Why the Federal Reserve will taper in September

by Eugen von Böhm-Bawerk

Something peculiar has been going on the treasury market during the latest round of quantitative easing (QE). If we study the chart provided below we find that treasury rates increased as soon as a QE-program was enacted, and fell immediately after its termination. Take the TSY 10 year for example; as soon as QE1 was implemented rates rose rapidly from a low of 2.08 per cent to a high of 4.01 per cent. What is striking about this is the fact that the low was set three days into the program, while the high was set three days after the program. A similar development occurred under the QE2 program. Rates reversed their sharp downtrend from the peak set around the end of QE1. A notable difference in the QE2 cycle was the apparent front-running by the market. Investors had obviously learnt how QE impacted various asset classes, so the rate peak came at the middle of the program, not at the end as witnessed under QE1. Still, the collapse in rates right after the program ended was significant.

Then came the maturity extension program (MEP) with a dual – unofficial – mandate. First of all, it was designed to “twist” the yield curve by swapping short term treasury paper for long term. In other words, the yield compression was now a wanted result; while in QE1 and 2 the fight against deflation was used as excuse to bail out Wall Street. In the MEP it was the federal government that needed bail out. And this brings us to the second, unofficial, reason for MEP. With forward guidance incorporated, short term paper was essentially positively yielding cash equivalents for the primary dealers. The Fed told them that prices on shorter maturities would be fixed. Voila, the federal government could easily sell papers along the curve. That rates fell during the MEP-program should not come as a surprise.

When QE ∞ was introduced on the other hand, rates remained stable at a low level. Rates started to climb first when hints of “tapering” to the QE ∞ program was provided. This is the exact opposite of what we have seen in previous programs!

Source: Federal Reserve (Fed), own calculations

We also looked at the impact FOMC have had on the stock market since Greenspan “the-stock-market-causes-GDP” took the helm at the Federal Reserve. We tested the FOMC impact by compiling an alternative S&P500 index. The alternative index simply traded at 0 on both the day of an FOMC press release and the following day. On all the remaining days the alternative index traded just as the real S&P index. The result speaks for itself: Without trading on the FOMC-days the index is actually trending downwards. So much for following William McChesney Martin`s dictum of “taking away the punch bowl just as the party gets going.” The gang that took root at the FOMC under the Greenspan and Bernanke era added liquor whenever the chance presented itself! In terms of capital destruction no single individual has probably caused more harm to the world than Greenspan; and we include the global elite from 1939 to 1945 when making this statement.

More specifically for the stock market we see that the S&P index behaves more in line with QE1, QE2 and MEP. It goes up until the punch bowl is actually taken away. Then it plunges until Bernanke panics and pour more liquor to keep the party going.

Source: Federal Reserve (Fed), own calculations

So, we know the stock market behaves as usual, so what can explain the marked change in the treasury market? To answer this we looked at QE relative to marketable treasury bills, notes and bonds outstanding. However, the MEP paired with forward guidance complicates our analysis, so we need to find a way to compare apples with apples. We therefore express both the treasury holdings by the Fed and marketable paper outstanding in 10-year equivalents.

Let us start with the Federal Reserve. The first chart depicts the stock perspective, namely the total asset side of the Federal Reserve ledger. The second chart shows the flow perspective in terms of weekly change in both mortgage backed securities (MBS) and treasury securities (TSY).

Source: Federal Reserve H.4 (Fed), own calculations

Source: Federal Reserve H.4 (Fed), own calculations

We then convert this information to ten year equivalents by utilizing the data found in the System Open Market Account (SOMA) held by the New York Fed.

Source: Federal Reserve Bank of New York - SOMA (Fed), own calculations

Source: Federal Reserve Bank of New York - SOMA (Fed), own calculations

We then proceed to outstanding marketable TSY paper available. We use the data as reported by the Treasury Monthly Statement of the Public Debt (MSPD) to get a breakdown by maturity. However, in order to put the whole thing into context we present the reader with a much more interesting chart compiled with statistics from the “Historical Statistics of the United States – Colonial times to 1970” and the Federal Reserve Z.1. statistics

Source: Federal Reserve Z1 (Fed), Historical Statistics of the United States from Colonial Times to 1970, Bureau of Economic Analysis (BEA), own calculations

After some chart-porn we are finally ready to answer the question posed at the beginning: why do interest rates behave different in this QE-cycle while stocks do not? The next chart show the reader the staggering fact that the Fed is about to be the buyer of TSY. If they maintain the current program the Fed will gobble up more than 100 per cent of net issuance by December. In other words, the Fed has become both the indiscriminate buyer and the only buyer. If there is one thing economist learn at University it is the simple fact that the price is set at the margin. But what happens when one single buyer becomes the entire market all the way up to the margin? Well, at that point the “market” price is fully dependent on this single buyer.

Source: Federal Reserve Bank of New York – SOMA (Fed), US Treasury Direct – Monthly Statement of the Public Debt (MSPD), own calculations

The main difference between QE ∞ and the previous programs is simply that the Fed has become the market. So when the Fed hints about tapering, the front-running holders of already issued TSY jump the ship and overwhelm the Fed program. Prices drop, yield spikes and the stock market is getting an additional boost as bonds-sellers park their cash in the S&P bubble!

Conclusion:

The multi-bubble machine called the Fed is at it again. This time they managed to create a gigantic bond bubble which will dwarf both the dot-com- and the housing bubble combined.

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What I Learned Working for the First Too-Big-to-Fail Bank

by Francine McKenna

Continental Illinois National Bank and Trust Co. of Chicago would have been 155 years old next year. You may be surprised to hear me praise this institution so highly. But it was my first real job and the place where I learned how to be a professional, including how to be professionally skeptical.

I joined Continental in 1981 as an intern in the employee relations department. The bank’s lending training program faced a charge of persistent discrimination by the Equal Employment Opportunity Commission in the recruiting, hiring, retention, and promotion of their lending program trainees. The bank hired several PhDs to build the data case that would prove otherwise. I spent three summers and all my school holidays during college primarily digging through dusty files gathering data to defend Continental Bank against the EEOC charge.

I was enormously proud to ride the train from the South Side of Chicago every day to work at a world-class bank wearing a navy blue suit and matching low-heeled navy classic Ferragamo bow-style pumps. Continental Bank headquarters was a beautiful, historic building at 231 S. La Salle Street, across from the Federal Reserve Bank of Chicago and at the beginning of the financial district “canyon” anchored by the architecturally significant art deco Chicago Board of Trade.

This was the age of gracious banking. We had “coffee” dates with colleagues every morning in the subsidized cafeteria. Bank officers dined in a private buffet or oak-paneled rooms served by tuxedoed waiters when entertaining clients. I aspired to one day make it to their pay grade.

When I started working there in 1981, Continental Bank was the largest commercial and industrial lender in the United States. The bank had been buying loans from Penn Square, a tiny Oklahoma City shopping mall bank run by a guy named Bill P. “Beep” Jennings since 1978. However, significant growth in the syndication of the loans originated by Penn Square did not occur until 1981 and Continental funded its purchases with foreign and domestic overnight deposits rather than traditional retail ones.

When Penn Square went belly up in 1982, the shock was heard around the world. Bank examiners and Continental Bank’s internal auditors had been documenting the deterioration of underwriting quality and the poor collateral due diligence as the volume of loans purchased from Penn Square ramped up.

Unfortunately, no one listened. Just like no one listened 16 years later, in 2000, when Harry Markopolos tried to tell the SEC about the Madoff Ponzi scheme. It wasn’t until Penn Square’s failure that the world really paid attention to how Continental Bank had grown so big so fast.

Continental Bank, according to an FDIC report, “was the largest participant in oil and gas loans at Penn Square and experienced large losses on those participations.” Even worse, when Continental’s internal auditors visited Penn Square in December 1981 they found $565,000 in personal loans from Penn Square to John Lytle, the Continental Bank officer responsible for acquiring the Oklahoma City bank’s loans. According to testimony by C. T. Conover, then the Comptroller of the Currency, to the House Subcommittee on Financial Institutions Supervision, Regulation, and Insurance in September 1984, senior Continental Bank management heard about the loans but never received the full audit report. Lytle was not removed from his position until May of 1982 and did not leave the bank until August 1982.

Mark Singer, in his book “Funny Money”, theorizes that Continental executives repeatedly ignored danger signs rather than actively covered them up. “Among bankers there is an inbred tendency to react to a fiscal humiliation as if one had spilled gravy on a tablecloth or neglected to send a hostess a thank-you note.”

As of March 31, 1984, according to a GAO study, Continental Bank had approximately $40 billion in assets. It was the largest bank in Chicago and the seventh largest bank in the United States, in both assets and deposits. That GAO study says the Continental Bank crisis started on May 8, 1984 when the bank faced a sudden run on its deposits. The run began in Tokyo when a wire story reported rumors that a Japanese bank might acquire Continental Bank. According to reports at the time, “when the item was picked up by a Japanese news service, the translator turned ‘rumors’ into ‘disclosure’ and Far Eastern investors holding Continental’s certificates of deposit panicked at the implications. That day, as much as $1 billion in Asian money fled from the bank.”

Eight days after the run began, regulators announced a bailout. The FDIC put $4.5 billion in new capital into the bank, assumed liability for the bulk of Continental’s bad loans and began the search for another bank to take over the institution. To fulfill a promise to protect insured and uninsured depositors from any losses, the Fed made additional emergency loans to Continental Illinois that rose to $8 billion.

I joined Continental Bank full-time in June of 1984 as a trainee. There were 50 of us hoping to be placed in internal audit, IT, or accounting after completion of a 15-week rotational training program. But the bank run did not subside over the summer and we started to worry there would be no bank and, therefore, no job for us at the end of the training. Continental Bank was shrinking in response to the money market’s continued lack of confidence after the May funding crisis. Federal regulators found no buyer for it and, in late July, the bank was nationalized.

Continental Bank, and my fellow trainees and I, survived the summer of 1984. In 1997 the FDIC was still describing the 1984 bailout transaction as “the most significant bank failure resolution in the history of the Federal Deposit Insurance Corp.” It was the biggest failure too, until the takeover of Washington Mutual in 2008.

In the fall of 1984 I went to work in internal audit, reviewing trust accounts that had farmland and crops as their primary assets. My impression of the bank’s internal audit team was positive. The department was filled with serious audit professionals who went out in the field and on the road all over the world to ask the hard questions. During this era there was no discussion of risk management other than what a trader or lender might be concerned about.

Unfortunately, the Penn Square loans to Continental Bank’s Lytle are an example of the obstacles we faced as internal auditors all the time. It was rare, in my observation, for an unpleasant or embarrassing internal audit report to ever make it to top management or to capture their attention if the issues raised could put the brakes on revenue growth.

The FDIC agrees. In a case study of the Continental Bank failure included in the report, “History of the Eighties - Lessons for the Future”, the agency says, “There was little doubt that the bank’s management had embarked on a growth strategy built on decentralized credit evaluation unconstrained by any adequate system of internal controls and that the bank had relied on volatile funds. But how well had the responsible bank regulators assessed Continental’s situation, and should they have been more assertive in requiring the bank to change its lending and other high-risk practices?”

I passed the C.P.A. exam in 1986 and left the bank in 1988 to take a job as an accounting manager at a publicly held distributor of electronics components. It was a step up in pay and a chance to manage people.

The FDIC slowly re-privatized Continental Bank after the bailout by periodically selling its shares to the public. The last shares were sold and the bank completely returned to private hands in 1991. In 1994, the bank was bought by the old (West Coast) Bank of America.

To see how much and, yet, how little has changed for the banks since, it’s interesting to look at Continental’s 1984 peer group. According to the Comptroller of the Currency’s testimony the eight wholesale money center banks in the bank’s peer group were Bankers Trust, Chase Manhattan Bank, First National Bank of Boston, First National Bank of Chicago, Irving Trust Co., Manufacturers Hanover Trust Co. and Morgan Guaranty Trust Co.

Bank Boston, the successor bank of the First National Bank of Boston, was also acquired by Bank of America.

Nearly all the rest are now part of JP Morgan Chase.

My early professional education at Continental Bank significantly influenced my career and my attitudes about regulation and responsibility in financial services. Other alumni have gone on to bigger things than I did, though not always better.

Jon Corzine, for example, began his career in finance in 1970 as a portfolio analyst at Continental-Illinois National Bank in Chicago while he was in business school at the University of Chicago. Recent reports that Corzine emasculated MF Global’s chief risk officer, and that regulators dropped the ball overseeing the brokerage before it cratered, show that the problems I witnessed at Continental still haunt financial services.

Roland Burris was a vice president at the bank from 1964 to 1973. Burris is best known today as former Governor of Illinois Rod Blagojevich’s appointee to complete Barack Obama’s term as U.S. Senator after Obama became President. (Blagojevich described the Senate seat as being worth its weight in gold, though not in so many words.) But long before this ignominy, Burris started his career as the first African-American to examine banks in the United States.

And Andy Fastow and his wife Lea both worked for Continental Bank after earning MBAs from Northwestern University. Andy Fastow, as most readers know, eventually became CFO of Enron Corp. While at Continental, he completed the bank’s lending training program and was placed in the energy lending group to work on the new “structured finance” team. This is ominous in retrospect, and if you don’t see why, just Google “Chewco.”

By the time the bank was re-privatized, Continental Bank management had initiated several transactions intended to focus the bank solely on its strengths. Continental Bank’s delegation of the majority of its internal audit activities to PriceWaterhouse in 1991 was the first large-scale partial outsourcing of an internal audit function. Also in 1991, the bank signed a 10-year contract to outsource most of its information technology operations to IBM. It was the largest bank at the time to outsource IT, according to an article in the Chicago Tribune. Additionally, “the bank contracted out its entire legal department to the law firm Mayer Brown & Platt. It had already hired Marriott Corp. to run its cafeteria and LaSalle Partners to manage its buildings.”

The officers’ lunch buffet was also closed. A golden era had passed.

This column was originally published as a BankThink opinion piece December 23, 2011 to celebrate the first issue of American Banker more than 175 years ago.

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This Is What JPMorgan's London Whale Office Is Investing Your Deposits In Now

by Tyler Durden

As part of the Appendixed disclosures in the aftermath of JPM's London Whale fiasco, we learned the source of funding that Bruno Iksil and company at the firm's Chief Investment Office used to rig and corner the IG and HY market, making billions in profits in what, on paper, were supposed to be safe, hedging investments until it all went to hell and resulted in the most humiliating episode of Jamie Dimon's career and huge losses: it was excess customer customer deposits arising from a $400+ billion gap between loans and deposits (with shadow liabilities and assets offsetting each other).

After JPM's fiasco went public, the firm hunkered down and promptly unwound (or is still in the process of doing so) its existing CIO positions at a huge loss. However, that meant that suddenly the firm found itself with nearly $400 billion billion in inert, non-margined cash: something that was unacceptable to the CEO and the firm's shareholders. In other words, it was time to get to work, Mr. Dimon, and put that cash to good, or bad as the case almost always is, use.

So what has JPM allocated all those billions in excess deposits over loans, which as of the most recent quarter hit a record $477 billion and rising as shown in the chart below:

Courtesy of Fortune magazine we now know the answer - CLOs: that remnant of the credit bubble excess from the mid 2000s, and which has logically made a stunning comeback now that the second credit bubble nearly popped a month ago following a few unprepared remarks by Ben Bernanke, is what JPM is actively funnelling cash into. Yes, the CIO is buying CLOs... With your deposit cash of course.

From Fortune Magazine:

According to several people familiar with the deals, JPMorgan's London chief investment office, which last year lost more than $6 billion betting on credit derivatives, is in the process of inking deals to buy significant portions of collateralized loan obligations, which are structured bonds that are backed by groups of loans to below investment-grade companies.

John Timperio, a lawyer at Dechert who specializes in CLOs, says he is working on two deals right now in which JPMorgan (JPM) is expected to be the main buyer. One is for loans to mid-sized companies, which carry more risk, but higher yields. In another deal, JPMorgan is planning to buy nearly all of the highest-rated piece of the CLO. "It's a fairly large deal," says Timperio. "JPMorgan is back in this market."

As a reminder for those who may have forgotten, CLOs are nothing more than a levered way to make the TBTF circle jerk even TBTFer, as one bank will arrange the CLO (by providing cash to junk-rated firms), tranche it, and then sell it, with other banks almost always picking up the vast majority of the issuance. In doing so, the financial system ends up effectively enmeshing itself in cross-default provisions, and any liability-cum-asset impairment (because one bank's liability ends up being another bank's asset and vice versa in the most phenomenal circle jerk) reverberates and picks up as much speed and destruction as there is leverage in the system. Per Forbes:

Perhaps the most surprising thing about the CLO revival is this: The entities that have emerged as the biggest buyers of the packages of risky bank loans are the banks themselves. JPMorgan holds more CLOs than any of its rivals. In the past two years, the bank has nearly doubled its holdings of CLOs to $27 billion, as of the end of the first quarter, which was the last time it disclosed its holdings. According to its filings, the CLOs were purchased by JPMorgan's chief investment office, which is the unit where Bruno Iksil, who was nicknamed the London Whale, worked. Three people confirmed that JPMorgan manages its CLO portfolio out of its London office. JPMorgan's CIO unit, which invests the bank's excess reserves, is now headed by Craig Delany, who took over for long-time CIO chief Ina Drew, who left shortly after the bank's multi-billion losses were revealed. JPMorgan slowed its CLO purchases in the wake of those losses. But it appears the bank is in the process of ramping up their purchases again.

Why are banks so eagerly returning to the worst practices that led to the credit crisis (aside from Bernanke's zero cost investable and fungible cash)? Two reasons: regulatory arbitrage, and leverage, of course.

Almost everyone in the CLO market, including many bankers, say one of biggest reasons banks are buying CLOs has to do with regulations. Financial reform was supposed to stamp out regulatory arbitrage, in which banks are able to swap one similar asset for another in order to be able to increase their leverage, which generally increases risk.

But that hasn't happened in the CLO market. Under the new capital rules, which were approved by the Federal Reserve in early July, loans to corporations have a risk weighting of 100%. The AAA slices of CLOs, which are the portion of the deals banks typically buy, have a risk weighting of only 20%. That means banks can invest five times as much in CLOs as they can in the underlying high-yield loans with the same amount of capital. The additional funds come from borrowing, which increases a bank's leverage.

In other words, when risk is repackaged as a CLO, it affords the bank 5x more leverage on the underlying equity. As for the ultimate collateral: as noted above it is the security of junk-rated companies - those which have a bad habit of going bankrupt every so often.

So assume a 50 cent recovery on the underlying loan in a standard scenario when the recession comes back and the delayed wave of corporate defaults finally hits, and further assume 5x leverage using the CLO structure: it means a 90% wipe out on invested equity.

As for what is the source of invested equity? Why client deposits of course: deposits which traditionally has been used to match loan growth, and thus have faced far less risk of 100% wipeout. Deposits, which represent a loan by a client to the bank in exchange for interest or what used to be interest before Bernanke came along. Sadly, in the New Normal, a deposit is merely a loan to the bank that retains all of the downside (i.e., full loss net of whatever FDIC protection the government may provide) and none of the upside: something US banks have been quite happy to take advantage of.

Cyprus may have had a forced bail-in, but US banks have a better plan: go all in with deposit capital, and pray for the best. Should a worst case scenario hit, and deposits get a 90% wipe out, then... oh well. It was coming anyway.

And while some $30-40 billion of the CIO cash gambling investing may be accounted for, it means some $400 billion is still "out there."

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The Case For Frontier Farmland

By: Scott Baker

The following post ran just recently over at Pathfinder Ventures blog, an investment advisory and asset management firm focused on select Frontier Markets. Our own Scott Baker provided the dialogue.

The following content is provided courtesy of our colleague Scott.  As Scott is passionate about the case for investment in frontier agriculture – a point in which we share much common ground – we asked him to share some of his insight:

“Last week I had lunch with an executive of a Mongolian real estate firm, where the conversation turned to the topic of how difficult it is to find real estate in city centres around the world at attractive yields. The hunt for such an opportunity brought back fond memories of the early 2000’s, when prices in many developing countries were undervalued and before dovish monetary policy created a stampede of investors seeking yield in developing world real estate.

We agreed that Ulaanbaatar’s downtown core is one of the world’s last real opportunities, where cap rates in excess of 10% are not uncommon. However, yield compression is underway as Mongolia transitions from a country where money was put into the ground to one where wealth is generated from assets coming out of the ground (mining). Further, on 17 June of this year the government initiated a program offering 8.0% mortgages for 20 years, a trend that is already gaining significant traction and if sustained will soon provide upward pressure on both commercial and residential property prices.

Though, if you’re not going to come to UB to compete with the Mongolia Growth Groups and MAD’s of the world, where else can you turn? You certainly can’t look frontier market hotspots like Phnom Penh, Luanda, Yangon or Maputo, as real estate is already overpriced. For example, shop houses in Phnom Penh are selling for $500,000+ and you’re lucky if you can garner a cap rate of 4.0%. Unfortunately, for the time being the real opportunity in city centers has come and gone. In our opinion, today’s real opportunity lies in farmland.

A global re-balancing of agricultural demand is well underway as a rising middle class of two billion people in the developing world demands larger per-capita quantities of everything from cereals to proteins. As countries seek food security there are two trends, among others, that I expect to accelerate: acquisitions of western brands (e.g. Shuanghui’s recent acquisition of Smithfield Foods), and increased demand for frontier agricultural land.

Why frontier farmland? Land in developed economies is no longer attractive to investors seeking a respectable cap rate, as Iowa farm prices confirm. In the mid-2000’s land prices went parabolic (see chart below) for what I term “Grade A” farmland (defined as land with rich soils, ample water supply and nearby important infrastructure). Though the uptrend has continued since 2010 through increased leverage from debt financing, a stage of maturity is likely nearing. So, rather than jumping on the bandwagon at this point and receiving a harsh thrashing (pun intended) I am upbeat about “Grade B” farmland (That which has a higher perceived risk due to its location and relative lack of development, causing it to be undervalued) as the potential upside is enormous.

Earlier this year I spent six months in Cambodia where market rates for agricultural concessions rank among the lowest in the world on a per-hectare basis, in some cases for as little as $500. The country’s red, loamy soils are ideal for growing rubber (a major cash crop in the region) and the market rate for operating plantations ranges between $10,000 to $20,000 per hectare. Investment in Cambodia is predicated on mean reversion between its two larger and more developed neighbors Thailand and Vietnam; that is, prices will have more significant upside due to higher prices in those countries. According to one of my local contacts, rubber plantations in those countries currently sell for as high as $50,000 per hectare.

Pathfinder Capital’s focus is on frontier markets where we see that significant upside still exists. Farmland and agribusiness, in select African and Asian nations, are two areas ripe with inefficiencies and lacking value-added services, resulting in sub-par yields and profits. Combined with the fact that the global agricultural community faces a demographic time bomb of aging farmers and slowing yield growth, the risk of both commodity and land values rising substantially continues to increase.

Therefore, we believe that capitalizing on this trend through aiding the increase of crop yields will lead to elevated cap rates and additional foreign investment.“

We’ll be discussing this subject more frequently in the near future, and tying it into an upcoming post on our current activities in southern Africa.

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Yearly Charts Signaled Major Trends

by Tom Aspray

It has been a good week for stocks even if they close lower today. In the middle of January, I reviewed the yearly charts of many of the key markets. From the ranges in 2012, the key levels for the stock market were the 2012 highs at: S&P 500–1474, Dow–13,662, Nasdaq 100–2878, and Russell 2000–869.

The Russell 2000 overcame the 2012 highs on the first trading day of 2013. The S&P 500 and Dow Industrials surpassed their 2012 high on January 17. The Nasdaq 100 confirmed on April 30 by finally exceeding the 2012 high.

The yearly ranges can be important in all markets as the USD/JPY surpassed its 2012 high in early January signaling a much weaker yen. It is down close to 16% for the year and has created some good opportunities in the Japanese stock market.

Therefore, for the rest of 2013, one should keep an eye on both the 2012 ranges, as well the current highs and lows for 2013.

Click to Enlarge

Chart Analysis: The yearly chart of the S&P shows the breakout above the resistance at line a that connected the 2000 and 2007 yearly highs. This completed a 900-point trading range, which has upside targets over 2400.

• The yearly chart of the S&P 500 (SPY) looks quite strong with January’s upside breakout.
• For the Spyder Trust (SPY), its 2012 high at $148.11 was also overcome on January 17.
• Basis the yearly chart, the next important support is at $142.41, which was the 2012 close.
• For the Dow Industrials, the 2012 close was at 13,104 while the Dow Jones Transportation Average closed at 5307.
• The yearly S&P 500 volume was the highest in 2009 but has since formed lower highs.
• The on-balance volume (OBV) is now well above the 2012 highs, which is a positive sign.

The Comex gold futures closed 2012 at $1675.80, which was well above the 2011 close at $1566.80.

• For 2013, this made the yearly range of $1798.10 and $1526.70 the important levels to watch.
• The 2012 low of 1526.7 was violated when prices plunged on April 13.
• Comex closed the day at $1501 and subsequently has dropped as low as $1179.
• This is a drop of $322 per ounce since the 2012 lows were broken on a daily closing basis. The 2010 low is at 1044.
• The yearly OBV has turned lower but did make a new high in 2012. It is well above its WMA.
• The SPDR Gold Trust (GLD) closed 2012 at $162.01 with a yearly high of $174.07 and a low of $148.53.
• The quarterly pivot for GLD is now at $129.89 with the S1 support at $105.92.
• Comex silver dropped below the 2012 low at $26.07 on April 12, and it has a quarterly pivot at $21.97.

Click to Enlarge

After all the press the dollar has received this year, many may be surprised by the relatively narrow ranges on the dollar index’s yearly chart.

• The Dollar Index closed 2012 at 79.87, which was just below the 2011 close of 80.52.
• The yearly chart shows that a doji was formed in 2012, which was a sign of indecision.
• A 2013 close above 84.24 would trigger a high close doji buy signal.
• The 2012 high at 84.24 has been slightly exceeded in 2013, which is a positive sign.
• The yearly OBV is acting much stronger than prices.
• The major yearly resistance is in the 88.80 to 89.71, which includes the yearly highs from 2008-2010.
• The EUR/USD rate closed at 1.3193, which was a bit above the 2011 close of 1.2959. The 2012 low was 1.2012 and the high was 1.3486.
• The 2012 high in the EUR/USD was exceeded on February 1 as it made a high of 1.3572. This is level to watch for the rest of the year with the 2013 low now at 1.2746.
• A breakout of these ranges is likely to be significant.

Crude oil closed 2012 lower at $91.82, which was significantly below the 2011 close of $98.83. So far in 2013, crude oil has stayed between the 2012 high and low.

• There is yearly resistance from 2012 at $110.55 with the 2011 high at $114.83.
• The quarterly R2 at 107.57 is now being tested.
• The quarterly pivot support is at 94.39 with further support at 91.82, which was the 2012 close.
• For yearly support, this year’s low at $85.61 is the key level to watch.
• If it were broken one would then focus on the 2012 low at $77.28 and then the 2011 low of $74.85.
• The yearly OBV is rising and is not far below the 2011 high.

What It Means: Based on the yearly charts, the dollar and crude oil look the most interesting. It would likely take significantly higher rates to push the dollar index above 89.71 for a multi-year breakout that would have major implications.

Given the technical readings on crude oil, a move above the yearly resistance at 110.55 does look likely.

How to Profit: No new recommendation.

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Gold building a base as evidence of physical shortage mounts

By Alasdair Macleod

Precious metal prices continue to build a base, with increasing evidence of a shortage of physical metal. In London gold forward rates (GOFO) continue to be negative, which means that the market will pay you more interest on your gold (COMEX:GCQ13) than on your dollars. GOFO is telling us that strong demand for physical from Asia has cleaned out the London market.

The chart of one-month GOFO covering the period from before the banking crisis is shown below.

Before the banking crisis GOFO was positive, peaking at 5.3% in August 2007, reflecting a Libor rate of 5.6% giving a premium for Libor over the gold lease rate of 0.3%. This is normal. When the banking crisis hit and the Fed reduced interest rates to zero, one-month Libor fell to 1.4% on November 20, 2008, and one-month GOFO went negative for three days in succession and two-month GOFO for two of those days.

The collapse in GOFO coincided with the end of a 20% fall in the gold price, marking the start of the subsequent bull market when the gold price more than doubled. Today the gold price has also had a sell-off and GOFO has now been negative for nine days, indicating a higher level of price stress than in the dark days of the banking crisis. Furthermore GOFO is persistently negative for up to three months this time signaling the shortage of deliverable bullion is more acute than in November 2008.

While the forward market in London is showing stress, the same is true on the Comex futures market, where warehouse stocks are dangerously low. The combination of the two with publicly recorded short positions on Comex is an explosive mixture.

The Managed Money shorts on Comex (mainly hedge funds) seem to be completely oblivious to a trap that even a junior trader would recognize. The longs have survived several debilitating bouts of margin calls, so can be assumed to be unshakable, and the bullion banks are now net long, which is highly unusual. The only speculators are the shorts of which hedge funds are the largest identifiable category, and they will be unable to close their positions at anything like current prices.

The UK’s Daily Telegraph recently published an article written by a UK-based hedge fund manager, which concluded that gold’s fair value is $240 per ounce. If his thinking is common to the other Masters of the Universe (as hedge-fund managers were once known) then it explains their actions.

There was an old saying in the London Stock exchange: “Where there’s a tip there’s a tap.” In other words, if someone tells you to buy or sell something he is promoting his own vested interest. It is a pretty good rule of thumb.

My vested interest? I try to stick to the facts. Opinions from economists and traders are to be detected and avoided. I suggest you read the Telegraph article in that light.

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