Gold Weekly
Eurodollar December 2011- December 2012
So here we have two charts which go to the heart of investors' expectation on future inflation and deflation. Yet both show a divergence in the charts. It has been said that interest rate traders are the smartest out there, and one could easily argue that there are so many gold bugs out there that only know to buy gold. If both of these facts are true, then we should expect a precipitous fall in the price of gold in with the next few weeks. But I am not so sure about that as these charts do not represent anything too contradictory. But it may shed some light into why we are heading down the road we are.
Before I go any further, let me explain what the second chart really symbolizes. (For those that are familiar with Eurodollar markets you can skip this and the next paragraph.) Eurodollars not a currency! Eurodollars are US dollars held in and lent from foreign banks. It is an extremely short term interest rate market based off the LIBOR. An outright Eurodollar contract is prices as 100-LIBOR, so just as in the US treasury futures, when rates go down, prices go higher. Since these are US dollars, this market is subject to swings based off of short term lending rate by the FOMC and everything else that effects the interest rate markets.(USD strength, economic data, etc.)
The LIBOR is the London Inter-Bank Offer Rate, or in English, what banks charge each other for short term loans. The futures markets shown above are based off the 30 day LIBOR. In the futures markets, this is about as short term as you can get. Anyway, what the second chart shows is the difference between expected short term rate at the end of 2011 and the end of 2012.
What this chart shows is that starting around April 2010, this market started pricing in fewer rate hikes out in to the futures. As the chart falls, so do expectations for tightening interest rate policy by the FED. After reaching a high of 1.20% the spread has fallen back down to .6% currently.
From the beginning of 2009, the ED spread shows that expectations of a higher amount of rate increase for the year of 2012 were increasing. In a sense, traders believed that in an environment when interest rates are going higher, on could expect the rate schedule to increase aggressively. Well now it seems as is that perception has changed drastically, and in a few short weeks expectations for rate changes have fallen by half. This signifies the belief that when the FED is forced into action, it will be a slow and gradual process, not the aggressive paradigm shifting rate hike schedule like had been previously indicated in the charts. From the looks of things these days, I would anticipate this spread to continue to narrow down to around 30 but should it go back and hit the 2008 lows at 0, then one should head for the hills.
A spread value of zero would mean that traders do not anticipate any rate hikes by the FED for 2012. It would signify a continuation of loose monetary policy for much longer than previously anticipated. Let me be blunt here: This is a strong possibility right now, and could be the catalyst for a blow up in the price of Gold.
Should interest rates remain at the current, near zero levels through 2012 it would imply a few major issues. The FED is so afraid of hiking rates, that it will keep interest rates at the currently depressed levels for quite some time. This keeps the cost of credit very low, which is what we need to generate a recovery in the mortgage and housing markets. But that is assuming that somehow, the US economy will right itself. The only reason to keep interest rates that low for that long is the fear that hiking rates would kill the economy.
Traditionally, when inflation is running higher, gold prices do the same. In order to check that, the FED would raise interest rates, and gold would be contained. The US dollar would also gain strength as part of the inter-market relationship. Gold is saying that inflation is here and will be here to stay, while the interest rate spread is saying that low interest rates are gonna be here for a while to come. It an sense the charts are confirming each other.
These charts could be at odds with each other in that lower rates mean the FED's primary concern is one of fighting deflation. But from a long term perspective, they can both be right. If the FED has got it wrong, it could be that their fight against deflation will actually lead to rampant inflation.
My theory is that we are now in a unique phase where we will witness both deflation and inflation. True, I would be more concerned for a deflationary break in the near term, than an inflationary one. But it is possible to have both.
A distinction needs to be made here. Inflation is a monetary issue, hyperinflation is a political issue. A hyperinflation blowup could result from keeping interest rates too low for too long. Combine that with the FED now monetizing debt through numerous buy back programs and you get a falling US dollar. We will not get to that hyperinflationary scenario until the world starts fleeing from the dollar.
Right now gold is hinting that that is exactly what is going on right now. And the FED, which would normally raise rates to fight coming inflation is too focused on keeping rates low so it can try to stimulate the economy. I fear that when all is said and done, there will be little that the FED can do to stem the incoming tide.
