The Market Versus the Fed’s Money Supply

The title of this alert just means the value of something is what the market says it is. It does not mean that value won’t change tomorrow, and it does not mean that if the direction of the market changes tomorrow, it was wrong about today.

If the market says that oil is worth $147 one day and $100 the next, that does not mean the first number was wrong. Nor does it mean the second number is right for tomorrow. The value of a barrel of oil is whatever the market says it is.

The market exists to discover value.

If you could do it with a pen and paper, you would not need the market. Speculators merely try to anticipate changes in values — over time. And charts are like a window into their message, or story, if you will…they are not a crystal ball.

But before I look at any position, the first thing I do is look at the chart in order to determine what the market is telling me about an asset or commodity, the economy or even monetary policy…

Technical “Chalk Marks” Suggest Deflation as Fed Policy Outcome

Maybe it is early, but the chart says the Dow could be ripe for a break to new bear market lows. That should be bullish for gold if it prompts the central bank into action.

For the past year, declines in the stock market have spurred gold higher on just this expectation, as was the case back in the last Dow bear (2001-02). When that happens, it undermines the dollar — and confidence in the central bank’s policy, making it less effective. It limits the Fed’s ability to cope.

For this reason, the Federal Reserve had deliberately chosen not to expand the money supply, which had been growing in the low single digits (year-over-year percent) for over a year, despite implementing massive rate cuts. It was a deliberately “sterilized” policy — in Bernanke’s own words — aimed at lowering inflation expectations without undermining the boom. It was aimed at shedding his moniker, “Helicopter” Ben. That was a tough balancing act — impossible, probably — and he was bound to get it wrong.

Trouble is, the market was betting that the risk was to deflation.

That is, we saw asset and commodity prices under continued pressure and technically significant chart moves in the dollar and gold suggesting that the market is anticipating this policy to err on the side of deflation, rather than inflation…not that the Fed wants any errors. In fact, the dollar’s move this week potentially reversed a 3-year downtrend.

At least, the bearish trend is neutralized…even if the U.S. dollar index were to drop back to 72 now, we could not call it bearish until it put in a lower low; the bulls might just be setting up a double bottom. Our readers know that I have been looking for a bottom in the foreign exchange value of the dollar for almost a year now. I don’t know how these trends will work themselves out over the next three-six months, but the case could be made for a bear market rally in the U.S. dollar index that extends back to the 90-95 level over the next year or two, before we get to the final chapter in its demise as the reserve currency.

Don’t forget, with respect to the U.S. dollar index, we are talking about its value relative to other funny money. That’s why I have argued that gold would advance despite it. So far, it has not.

Although there is no deflation yet, those footprints suggest the market is starting to think about it.

There’s Good Reason to Disagree with the Market

I think the odds are very low that you will see deflation — outside of a short-term aberration. This is because banks can create money, and there is nothing restricting them from creating all they want.

There is no gold standard today.

Governments got rid of the gold standard so they could inflate without restriction.

Moreover, the central bank has only increased its control of the financial sector over the decades. If we ever had a real deflation (in the monetary aggregates), it would have to be deliberated. That is why the odds are low.

According to the True Money Supply, an Austrian School monetary aggregate, the Fed is currently no tighter than it was in the late ‘60s or mid-‘70s, or even 2000, for that matter.

It is not the 1980, 1990 or 1994 Fed, which was committed to disinflation — and had the public behind it. Nor is it as easy as Greenspan’s post-1996 or post-2001 Fed.

Still, the Fed’s policy could produce a deflation scare if it overshoots in its aim against expectations and allows some deflation in money and credit by some unforeseen accident…or moral hazard.

Such a scenario would probably make the chart right about $695, and boost the dollar.  And this could happen even if we are ultimately right about gold going to $3,000, or higher. It would be temporary, no doubt, Ben would quickly sport his helicopter hat in response.

But there is reason to doubt even a deflation scare.

I am skeptical that the Bernanke Fed will stick to its guns on the money supply for the following reasons:

  1. The Fed’s current policy is already net bearish for the “boom” — That is, without money supply growth the “boom” will continue to falter.
  2. The political mandate for a tight Fed is weak — In the current economic condition without a forced hand, the Fed will increase money supply.
  3. The economy is in no shape for a tightening — At this point the economy is used to cheap money and a tightening of the money supply would cause a “bust” cycle.

However, as long as the Fed can bluff and withstand from increasing the money supply the gold chart will probably be right. If the bulls cannot hold the Aug. 15 low at about $774 on the front-month Comex contract or recover the $850 handle anytime soon, we’re going to $695, plus or minus, over the next few months.

This risk will dissipate if the bulls can recover $850, especially on a strong dollar. In fact, we have to look back only to 2005 for an example of this bullish scenario. I have already remarked on the similarities in this correction to 2004.

The 2004 correction in the gold sector was the one that occurred ahead of the Fed’s last tightening. Six months after the tightening started, the U.S. dollar began to advance. It advanced all year in 2005.

Likewise, I expect that the gold market will shrug off the deflation scare and recover soon here, as well, ultimately undermining the dollar advance. That is right: The U.S. dollar is the dependent variable, not gold.

It is correct to say that the U.S. dollar is gaining ground on the heels of gold’s correction; it is incorrect to say that gold is weak because the dollar is strong. Gold is weak because the Fed is targeting it.

But the Fed is bluffing with a bad hand.

Ed Bugos
October 14, 2008