Rather than “forecasting” 2005, which we let the Wall Street pundits do, I think it will be more useful if we share with you our thoughts about the next calendar year. I’ve never thought market strategists could get much out of predicted numbers anyway, especially when respected analysts are always all over the lot. It was interesting to see Barron’s year-end lineup of pundits Dec. 13, because of the dozen responses nine saw the 10-year bond climbing above 5% and a tenth going to 4.9%. Merrill Lynch’s Richard Bernstein sees the bond yield falling to 3.85% even with the S&P500 climbing to 1200.
Yet with all these high yields, which presumably imply higher inflation expectations, not one of the 12 picked commodities as the preferred sector. Abby Cohen of Goldman Sachs sees a 5% yield, a nifty 1325 S&P500, with “tech” her favored sector. She’s the only one of the 12 to mention inflation: “The equity market can tolerate rising interest rates as long as the rise is gradual and inflation is not problematic." But why would long-term interest rates rise if inflation is not problematic and equities are booming?
Which leads into a question that has been bothering some of you about our own inflation warnings. With gold still toying with $450 oz, why is the 10-year T-bond trading at a lowly 4.19%? When we look over recent history – a dozen years or so – yields on the long bond have more often than not been above 5% with gold at much lower levels. What’s going on? The answer, simply, is that the monetary deflation that took gold down to $255 in 2001 wrung out the last gasps of the Old Inflation (to coin a phrase). By that I mean the monetary inflation that began 30 years earlier as gold climbed from $35/oz to the $600 level in 1980. In an economy with a mature debt structure, it takes a long time for the general price level to catch up with gold, and the bond market also takes its time reflecting the unfolding of that gradual rise in prices.
By 2003, we could say we were back to equilibrium when gold was back at $350, the Old Inflation having finally been neutralized. It was as if we were back at $35 gold and a Dow of 1,000, with the 10-year bond at 3.5%. If only the Fed had changed policy to freeze those numbers in mid-2003 -- with gold at $350, the Dow again on its way back to 10,000 and the 10-year at 3.5% -- we would have captured an optimum condition. The Old Inflation would have ended without a New Inflation growing from a standing start.
Here we are 18 months later, though, in the early stages of a New Inflation that is not yet seen as problematic. Following this same line of reasoning, it is as if we were only a few months away from President Nixon’s August 15, 1971 decision to sever the dollar’s gold link. He hoped a devalued dollar would reduce the trade deficit and decrease the unemployment rate. In that early period of the Old Inflation, the stock market had soared, breaking all records for volume in that third week of August. Bond yields rose a bit, discounting the slight inflation the bond market could see coming with gold at $45 and headed to $70 by the end of the year. But it seemed like it was all working nicely. By late December, Nixon had worked out a new pattern of exchange rates with 10 of the major trading partners at the Smithsonian Institution. Nixon pronounced the Smithsonian Agreement “the most significant monetary agreement in the history of the world.”
This precedent suggests a way of thinking about 2005 better than the assumptions that led the Barron’s pundits to predict the 10-year note going to 5%. From where we are now, the New Inflation won’t seem that problematic 12 months from now, with a 4.5% yield more likely. Gold would have to go to $500, I think, for the yield to go over 5%. The more serious problems with gold at $500 would be the weakness of the dollar and the difficulties it would cause our trading partners. They are doing a better job of managing their currencies, with the euro especially stable against gold.
Here again, the Wall Street pundits seem hopelessly confused without the reference point gold provides. David Rosenberg of Merrill Lynch, for example, celebrated the Fed’s increase in the funds rate to 2.25% from 2% last week, seeing it as “a catalyst for dollar support,” in that it is now “at a premium to the ECB policy rate (of 2%).” The yield on our 10-year, he notes, now sports “juicy” premiums over 10-year bund yields at 3.53%, Italian yields at 3.68%, Swissie yields at 2.2% and JGBs at 1.35%. You need only look at the gold charts in euros, lira, Swiss francs and yen to see that there is no “juicy premium” for dollar bonds or dollar support. In 2005, dollar purchasing power will fall faster than it will in the other currencies. The yen is right where it should be, at Y46,000/oz, finally out of deflationary territory. At E330 oz, the euro is also at a sweet spot, exactly where it was almost two years ago, with two dozen swings past this price in between. As for China, $500 gold would cause serious domestic political problems for Beijing. With the dollar/Yuan peg and with inflation traveling much faster in China than in the U.S., the government would be forced to break the dollar link. Even at $450, the advantages of the peg may be outweighed by the inflation costs. If nothing changes with dollar/gold, I’d expect a refixing in early 2005 at something closer to 7:1, from the current 8.3:1.
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From this baseline, what are the forces pushing on the financial markets? Monetary? Fiscal? Regulatory? Geopolitical?
The most troublesome, of course, is the Fed’s continuing experiment with the funds rate. If it sticks to its 25bp measured pace well into 2005, as so many pundits expect, gold would be pushed toward $500 oz, the euro to 1.45 and the yen under 100. Fed funds futures are close to 100% certain there will be another 25bp at the Feb. 2 FOMC meeting, but at least we will get the minutes of last week’s meeting on Jan. 4. I eagerly await release of the minutes, the first since my “Quick Trip to Washington” two weeks ago, when I made the case that the Fed was moving in the wrong direction, and had to change its operating mechanism to bring gold down directly to $400. In the November minutes, the Fed was still ignoring the gold signal, noting: “In foreign exchange markets, the dollar declined appreciably, apparently in part on continuing market concerns about the financing of the U.S. current account deficit.” I’d hope at least the minutes of the December meeting would drop this most unhelpful line of reasoning, which leads policy in the wrong direction.
What I hope to see more of if the gold price remains where it is or higher is the line of reasoning that showed up Monday with Steve Forbes’ WSJournal op-ed, “A Letter to John Snow,” where he argued the Fed should be targeting gold and bringing it down to $400, exactly the point I made in my visits with Fed officials two weeks ago. Even if funds go to 2 ½ % on Feb. 2, the Forbes argument will almost certainly be raised with Fed Chairman Alan Greenspan when he comes before congressional banking committees later in the month. Of all the pundits we’ve heard from on 2005, I take encouragement from Ed Hyman’s end-of-the-year comment that he expects funds to be at 2 ½ % at the end of 2005. Of course, if the Fed were to aim at $400 gold instead of the funds rate, funds would probably float back below 2%.
What about fiscal/regulatory policy? Here’s where we might see a happy combination of higher equity and bond prices and lower gold prices. President Bush has set his priorities for 2005 with tort reform first up, Social Security reform second, and tax reform last in line, after a tax commission soon to be named reports late in the year. Of the three, the latter would have the biggest positive impact on stocks and bonds and on the demand for liquidity in the ensuing economic expansion. But action is most unlikely in 2005 and will be iffy in 2006 as well unless the dollar problem is fixed in 2005, which would increase the President’s political capital with the public and the Congress.
With considerable negotiations and compromise, tort reform stands a good chance of enactment early in the year, but it would have only marginal effect on the efficiency of the economy. And as for partial privatization of Social Security, my guess is that the President will get legislation out of the Congress, but I’m not sure it will have much net impact on the efficiency of the economy in 2005. It would in later years, as younger workers with retirement investments become advocates for changes in fiscal, monetary and regulatory policies that encourage greater capital formation.
As for the regulatory picture, the dark horse for 2005 would be a softening of the regulatory regime surrounding Sarbanes-Oxley. Treasury Secretary Snow, who seems at sea in discussing monetary or exchange-rate policies, is at home when his focus is on the regulatory drag of the Sarbanes-Oxley legislation that whipped through Congress on the heels of the Enron scandal. His front-page WSJournal interview last week suggesting he will make some further noise about paring back its worst provisions was the best news of the week. If you recall, at the time it made its way through Congress we saw it as the equivalent of a major tax increase, especially on entrepreneurial capitalism, and reckoned it knocked perhaps 750 points off the Dow. In sharply reducing the demand for liquidity, it was responsible for sharply pushing up the dollar/gold price, a side-benefit that took the dollar out of deflationary territory. Anything Snow can achieve now would have a side-benefit in the opposite direction, moving the dollar out of inflationary territory.
Geopolitical risk? That really covers so much ground and so many variables that it deserves a paper all its own, which I hope to deliver to you soon. The big variable is oil, at least as far as the financial markets are concerned, and unless the dollar is fixed, that will be a negative for the year… and a big positive if the dollar is fixed. As for the Middle East, Iran, North Korea, China and Taiwan, I’ll have to get back to you.