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Effects of a Bond Market Plunge

Clive Maund
12 April 2004

There are many conflicting forces at work in the gold and gold share market right now, added to which we have seen an increasing polarisation amongst prominent market commentators over the past week or two, with some remaining outright bullish and others turning bearish. In the face of all this the safest and most effective approach to this market is one of pragmatism, i.e. strategies based on a cool appraisal of the possible scenarios going forward, which are not hostage to any dogma or preconceived ideas.

For many, many months we have observed, and gone along with, the major bear market rally in the general stockmarket, aware that it has been fuelled by an unsustainable combination of zero real interest rates, a massive injection of liquidity and the unbridled expansion of credit and debt, the purpose seemingly being to stoke up a "Teflon recovery" and a feel good factor, so that the current US administration gets re-elected. It is a combination of circumstances that cannot continue - and will not continue.

There is a "Sword of Damocles" hanging over this market and that is the spectre of rising interest rates, which, given the magnitude of the excesses, will lead to a possibly disastrous implosion. The administration and the Fed are "keeping their fingers crossed" that they can stave off rate rises, or at least the effect of rate rises until after the election, but due to the fact that the situation is not entirely within their control this is a forlorn hope, especially given what has happened in the bond market over the past couple of weeks.

Rising rates are the "Kiss of Death" for the stockmarket, and the moment rates start rising we can expect to witness a severe decline in the general stockmarket. This is partly because the first rate rise, however modest, will be the equivalent of draping the New York stock exchange with a 50-foot high banner saying "Take Profits!" - whatever they say no-one will believe that the rise is anything other than the first of many. To be realistic, US investors should also factor in the ravaging effects of the falling dollar on their capital. Even though the US is a huge country, almost a continent and it is therefore easy to adopt an insular, inward looking attitude and ignore the effects of the falling dollar, it should still be acknowledged for what it is, a real loss of international purchasing power. It is for this reason that I have also included a long-term chart showing the Dow Jones index expressed in Euros above.

On Friday the 2nd the bond market plunged amid a wave of selling, resulting in the biggest one-day loss for years. Such a move at this juncture, although only a one-day occurrence, signals the probable start of the long-awaited stampede out of bonds. Bonds down equals interest rates up. Real interest rates are already rising and it is now only a matter of time, probably no more than a few months, before the Fed's hand is forced and "official" interest rates have to rise. The impact of rate rises on a chronically debt-ridden and maladjusted economy cannot be over-estimated. When this happens the stockmarket can be expected to nosedive.

Although aware of this lurking danger my thinking until now had been that the gold share market would likely be granted the time to work in another intermediate uptrend before the wheel came off the general market, and this uptrend has been starting to get underway over the past few weeks. The widely held belief, for a long time, has been that they, the current Administration and the Fed, would simply not allow the markets to unravel before the elections in the fall, and would prevent this from happening by a policy of zero interest rates and limitless liquidity etc, even if it did undermine the dollar. I have known that they would try to pull this off for a long time, and you have to give them credit (no pun intended), they have very nearly gotten away with it - it's April now, only 7 months to go and the major TV networks are already talking about the wonderful recovery and were looking forward to being able to say, in a few months time: "You've never had it so good!"

But, alas, the action of the past couple of weeks in the bond market shows that bond investors are getting tired of endlessly stumping up money to buy mountains of paper in a technically bankrupt economy, and unfortunately the government and Fed do not control this market. The action in the bond market on Friday the 2nd hoisted a big red flag saying "GAME OVER." This action could well signal the start of a rout in the bond market, to be swiftly followed by rate rises and a general stockmarket cave-in and Real Estate crash.

There are 2 ways in which this train of events may impact negatively on PM shares over the intermediate term. If the stockmarket tanks, as expected, then investors will be dumping all stocks indiscriminately, and can be trusted to "throw out the baby with the bathwater" and this may include PM stocks.

Fundamentally it might make no sense, but it is a dangerous mistake to underestimate the destructive power of a mob on the move. We will know if this is happening if the important support levels shown on the charts below are breached around the time of the onset of a general market meltdown. If they are it will indicate a serious technical weakening and open the door to the possibility of steep declines. There is, however, one factor that could save the PM stocks and even cause them to rise when the general stockmarket caves in, and that is if there is a SIMULTANEOUS flight of capital into the precious metals, causing an immediate dramatic advance by both gold and silver. Treading water won't be good enough. In my view, if the metals only succeed in holding steady, the stocks will get taken down. The second potential negative effect of these developments, in particular the rising rates, will result from any support given to the dollar by these rising rates, although this is more difficult to quantify. The dollar has been strengthening in recent weeks, and this looks like it may have been in anticipation of rising rates. To the extent that the dollar rises, it will probably have an adverse effect on gold, which appears to have just double-topped in the $430 area, and is currently therefore in a trading range above $390.

If the general market does experience a panic sell-off, as expected, over the coming weeks/months, and if gold and silver stocks get taken down too it will, of course, create a major buying opportunity in these stocks for those investors who are cash rich, as in the ensuing mayhem the precious metals can be expected to outperform virtually every other asset class and so the PM stocks should rebound strongly post crash and forge ahead.

Critical support levels for the HUI and a selection of mainstream gold stocks follow for subscribers...

11 April, 2004
Clive Maund

Clive Maund is an English technical analyst, holding a diploma from the Society of Technical Analysts, Cambridge and living in southern Bavaria, Germany.

Visit his website at clivemaund.com.

No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.

Copyright © CliveMaund 2004. All Rights Reserved.
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