Monday, January 02, 2006


The price of Gold is yelling loudly that interest rates must go much higher; 7% or more on the short rate soon and on the long end within two years. The bond market yield curve is calmly suggesting stating that rates are headed down in the near future; short rates all the way to five year rates are forecast to fall at least a half a point in 2006.

The situation reminds me of the contest between the wind and the sun. The contest was to remove the traveler’s cloak. The wind went first but no matter how hard it blew it could not take the cloak away. When the sun smiled the traveler gladly took off the cloak. Chairman Greenspan would call the situation a conundrum.

I call it a war and my daddy taught me not to take a pocket knife to a gun fight. No less than Einstein declared that the most powerful force in the universe is compound interest. Fighting the bond market like fighting the Zulus, the price of money just keeps on compounding and the Zulus just keep on coming.

The bond market has too much ammunition on its side. The annual rate of change in industrial capacity utilization is nearly zero and capacity usage is only at 80%. During the boom times in recent years, it has been the semiconductor business that has run full tilt bozo. Right now, there is slack capacity in semis even though the industry is expanding rapidly. Communications equipment has never recovered from the 1990's boom. Resources are available. One thing that is often missed is that the US produces more energy than any other nation in the world. We import only a small portion of our total needs. If you are going to a fight, you must first learn the facts. Gold is a small player on the large stage of life.

Many comparisons of the current economy are being made to prior years. However, one must go back to the 1950's and 1960's to find a time of such high GNP growth coupled with low inflation. I love to remember the wonderful market we had in 1963 to 1965. The market was great because earnings were growing but new technology (Xerox and main frame computer companies were changing the world) was holding down inflation. Stocks of the hot companies would shoot up 25 or more points in a week. Stocks were so volatile that trading was dicey and fun.

Periods of volatility typically follow long periods of relative calm. We have been in the calm before the storm for about 2 years. Hold onto your hat because the wind is ready to blow.

Technology and globalization are holding down inflation. GNP just ran the track at a fantastic pace of better than 4%. The time was better than Seattle Slew carrying 150 pounds. For the past year and a half, Greenspan has been adding weight to this horse and it carries the weight as good as Sea Biscuit. If the FOMC adds weight in January and March, it will take its toll. The economy will slow; demand for gold will slow while bonds, stocks and real estate will all get fresh legs.

How long can Gold fight bonds? Gold might keep fighting another year or more, however, the battle is lost. Bonds can lick gold with one hand tied behind its back.

Of course, there are many possible scenarios. It is possible that bonds win the first round, slowing the economy temporarily, with gold winning a second round, taking inflation and the economy on a wild ride. Gold could get help from the oil market for another year or two, but in recent weeks oil has been giving aid and comfort to the enemy. My guess is that Bernanke will join the fight on the side of bonds. I expect him to shoot for real interest rates of about 2%. Gold will not be able to stand up to 2% real rates.

My belief is that head line inflation is about to roll over below core inflation. This means that to achieve real rates of 2% Bernanke might have to cut rates not raise them. Don't laugh, in February of 1995 the FOMC made the last in a long string of rate increases and 5 months later it began a new string of rate decreases. I grant that it is not likely that the FOMC will increase rates by a half a point like it did in 1995, which implies that the drop in GNP will not be as large.

At the current time, I do not plan to short Gold. The speculative demand is too great to bet against in the short run. On the other hand, I will make long term investments that are consistent with strong growth, low inflation and low bond rates. Hmmm, buy stocks or real estate? I’ll take stocks!