Market Update

Gold on Launch Pad As Rate Hikes Near Their End

7/24/06

Dollar and Bonds:

From the July 10th Update:

"The expectation of interest rate hikes provided a boost for the dollar index in June. However, the dollar rally seems to have run out of steam after the FOMC raised the short term rate by 0.25% to 5.25%. I believe we have the proverbial "buy on rumor, sell on news" situation regarding the dollar / interest rate movement. Consequently we might see the dollar meandering between 84 and 88 before eventually breaking down to test an all-time low of 81 by year's end."¨

"US long bonds tried to climb back above the channel but failed as the Bank of Japan is rumored to be about to lift interest rates, which are currently near zero percent, for the first time in almost six years. This is a bearish development for US bonds."

Last week, Ben Bernanke made soothing remarks about inflation, and acknowledged that growth in the American economy may be slowing.

Those remarks have strengthened the case that interest rate increases may be coming to an end. While the seventeen straight interest rate hikes by the Fed since June of 2004 provided little help to calm gold and commodity prices, the effects are now being felt in markets across the board from housing to high-tech. The S&P 500 has broken down out of its 3 year uptrend and cannot sustain further rate shocks.

As seen from the charts above, in December of 2005, the dollar index started its rebound from its historic low of 80. In April of 2006, after an uptrend that lasted 16 months the dollar index broke down. This breakdown is significant, and given our belief that the rate hikes will be finished by September, we see limited upside by the dollar, capped by its 200 DMA of 88.

US long bonds tried to rebound but stayed below the trend line.

Gold and Silver:

From the July 10th Update:

"Both gold and silver broke out in late 2005 and have likely just successfully retested the 200 DMA (day moving average, red line) in June. Gold is currently just beneath the 50 DMA of $630. Given that it has risen over 20% from the correction low of $520, we wouldn't be surprised if it corrects one more time back to 200 DMA of $560 before resuming the uptrend."

Gold came out of its 2 decade long hibernation in December 2005, when it pierced through the key resistance level of $500. Its subsequent action was not at all unusual for a bull market, as gold quickly raced to $720 before a retest of support occurred in May.

On May 12th gold hit a multi-decade high of $730 before falling back to $570 in June. Since then gold has been rather volatile, with daily rises and dips between $5-15 seen as the norm. Again increased volatility is norm when an important resistance has been overcome.

We continue to believe, with the aid of Newmontˇ¦s technical chart, that the gold and gold equity bulls will resume their fierce uptrend in Q3 of 2006. Throughout the summer, barring any major unforeseen developments in the Middle East, we expect gold to consolidate in the $560-700 range.

XAU:

From the July 10th Update:

"In June the XAU index briefly dipped below its 200 day moving average, bottoming at about 120. The XAU is currently at about 143. Given that the XAU has run up 20% in just 3 weeks, we could see a dip to the 130's. Again, as we noted, summer is the time of consolidation. Volatility is the name of the game until the XAU makes its emphatic break out towards the latter part of the year."

"The ratio of XAU over gold is currently just above its 200 moving day average of 0.23. The past peak of the XAU/gold ratio is about .28. This indicates that mining equities are not overvalued relative to the current price of gold. We still don't see a premium in gold stocks."

The XAU index closed the week at 133 just above its 200 DMA (daily moving average). During the summer months of thinning volume it may be possible for the XAU to breach the 200 DMA. Nonetheless, any significant moves ahead of the expected run-up in autumn should be seen as brief and temporary.

The ratio of XAU over gold ended last week at 0.21, which is below its 200 DMA of 0.237 and 50 DMA of 0.221. Low ratios often indicate the bottom of gold, rather than peak. Mining equities remain undervalued relative to the current price of gold.

S&P500, Nikkei, Shanghai:

From the July 10th Update:

"In late June, The S&P 500 broke down from its 2-year-long rising wedge. This is bearish for the equity market. If S&P stays below the channel by the end of August, this will likely mean that a multi-year peak is in place for S&P 500. Such a case would not exactly be friendly to the gold stocks (since gold stocks belong to the equity class) and we should pay close attention to the overall equity environment."

The S&P 500 is now feeling the effects of higher interest rates. Real estate markets are affected by higher ARM (adjustable rate mortgage) rates, and auto and consumer retail markets are affected by higher car and credit card loan rates.

The overall economy is also suffering from the effect of higher oil prices. Due to higher prices, every month hundreds of dollars are being poured into gas tanks rather than department stores and local restaurants. The S&P 500 has firmly broken down from its 3 year uptrend and cannot sustain further rate shocks.

While there is a need to clamp down on the raging commodity markets, the Fed has no more room to raise rates further. It is our belief that Bernanke will halt the rate hikes by September and possibly start cutting rates by the end of the year.

The Shanghai has continued its uptrend as the Chinese economy continues its rapid growth. Last Thursday the Chinese government announced that the economy grew 11.3% in the second quarter compared to a year earlier. It was the largest GDP jump in six quarters. For much of 2005, the Chinese central government took drastic measures to slow down the economy. This has built up pent up demand for a rainy day in case the US economy craters. With US markets seemingly slowing down rapidly, they are now allowing Chinese domestic consumption to pick up the slack from export markets.

CRB and Oil

From the July 10th Update:

"Last week crude oil prices set new records, climbing as high as $75.55 a barrel. This year the price of oil is up about 23%."

"The CRB ended last week at around 350 and remains comfortably in its uptrend. Both markets confirmed the commodity uptrend."

The initial outbreak of war between Lebanon and Israel about two weeks ago helped send oil to a record high of $78.40. Oil looks to be quite stretched above its 200 DMA. Prior times (Oct 2004 and August 2005) when oil was $15 above its 200 DMA, a correction back to 200 DMA (currently $66) ensued.

The CRB has remained comfortably above its 200 DMA at the moment, if oil were to correct back to high 60ˇ¦s, other components in the CRB (such as metals) must pick up the slack for CRB to remain above 200 DMA.

Conclusion:

Home builder stocks have cratered 40% this year. The S&P 500 has broken down from the uptrend established since 2003. The seventeen consecutive rate hikes are now being felt across the board in the US economy.

It is apparent to us that the cycle of interest rate hikes by the Fed is coming to an end. This could turn out to be a very bearish development for the dollar as foreign investors need high dollar interest rates to overlook dollarˇ¦s defects such as trade and budget deficits.

A possible pause of interest rate hikes supports our view that the dollar index is about to test its historic low of 80 this year.

Gold and the dollar tend to go in opposite directions. We have a very favorable view of gold for the fall in light of

1. dollar weakness ahead
2. fall is traditionally a strong demand season for gold
3. the fact that $500 support for gold was retested in the summer

Gold market should remain volatile and trade in the $560-700 range in July and August. Once the summer ends, seasonal gold demand picks up, traders return to their desks from vacations, and the Federal Reserve officially ends its cycle of rate hikes, gold will be propelled to new highs past $720. We feel that these factors will help make this autumn the most spectacular showing for gold we have seen to date.