The Battle for $700 Rages On

May 28, 2007 – I am writing this newsletter one week earlier than planned because several markets are at critical points. In short, there is simply just too much happening at the moment to leave this letter until next weekend.

In the last letter I wrote about the Battle for $700. The gist of the article was that governments with the assistance of select bullion banks – which together are also known as the “gold cartel” – were capping the gold price to prevent it from exceeding $700. I noted how gold has also been capped at times in the past, but that gold always eventually won the battle by exceeding each key price level where the gold cartel decided to pick a fight. I fully expect gold to break above $700 in time, again winning another battle.

I also wrote in the last letter about the motivation of the gold cartel to cap the gold price, but I focused on their big picture aims, namely, that gold was being capped to make the dollar look good. I left out one motivation because I wasn’t completely certain at the time that it was a critical factor, but I am now, given what has happened over the past couple of weeks.

It’s a motivation that has immediate impact, rather than being one related to the long-term big picture. In short, governments don’t want the gold price to climb over $700 because the monetary and financial markets will start spinning out of control to correct the structural imbalances that have been building, and that result is a fearful prospect to governments.

It is important to recognize that governments fear everything they cannot control, because they view anything outside of their control as a potential threat to the special position of privilege and perquisites that government apparatchiks have carved out for themselves. This observation particularly applies to the US government, which has so much to lose when the dollar goes into the tank by collapsing against gold and other tangible assets. When that happens, the dollar’s unique position as the world’s reserve currency will be irreparably undermined.

To postpone this inevitable outcome, the US government intervenes in various markets in order to force its will in an attempt to achieve its preferred outcome, to the detriment of the market participants as well as the market process itself. As the 20^th century’s greatest economist Ludwig von Mises warned us, governments will destroy markets long before they ever understand how markets work.

We’re presently seeing the force of government rippling through the various markets, several of which have now been pushed to key levels. I would like to review some of these, starting with the stock market and the accompanying chart of the S&P 500 Index.

What do Argentina in 2000, Russia in 1990 and Weimar Germany in 1921 have in common with the US today? The answer is that they all have rising stock markets measured in terms of those countries’s domestic currency. In other words, the experience in these and dozens of other countries shows that stock markets rise as the country’s currency collapses.

Readers know that I am expecting the dollar to collapse. I’ve even co-authored a book about it. The strong uptrends in the Dow Jones Industrial Average and the S&P 500 are exactly what one would expect to see in the months prior to a serious collapse of the dollar.

Therefore, the stock markets are giving us an important message, namely, the dollar is indeed in the process of collapsing. People are fleeing the dollar, and one way to do that is to buy non-financial stocks.

In contrast to T-Bills, bank deposits and other dollar denominated assets, stocks are not dollar denominated. We buy and sell stocks in terms of dollars in the US, but we do that as a matter of convenience. One can also buy and sell Exxon, for example, in various different currencies.

Oil producers like Exxon offer protection against a collapse in the dollar because regardless what happens to the currency, people will want to buy gasoline, and they will do that with whatever we end up using for currency after the dollar collapses. Again, look at what happened in Argentina, Russia and Weimar Germany to fully understand the implications of what happens to stock markets in a currency collapse. Companies are wealth producing franchises and well-managed ones survive currency collapses to continue producing the goods and services its customers want.

The second chart of the S&P 500 Index is also important. It presents the S&P in terms of gold, and we can see a clear downtrend. In other words, though stocks are rising in nominal terms, they are not rising in real terms. This chart therefore makes clear that in a currency collapse, one is better off holding gold than the S&P 500 Index, which is a point that I have been making time and again as the stock market climbed relentlessly higher. But there are two other important points to make from the above charts.

The first chart shows that the S&P 500 is about to break into record territory, joining the DJIA which has already made record highs. This event – when it occurs – will be an important confirmation that the flight from the dollar is continuing. In fact, a new record high in the S&P will be signaling that the dollar collapse is picking up momentum.

The second point relates to the second chart. The price of the S&P in gold terms is at the top of its downtrend channel. In other words, this current point reflects an extreme in relative valuations.

Always assume that a trend will continue. So what this second chart is saying is that a turning point is near if in fact this downtrend in the price of the S&P in terms of gold is going to continue. But this chart is also telling us something meaningful about gold. Namely, when compared to the S&P 500, gold is at a relatively low valuation. This conclusion is also supported in other ways.

For example, the price of crude oil has been rising in recent weeks, while gold has been in a decline. As a consequence, the price of crude oil has risen to 3.10 goldgrams per barrel, the highest price this year and up from 2.57gg per barrel in January. What’s more, even this price is distorted, and significantly understates gold’s low valuation.

Presently, West Texas Intermediate (the crude blend that serves as a benchmark for US prices) is trading at a $6 discount to Brent crude from the North Sea, which is more representative of international prices. Normally, WTI trades at a $1 premium to Brent, to account for among other things, shipping costs. Thus, if normal spreads prevailed, WTI would be $72.20 per barrel, and its price in gold would be 3.43gg per barrel, nearly 11% more than current levels. In other words, the abnormally low WTI price is making gold’s relative undervaluation less noticeable.

While the unusual price spread between WTI and Brent is due to many factors, one of them is the hand of government. Oil is being made available from the US Strategic Petroleum Reserve, which is only at 70% of its 1 billion barrel capacity. Selling oil from the SPR and not replenishing the SPR to full capacity has clearly impacted crude oil prices to some extent, making them lower than they would be without the government disposals from the SPR.

Finally, there is one more chart that needs to be considered to fully appreciate how markets have reached key levels. It’s the accompanying chart of yields on the 10-year Treasury Note. Please study this chart carefully.

I have noted many times in recent years how interest rates on government paper are artificially low. This result occurs because the US imports more goods and services than it exports, with the result that it needs to pay for this imbalance by exporting dollars. These dollars end up in foreign central banks, which then send them back to the US to invest in US government paper. The huge flow of dollars overseas resulting from the trade imbalance perforce results in a huge demand by central banks for US government paper, thereby making dollar interest rates lower than they would be if trade flows were balanced.

Despite the abnormal demand for government paper from these circumstances, long-term interest rates are rising. Most importantly, the yield on the 10-year T-Note is about to break a multi-decade downtrend channel.

Thus, long-term interest rates are climbing higher, and rising interest rates will severely disrupt the US financial system, which has become accustomed to low interest rates. It will be the same kind of disruption that occurred in the early 1970’s when yields began rising, though this time the impact will be worse. Back then the US was the world’s largest creditor nation, and it’s now the world’s largest debtor, with a mountain of risky derivatives that it must deal with as well.

What does all of this mean? I think we are much closer to a collapse of the dollar than we would like to think.

As frightening as that prospect may be, we cannot ignore the writing on the wall. Or to put it more accurately, we cannot ignore what the markets are telling us.

The message is loud and clear. The flight from the dollar is rapidly picking up speed and momentum, notwithstanding the concerted efforts by various governments to keep that from happening.