cooling down the interest-rate market bears who have taken it upon themselves to lift rates away from their historic lows (that is, to exact the security premium). Such a tightening could have the psychological effect of convincing bond market investors that, while the Fed has every intention of maintaining an "accommodative" monetary policy, it is vigilant to the dangers of inflation.
David Penn may be reached at DPenn@Traders.com.
SUGGESTED READINGAuerback, Marshall . "Greenspan Put, Bernanke Put . . . Now The McTeer Put?", International Perspective, www.prudentbear.com: August.
Canto, Victor A. . "Someone Left The Price Rule In The Rain," National Review Online, www.nationalreview.com: August.
Connors, Laurence A., and Blake E. Hayward . Investment Secrets Of A Hedge Fund Manager, Probus Publishing.
McCulley, Paul . "Needed: Central Bankers With Far Away Eyes," Fed Focus, www.pimco.com/ff/aug03/index.htm: August.
Schwager, Jack D. . The New Market Wizards: Conversations with America's Top Traders, HarperBusiness.
Wanniski, Jude . "A Gold Polaris," Supply-side University, www.polyconomics.com: March.
_____ . The Way The World Works, Regnery Publishing.
Wilcox, Stephen . "Market Valuation Measures: Does The Fed Model Really Work?" American Association of Individual Investors (AAII) Journal: November.
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