In just the past ten days, the price of gold has climbed $20 to the $395 level, which helps the nominal growth of equity values. The DJIA is back over 10,000. One of the two primary reasons that we expect a decline in the demand for liquidity is the agitated warnings from the Bush Administration about a likely terrorist attack this summer. The other primary reason is a slight decline in the market view that the Fed will raise the funds rate by a quarter point on June 30, now 86% according to futures trading, compared to 96% ten days ago. Thursday’s report that core inflation is behaving itself and initial unemployment claims were higher than expected are reasons behind this change in expectations. This combination has pushed the euro back over 1.22 to the dollar and “strengthened” the yen at a proportional rate where it sits at about 111 to the dollar.
On the other hand, oil has dipped to $39/bbl, on the expectation that OPEC will agree to increase production when it meets on June 3. My sense is that President Bush’s speech this week has reduced the threat of Middle East oil disruptions marginally. This is because of the slight policy shift that opens for the first time the possibility U.S. troops will be withdrawn from Iraq in the foreseeable future. The President indicated “full sovereignty” will be turned over to the new government, with British Prime Minister Tony Blair announcing that in his view this means the interim government will be able to limit the actions of coalition troops, British as well as American. There has been some fussing on this point from Secretary of State Colin Powell, but what is crystal clear is that if the government elected next January gets control of Iraq’s oil revenue and at the same time advises President Bush or President Kerry that troops are no longer needed to provide security, the last thing that Islamic insurgents will wish to do is disrupt oil supplies. If this scenario unfolds in this manner, global oil consumers can breathe easier, and reduce their inventories from crisis levels. Oil then would be able to adjust to a more traditional relationship with gold, somewhere below $30/bbl.
A key element in this scenario requires a commitment by the United States to withdraw all of its troops from Iraq, sooner or later. We note that Senator Kerry is being pushed now by the anti-war factions in the Democratic Party to make such a commitment. As an anti-war protester during the Vietnam era, Kerry is chary about playing that card, which his political advisors warn would be viewed as “cut and run” by white males, who he will need to win in November. The obvious solution would be for Kerry to promise to bring home the troops just as soon as it is practical to do so, hopefully within months of the Iraqi elections next January. President Bush does not have any national security advisors who want to pull out, still hoping to maintain a military presence for as long as that is practically possible. This is tied to their concern for the security of Israel, which has always been a primary motivation of the neo-cons in promoting regime change in Baghdad, by one means or another. It now is becoming obvious, as Zbigniew Brzezinski has been saying for many months, that a satisfactory Iraq outcome requires resolution of the Palestinian issue. Both Bush and Kerry should be willing to tackle that problem, regardless of the sensitivities of the Jewish political establishment and the votes they might influence in November.
What should we expect in the markets in the month ahead? Lots of wiggling in equities, bonds, gold, oil the dollar. If the corporate tax bill gets back on track after the Memorial Day break, gold should stop its rise and even decline, even if it begins to appear there will be no increase in the funds rate on June 30. It does seem that GOP leaders hope to get the tax bill to the President before the July 4 recess. If it is killed for the year, we have to hope that other positive developments in the Middle East and a decline in geopolitical risk increases the demand for liquidity. If not, there will be attempts to beat back a new incipient inflation with higher and higher interest rates.