Testing the Floor
Jude Wanniski
June 12, 2002


When the Dow Jones Industrial Average was at 9700 last week, we said it might dive through 9500, but our surmise is that will be the floor to the bear market. It did dive through 9500 on Friday, but popped up later in the day, and yesterday fell 200 points from its high of the session to stop just short of 9500. We don`t usually pay much attention to chartists, floors, ceilings or resistance levels. But monetary deflation is purely a technical phenomenon, and we chose 9500 as a likely stopping point for the bears when gold moved above $320. When gold was at $265 a year ago, we suggested 8500 as a floor. Here are some thoughts on where we go from here.

GOLD: When gold flirted with $330, the markets were concerned about a nuclear exchange between India and Pakistan. We can never say for sure how much of a movement in the gold price can be attributed to one risk factor or another, but we assume almost all of the $10 decline in the last week was due to good news from Delhi and Islamabad on the peace front. There is still upward pressure on gold developing day by day as fiscal problems at all levels of government increase the risks of present and future tax burdens on the productive economy. Don`t expect big jumps on that account, though, as the process will involve nickel-and-dime movements, and gold may still not reach $350 this year.

FED FUNDS: Eurodollar futures still are pricing for about 75 basis points of hikes in the funds rate by year`s end -- down from 100 bps just last week and 200 bps in March -- but I would not be surprised if the Fed did nothing at all. Michael Darda expects a half point at most, and then only if the Fed has some kind of hook to justify it. As we cannot imagine irrational exuberance on Wall Street with the factors in play, the only reason to "justify" a higher funds rate would be a marked improvement in the employment outlook. Chairman Alan Greenspan would get very nervous if gold shot past $350, because he would know he could not stop the move with increases in the funds rate and the only way to then head off increases in the CPI and PPI would be to contract the economy and have selling at distress prices. Been there, done that. If there is no justification for a funds rate increase, how long does it stay at this low level, 1.75%? Of course, if the Fed switched to a specific price target instead of trying to manage the entire economy all by itself, the funds rate would be released and would rise to a rate the market itself would justify.

DEATH TAX: It would be nice if Congress repealed the estate tax in perpetuity, which the House voted to do last week. As the WSJournal`s lead editorial indicated Tuesday, the votes are not quite there in the Senate. It was when Senate Majority Leader Tom Daschle yesterday announced he would bring it to the floor immediately for a vote that the DJIA swooned its 200 points, as the decision was a sure sign the Democrats could kill repeal. Delay would have given the GOP time to pick up the needed votes. The Democratic strategy is to propose an amendment to eliminate all estate taxes under $4 or $5 million, which will look like a good deal to everyone with an estate under that level. The current 55% rate would apply to Bill Gates and all others. Republicans will resist because so many of their supporters have big estates. But Senators like Breaux and Landreau of Louisiana and Torricelli of New Jersey will be able to say they voted for the little guys and escape punishment at the polls. This will be fun to watch, with Republicans now saying they would rather see the effort die and take the issue to the polls, hoping to gain control of the Senate and win it all next year. It won’t happen. They’d be better off trying to get the 55% rate down in a compromise, to a level where this tax might raise more revenue than it costs to collect. Estates above $5 million will either have the lawyers and accountants to provide an escape, or for the really big folks, a mailbox in the Canary Islands will be advised. My guess is nothing will happen. All we will get on both sides is posturing.

OIL: The connection between gold and oil has been close to its traditional ratio recently after a long period of disconnect. With gold at $320 and benchmark crude at $24, we are not too far from the long-standing 15-to-1 ratio, as both commodities react to political tensions and both fell off for the same reason. Except for brief periods, though, gold moves solely for monetary reasons, not commercial reasons. The demand for gold bullion is not the same as the demand for oil, as gold stocks are never "used up," while oil inventories are drawn down soon after they are produced. Most other internationally traded commodity prices remain out of synch with gold and oil and would have to move higher to get into synch. Without a serious domestic economic expansion, which we do not see, it will take longer for the commodities to catch up with gold and oil.

BOND YIELDS: Because we see an unexciting stock market ahead, the long bond still remains a good bet at 5.55%, even if it sits there and all you get is the coupon. Its tendency could be to improve toward 5%, especially if we are right about Greenspan and the funds rate.

JAPAN: It is impossible to tell what is going on under the blankets at the Ministry of Finance, as the bureaucrats try to come up with some supply-side tax cuts while the Tax Commission resists. The Nikkei has been jumping around as a result, with some decision expected before June is out. Our Nathan Lewis points out that a decision in Japan is not necessarily a decision, as it will still have to run a gauntlet before final enactment. We remain hopeful, as the idea seems to be popular in Japan. The cover of the most recent issue of its most influential business magazine, Nikkei Business, pictures President Koizumi and his Finance Minister Takanaka, with a headline “JUST DO IT,” referring to a proposal to cut the corporate tax rate.

IRAQ: Defense Secretary Donald Rumsfeld is rattling his sabers over the evil Saddam Hussein, sounding as if the bombs will start falling any day now, but there is less and less chance of that happening this year, I`m told. The White House is now saying it would like to be rid of Saddam by the end of the President`s first term. He will have to build up a war chest before he does as federal revenues continue to decline as Congress is finding ways to spend like drunken sailors under the veto-proof umbrella of fighting terrorism.

ISRAEL/PALESTINE: President Bush seems to have promised Israeli Prime Minister Ariel Sharon that he will feel no pressure to negotiate with the Palestinians anytime soon, a few days after he seemed to promise Egyptian President Hosni Mubarak that he would pressure Sharon. If the Palestinians see this as another delaying tactic by Israel to expand the settlements on the West Bank, there will almost surely be an escalation of violence, maybe spilling into the U.S. If Secretary of State Colin Powell gets Sharon to show restraint on expanding the settlements, at least that irritant will not promote more terrorism. The President’s smooching of Sharon was one of the low points of his presidency, leading reporters to speculate that he is trying to help his brother win re-election as governor of Florida with the Jewish vote. Colin Powell once again stepped into the breech, yesterday explaining that the President really did not mean to suggest there would be no further efforts on talks toward a Palestinian state, and maybe there will be some this summer. Zzzzzzz.