New website

Prudent Observer is transitioning to a new website.

Short dollar trades reverse

Earlier this year when financials puked (Bear Stearns and friends), euro and gold rose to record highs. Although there hasn't been any big institutional failure since Bear Stearns (maybe IndyMac counts), the pukage during the past couple months was arguably more severe (Fannie, Freddie, and friends). But did euro and gold rise to record highs? Hardly. I blame it on two things: moral hazard and dollar jawboning.

The market has accepted the notion that the government will bail out any major financial institution in the name of systemic risk. Of course, such bailouts merely prolong the inevitable, while robbing the tax payers. But for now, the government seems to be able to restore market confidence as they see fit, albeit artificially and fraudulently. It will only be a matter of time before the market acknowledges that the current credit crisis is beyond the reach of government bailouts, and that such bailouts only exacerbate the problem.

Last month, the government embarked on a chorus of dollar jawboning - a concerted effort (Fed, Treasury, and Exec. Branch) never seen before. Although it was a bluff, the dollar jawboning managed to keep the lid on euro and gold as stocks took a nose dive. Bernanke and Paulson must be giving each other HIGH FIVES right now, because just as euro and gold finally started to call their bluff, crude began a long-awaited correction and stocks began a long-awaited bear market rally; their timing couldn't have been any better.



Now the Fed has wiggle room to make even more bluffs. So for now, euro and gold must wait to see better days...most likely towards the end of Q3.

Bounce Bounce Baby

Equities have finally put in a temporary bottom, and it looks like the rally will continue for the medium term. Just as all the macro puzzle pieces seemed to fit together for the next dollar sell-off, the short-dollar puzzle is now falling apart (temporarily), and it will take some time to piece it back together (probably late Q3).

Financials bounce, crude corrects, gold holds steady...

We finally got a bounce in stocks, notably financials. The SEC's attempt to scare (squeeze) bank shorts is just another sign of desperation...by the way, why didn't the SEC include Wachovia or Wamu in their do-not-short list? Meanwhile crude is undergoing a correction (long overdue), which has put some pressure on precious metals, but not as severe as recent correlations suggest. Gold:Crude ratio has actually risen sharply this month, and I think it indicates a significant change in market sentiment in favor of gold.

Gold:Crude ratio YTD


Speaking of gold...what's up with gold stocks? My favorite gold stock, YAMANA, got hammered this past week. Yamana had a spectacular breakout late June, but it has since erased all those gains. Indeed it's pretty frustrating to see mining stocks underperform the physicals so drastically. There are no doubts about the strong fundamentals of Yamana (it's the one stock that I've actually done my homework), so I'll just keep buying the dips. I think Yamana's sell-off last Friday provided such an opportunity, so I bought some Aug 16.0 calls...I figure I'll cover if the lower range is broken, otherwise it should rally to at least 16 before mid-August.

Yamana (AUY) YTD


Update on 7/22/08: Yamana broke 14. Maybe some other time...

Euro: big move within next two days

According to my watch, we're probably going to see a big move in euro within the next couple days...either up or down. There seems to be a lot of euro bears out there, and euro has been lagging behind gold, silver, and yen. Looking at the charts, euro is testing its recent breakout in a symmetrical triangle formation (hopefully a bullish pennant), while eur/jpy also seems to be near a critical juncture. Tomorrow we have NY manufacturing, PPI, and retail sales data coming out at 8:30am, so look for some big moves around that time. Also note that Citi, JPMorgan and Merrill Lynch are coming out with earnings on Thursday. If euro is going to break $1.60, which I hope it does, it's gotta happen this week.

Euro: 2-week (potential bullish pennant)


EUR/JPY: 1-month

Targets for gold and silver by year end

When Bear Stearns fell in March, gold peaked at $1,034 and silver peaked at $21.44. With Fannie and Freddie about to go under, along with a few other institutions in the near future, it is all but certain that the March highs will be taken out. The question is, as gold and silver rally to unchartered territory, what will be the next target before any kind of consolidation? I realize that such attempts turned out to be futile for crude, and precious metals will probably end up shocking everyone as well, but it's fun to guess. So here's my conservative targets for gold and silver by the end of the year...

Gold: $1,100
Silver: $24



Update on 7/22/08: Targets seem more likely early next year.

Treasury promises to buy Fannie and Freddie equity

I talked about the possibility of a reflation attempt in the near future, and we just might see it. Despite the 250bp rate cuts and "innovative" credit facilities by the Fed, we have yet to see a full blown monetization effort by the government. Fannie and Freddie own over $5 trillion of US mortgages, and the government will do anything to maintain market confidence; this is just the beginning of the end. Bear Stearns is nothing compared to the current problem, because the potential systemic risk goes beyond the financial markets; the full faith and credit of the US government is on the line. At times like these, I'm amazed at how schizophrenic the market can be. Just last month, Bernanke was mouthing that downside risk had diminished, and that he was considering rate hikes to support a strong dollar. HA! Indeed this whole situation is very sad, and a lot of people's lives are going to be ruined because of it. But seriously, Wall St and Main St should have seen this coming.

Interpreting EUR/JPY and Equity Divergence

During the past half-decade, eur/jpy has (had) been highly correlated to stocks. This correlation is currently breaking down. So what does a rising eur/jpy mean after a wild consolidation since the subprime crisis went full blown last summer? I think it means that deleveraging is slowing down as investors are finally grasping the direction of various markets and acknowledging that a bear market in stocks has begun. Therefore, the divergence between eur/jpy and stocks will continue, whereas eur/jpy and gold, for example, will start to correlate.

EUR/JPY and SPX: 6-year


EUR/JPY and Gold: 2-year

Yen diamond

Assuming eur/jpy is about to rise to uncharted territory, a breakout by yen from its current diamond formation will mean there will be an explosion in euro beyond $1.6. I'm not entirely sure about the cause and effect of all this, but I'm assuming the imminent eur/jpy breakout is an independent phenomenon, which I will explain in my next post.

Yen futures: 1-month

Gold: potential big upside

1. Retest of breakout from 3-month consolidation seems to be complete.
2. There is a break above the falling wedge formed over past 2 weeks.
3. A bullish engulfing pattern formed today. Shadows are not a consideration.
4. RSI divergence (1hr) strengthening.
5. Euro will soon retest $1.6.
6. Crude seems to have bottomed.
7. Stocks are puking.

Gold: 3-month (retest complete + bullish engulfing)


Gold: 20-day (falling wedge breakout + RSI divergence)

Euro and Yen may have bottomed

I think the dollar is ready for another leg down.

Euro had a big sell off following Trichet's dovish comments, but it was just a flush-out of those who were betting on a hawkish statement; the dollar bears are still holding strong.

Euro: 1-month


Yen is probably the most difficult to trade, and I know this from personal experience (ouch). You just know that the usd/yen is about to go into a secular decline, but it fools you every time. Looking at the yen chart below (futures, so inverse of usd/yen), one can see that the massive rally on 6/26 turned out to fool everyone trading the breakout. I drew the two falling wedge lines on 7/2, and one can see that, while the falling wedge is still in tact, volatility/noise is pretty high. I mentioned in my previous post that we might see a return of reflation, and a clear indication of that would be if yen and stocks rallied at the same time, while carry trades like euro/yen and cad/yen skyrocket.

Yen futures: 1-month

Reflation around the corner?

Many people are expecting a bear market rally in stocks right now, but I think there may be more downside left (i.e. S&P will break below 1200 before there's any kind of rally). Alternatively, I'm also considering the possibility of reflation. Excluding food and energy prices, there's actually deflation in the economy right now, and I'm wondering if some sort of reflation is around the corner. If so, we can see a rally in stocks, commodities (optimal scenario for mining stocks), and FX all at the same time. Of course, the dollar will be sacrificed. I think the best option for central banks right now is to finally open up the monetary spigot.

Whatever the case, it's good to know that gold does well during both inflation (as a hedge) and deflation (as money).

Tough market, but still bullish on gold

There is much to talk about, but I'm strapped for time so I'll keep things short. First, the dollar index broke above its recent downtrend line today, but I think it's a bull trap. Second, crude sold off by almost $8 to $135 today ($135 seems like a pretty good buy to me), yet euro and gold held up pretty well. Indeed, crude has been outperforming euro and gold by a big margin this year (mainly due to increased supply/demand premium and Middle East premium), so it is not surprising to see euro and gold turn a blind eye to crude's puke action today.

I think a lot of traders/trading programs were trying to assault gold today based on the massive crude sell off, but it must have been a frustrating attempt because gold refused to break below key support (910-915). I can't wait to see all the gold shorts that piled in today get squeezed eventually. I have been anticipating an imminent break above 950, but I will be more patient about it. But assuming we are at the cusp of the next bull run in gold, there is one thing that I am almost certain about: gold is not going below 910. If gold does break below 910, I am going to short the hell out of it.

Gold: 1-month (potential falling wedge)


Gold: 6-month (retest of breakout complete?)

Gold: last call

Right now is your last opportunity to buy gold before the next bull run. If you hesitate even for a day or two, you will probably miss the bus. Despite a sharp dollar rally since the ECB meeting (dovish), gold has held up pretty well, and it refuses to drop below $920. I expect gold to break above $950 by next week.

ECB Update

Right now it's about 8:35, and we got the 25bp hike by the ECB, but "Tricky" Trichet seems to be signaling a "one and done" rate hike (dovish). Payrolls came out below forecast, but not as far off as the ADP numbers. Gold and silver were poised for a lift off, but they are not budging. This doesn't look good, and I'm expecting a correction today. If prices do come off, then I'll be looking to buy back at 920-930 for gold 17.75-18.10 for silver.

ECB Vicious Cycle

A prelude to tomorrow's ECB meeting (25bp hike all but certain).

From Macro Man


Indeed, the ECB is fighting a lonely battle. Despite risk to growth stability, I guess they are doing the right thing. As the German finance minister during the 1960's once said:"price stability may not be everything, but without price stability, everything is nothing." A rate hike by the ECB, coupled with weak payrolls, will probably send euro to record highs.

From CitiFX Technicals:

Bank of Korea intervention

Apparently BOK sold about $3b into the market yesterday to prop up the Korean Won. Inflation is out of control in my home country, and it will be interesting to see how far the government will go to support the Won. Maybe the government doesn't really understand economics, but Korea's inflation is a product of printing money to buy dollars so that exporters (Samsung, LG, Hyundai) can benefit from a cheap Won. I remember when the Won was at 900 last year, people were complaining about its negative impact on exports...now that the Won is above 1000, people are complaining about inflation. Frickin make up yo mind foo.

Copper: consolidation complete?

Copper seems to be near the end of a 3-year consolidation. Copper is actually breaking into record highs as I write this post. This should be good for Yamana (AUY), as they own a significant amount of copper deposits (though they are marketed as a gold producer). Despite a weakening global economy, supply/demand is favorable for copper. Mining production remains very low, while the coming infrastructure boom will provide significant demand for copper.

3-year copper spot

Gold: this better not be a fakeout...

There might be a re-test of the breakout...I believe in this bull market!

6-month gold futures