by Kevin Klombies, Senior Analyst,

The forex markets remain in a state of chaos with the Reserve Bank of Australian intervening on behalf of the Aussie dollar for the third day in a row and the Bank of Japan threatening to start selling yen. Years and years of capital flows are being reversed in a matter of a few months. Warren Buffett- we believe- once commented that you don’t know who is swimming naked until the tide goes out so with the flow of liquidity rushing to exit all the global nooks and crannies we are getting a first hand look at what is real and what is not.

At top right we show a chart of gold futures and the S&P 500 Index. We are going to return to a topic based on the gold carry trade that we introduced in Monday’s issue.

The thesis is that the gold carry trade (borrowing gold from the central banks at a low lease rate, selling it, and investing the proceeds in higher yielding securities) helped provide the marginal liquidity that powered the stock market higher into the Nasdaq’s peak in 2000. As the stock markets tumbled the price of gold bottomed and as the gold carry trade came to an end the yen began to decline versus the euro. In other words the end of the gold carry trade marked the birth of the yen carry trade.

The chart below right compares the S&P 500 Index with the cross rate between the Japanese yen and the euro.

The peak for the yen against the euro was made in 2000 at the bottom for gold prices. The bottom for the yen against the euro was made through 2007 and 2008 concurrent with the peak for gold prices. Fair enough.

The point that we are circling is that major stock market tops like 2000- 2001 and 2007- 2008 have also marked major trend changes in other markets. While it may not have been intuitively obvious at the time- especially to the Bank of England- the demise of the tech and telecom cycle set the low for gold prices and helped create a multi-year commodity price bull market. Gold prices did not rally for a day, week, or month- they literally rallied for years. In fact gold prices trended higher while the SPX declined into 2002- 2003 and then continued to push higher until the stock market peaked and turned lower.

To us this suggests that the yen is the next ‘gold’. It may get beaten back by central bank intervention temporarily and it may be some time before the markets stop viewing it as a negative but years from now and at much higher levels we will look back at the yen and realize that its multi-year bull market began back in 2008.



Equity/Bond Markets

Most cyclical markets are driven by capital flows which is why we write every now and then that we have to ‘follow the money’. It is no surprise that the Brazilian real and Russian ruble are declining almost as fast as the equity markets of these two countries because that is what happens when the music ends and money begins to head for the exits.

Our page 1 point was that the transition from bull to bear for the S&P 500 Index’s trend marked the bottom for the yen in much the same way that the conclusion of the tech ‘bull’ marked the bottom for gold prices eight years ago.

Every time the yen begins to rise, by the way, economists pop up and suggest that this will do tremendous damage to Japan’s economy. Years ago when we were making wildly bullish projections for the Canadian dollar (something like .8800 back when it was trading closer to .6500 against the U.S. dollar) we were told that this was not possible- that anything close to 80 cents would bankrupt the country. The point, however, was not that the Cdn dollar could rise but rather what would have to happen to make it rise. The answer, of course, was very strong commodity prices.

In any event the chart at top right compares the ratio between the Nikkei 225 Index and the S&P 500 Index with the Japanese yen futures from late 1984 through 1990. Notice that the yen began to rise in early 1985 while the Nikkei did not begin to outperform until early 1986. Money began to flow towards Japan and in due course Japanese stocks began to outperform.

Quickly… at bottom right we show the Canadian dollar futures, the CRB Index, and the ratio between Canadian and U.S. equities. Below we have included a comparison between the CRB Index/S&P 500 Index ratio and the ratio between the Philadelphia Gold and Silver Index (XAU) and the SPX.

There are (at least) three relationships that remain ‘sticky’. The CRB/SPX ratio remains far too high, the U.S. stock market has yet to show any kind of relative strength, and (page 5) the oils are still too high as well. Our conclusion? Crude oil prices have to continue to move lower.