Fedwatch: Gold's Bounce
Jude Wanniski and David Gitlitz
February 21, 1997
TRADING RANGE: We were happy to see Abby Cohen, the chief market strategist at Goldman Sachs, announce Wednesday that she now sees the Dow Jones Industrial Average settling into a “trading range.” Cohen is among the most prominent bulls on Wall Street, one that we take seriously, as her broad market forecasts have been similar to ours, although there has been no contact between us. Her gentle retreat from the chorus of bulls calling for 8000 around the corner is the right one. It was the position we took last week, noting that market expectations of a budget agreement in our divided government have gone as far as they can go without palpable action. Our January 2 forecast of a DJIA between 7400 and 7800 this year rests on a successful outcome to this year’s budget battle, including positive action on tax policy. The skittishness in the markets should be with us for the next three or four months, as the White House and the Republican Congress get beyond general statements of principle into the details of budget-making.
CAPITAL GAINS: One of the reasons there is little downside risk of a major DJIA correction is that there is unanimous agreement -- after almost a decade of partisan struggle -- that there will be a cut in the capital gains tax as the glue that holds together a budget deal. There is still considerable public posturing from Treasury Secretary Bob Rubin about how we don’t need it, that the economy is doing fine without it, etc. And there are some protests from liberal commentators that the stock market is already high enough without it! But a retreat by Clinton would sour his relations with Congress for the rest of his second term, which is why it can’t happen. The real downside risks are in the details that will be worked out by the Senate and House budget committees, which practically have more control over the nature of the capgains cut that survives than do Senate Finance and House Ways&Means. This is because they are driven by the scoring of the Joint Tax Committee, which always manages to find ways to determine that a capital gains cut loses revenue. Ken Kies, the staff director of Joint Tax, was on the wires Thursday stating he sees no reason why there cannot be a broad-cased capgains cut this year. In a worst-case scenario, though, the power struggle over revenue estimates will chip away at a “broad-based cut” until it is only a shadow of the optimum, a pure 50% exclusion. GOP supply-siders on Capitol Hill worry there will be attempts to save money by exempting corporations from the cut, requiring a holding period, mandating the average cost method of calculating gains, eliminating indexing, and even chiseling on real-estate rollover provisions and partnership income.
GREENSPAN: The most important ally the GOP supply-siders have on capital gains is Fed Chairman Alan Greenspan, who has become more aggressive in arguing the benefits to the national economy of cutting or eliminating the capgains tax than at any time since his appointment in 1987. I think Greenspan also understands far better than Rubin that another failure this year on capgains would see an unraveling of the stock market “exuberance,” because it would be reflective of poisoned relationships between the two political parties and renewed gridlock. A successful bipartisan budget would make his job at the Fed much easier. He is, of course, aware of our arguments that market expectations of a higher level of economic growth via productivity gains have been accompanied by increased demand for dollar liquidity. These in turn have caused the decline in the price of gold and strengthening of the dollar relative to foreign exchange. The process would reverse with a breakdown of comity between Congress and the White House. For this reason, we are hoping Whitewater, etc., remains on the back burner. There are GOP suspicions that the White House will drag its feet on budget compromise until it is sure the GOP investigations are not life threatening.
FEDWATCH: GOLD’S BOUNCE
Does the rise in the price of gold back above $350 trouble us? The short answer is, no. As we pointed out last week, the accelerated decline of gold below $340 (it fell beneath $337 in intra-day trading last Wednesday) was signaling an increased scarcity of dollar liquidity, raising the risks of a highly damaging deflation episode. A continued collapse of gold would not have been reassuring particularly if, as the markets now assume, Fed Chairman Alan Greenspan is disinclined toward easing to relieve a dearth of liquidity.
Nevertheless, the gold price decline of the past three-plus months overwhelmingly has been a salutary circumstance, a manifestation -- at one in the same time -- of expectations for rising returns in dollar-denominated assets and declining monetary risk. The extremely close inverse relationship between the price of gold and the DJIA attests that the gold price indicates the rising global attractiveness of dollar-based investments since November. Regression analysis demonstrates a correlation of 80% between the two variables, far too close during the course of nearly four months to be dismissed as mere coincidence. We also rate it as no mere happenstance that this positive confluence of forces coincided with the November elections. In fact, pushing up the start date of the regression to November 6 -- the day after the election -- increases the correlation by a full percentage point.
To be sure, then, we would not be sanguine about a continued reversal of the gold price, but we rate that as unlikely. There is no sign that the Fed’s open market desk is dispensing unwanted liquidity. If anything, reserve injections for the past week have been lighter than normal, with the funds rate trending somewhat below the 5.25% target. At $350, or thereabouts, the gold price still reflects considerable strengthening of confidence in dollar purchasing power relative to early November levels around $383. The price action over the past several sessions indicates only marginally lower dollar demand, not a liquidity glut. Although the gold-price backup takes some of the pressure off Greenspan for a near-term easing of short-term rates, it leaves considerable room for bond yields to fall. Our bond outlook remains bullish, particularly if Greenspan throws the market no curves in his Humphrey-Hawkins testimony before Senate Banking on Tuesday.