Gold to Replicate Oil's Parabolic Move; 30-yr Treasury Yields to Soar

With multiple bank failures looming and the US government doing nothing but take on bad debt and assets onto their balance sheet, we are looking for new lows in the US dollar as the fundamental backdrop of the US financial system continues to worsen by the day. Inflationary pressures continue to mount with oil and food hovering near their all-time highs, and the US continues to be hardest hit with respect to inflation due to the high cost of imports based on the declining purchasing power of the dollar. Note that while Europe, for example, has to pay the same $145 for a barrel of oil that we do, their currency has also appreciated almost 20% since last year, thereby mitigating some of their inflationary pressure.

Furthermore, with the US posting its sixth straight month of job losses in June, and the employment picture getting seemingly worse by the day, you can expect the unemployment rate to start ticking up toward 6% by year end. Take into consideration that these looming bank failures will definitely lead to large job losses in financial services, in addition to the layoffs recently announced within the energy-sensitive transportation sector, i.e. airlines and car companies like GM (GM).

In essence, what is happening is that the US government is taking on very large amounts of debt at the same time that their revenue base (i.e. tax collection) is declining due to higher unemployment and high inflation, which curbs consumer spending on discretionary items and hence produces slower growth for US corporations and therefore less corporate tax generation. Think of the US as a large company with debt levels climbing significantly and revenue and profit declining. What usually happens in a situation like this? Well, lenders usually begin to become much less willing to lend capital at prevailing rates, and at the same time the debt-laden institution is more likely to want to raise additional capital to maintain sufficient debt to equity ratios (and/or bailout failing financial institutions. The rising debt levels coupled with declining income lead to the perception of higher probability of default (even if slightly), and the higher probability gets priced into borrowing costs in the form of higher rates needing to be paid to lenders.

What will happen is that demand for newly issued treasuries will begin to wane and large current holders of bonds (i.e. China and Japan) will likely be more inclined to reduce their holdings of US debt as risk levels associated with these bonds rise in conjunction with the fact that the value of these bonds continue to decline due to the devaluation of the dollar. 

You can see how a situation like this turns into a rather vicious circle, with weak fundamentals affecting dollar values and dollar values causing a negative change in behavior which in turn puts pressure on fundamentals.  High inflation coupled with slow growth, rising unemployment, a weak currency, and rising debt levels is likely the worst situation an economy can be in which is why monetary policy is seen as so critical in maintaing all-important price stability. When inflation begins to soar, and central banks begin to lose credibility in containing inflation expectations, it is very difficult to work an economy back to stable ground without severe consequences.

Hence, we are expecting the yield on the 30-Year Treasury Bond to go much higher than the 4.44% it currently sits at as the risk associated with holding US debt increases and the expectation of prolonged high inflation begins to take form. Note that while the Fed has full control over rates at the short end of the yield curve (ie Fed Funds Rate), the Fed has zero control over yields at the long end which are completely set by open market forces.

Now looking at the trades, gold has several things going for it on a fundamental as well as technical basis. First off, we are in a financial storm predicated on worries over the soundness of financial institutions and the inherent value of the US dollar. This is the perfect backdrop for gold, as global investors tend to run to the yellow metal as the ultimate safe heaven in times of uncertainty within the financial system. Secondly, inflation expectations remain high and the dollar continues to weaken. Thirdly, central bank diversification out of US bonds is likely to benefit gold as central banks tend to increase their gold holdings in times of uncertainty and environments where risk aversion is prevalent.  Fourthly, the recent double bottom at 85 on the streetTracks Gold ETF (GLD) chart looks eerily similar to the double bottom at 80 we spotted on the United States Oil Fund (USO) chart back in March, which ultimately presaged oil's parabolic move from the 80s to 140s.

Take a close look at the USO chart below, paying particular attention to the mid March 2008 to early April 2008 double bottom at 80. Now stretch it out over a couple months rather than one month, and notice how closely it resembles the mid-April to mid-June double bottom at 85 on the GLD chart. They are almost perfect replicas and we believe we are at the same exact stage of the gold breakout with respect to oil....just beginning a major move to the upside.

Moreover, with oil nearly doubling over the past year and significant percentage gains made, it is likely that hedge funds and large institutions are now in search of the next asset class which may have greater potential for larger percentage gains down the road. This will likely lead them to gold, as the asset class is similar and it keeps them highly hedged against inflation. 

Hence, with fundamentals as well as technicals in place, we believe that gold has potential to become the new oil going into year end, and are looking for a very strong double top breakout over 100 in the GLD very soon.

In this kind of environment, with inflation expectations running high as well as multiple looming bank failures, there really is no limit to how high gold can go. Would it surprise me to see $1500-2000/oz by year end? No. Based on these assumptions, we have been buying the September 100 GLD calls here and will likely sit on these until gold breaks out over $1000.

Also note that large institutions have been taking extremely large positions in these calls over the past few sessions, with over 60,000 calls being bought yesterday and over 110,000 in open interest. Second of all, we have also been buying the September 90 puts on the iShares Lehman 20+ Year Treasury Bond ETF (TLT). It essentially tracks bond prices at the long end of the yield curve, and since we are bearish on bonds going forward, we'd like to have some exposure to the downside move.

click to enlarge images

GLD

USO

TLT

Disclosure: Author is Long September 100 GLD calls, Long September 90 TLT Puts

Comments

[jkollin]

looks like gold moved up at pretty much the same time already...and the demand is far more elastic...

[truthbetold]

Keep dreaming doomsayer. Oil is consumed, gold is not. America is still the shining city on the hill despite yours and the rest of the media's attempts to hide that reality. Dollar has likely bottomed as the other economies are in worse shape. S&P 500 down 20% while china down 50%. 50%! Think about that. Foreigners recognize the amazing opportunity of the weak dollar and weak US real estate and are buying while you fear monger the US investors into panicing. Vote the DEMS out of congress as they created this problem and stand in the way of the solution: Drill for US oil, creating US jobs and reversing the trade balance. We buy 12 million of our 20 million consumed barrels of oil a DAY from overseas. If we could produce 6 million more a day in the US or even 2 million, it would change things drastically. More US jobs, better trade balance, lower oil prices all could be had if congress would just GET OUT OF THE WAY. Vote those bums out. Offshore drilling is radically safer than it was in the 60's. Technology allows drilling in the violent North Sea without a single spill or spills during huricanes. Release our vast resources that are held prisioner by the Democrats!

[Get real!]

truthbetold says, "If we could produce 6 million more [barrels of oil] a day in the US or even 2 million, it would change things drastically."
Sorry to burst your bubble, but these numbers are impossible. For instance, even if ANWR (Arctic National Wildlife Refuge) held as much oil as in the oil companies' wet dreams, the most it would ever produce is 780,000 barrels per day, 20 years from now at its peak.
Remember, the U.S. consumes 25% of the world's oil, but we only have 3% of the world's oil reserves (and that includes ANWR and the Outer Continental Shelf). If we could produce 2-6 million more barrels per day, we would be the number one oil producer, more than Saudi Arabia pumps. Did you know the US is already the world's number 3 oil produceer, after Saudi Arabia and Russia, even though we only have 3% of the world's oil reserves? WE ARE SUCKING AMERICA DRY, EXTRACTING OIL SO FAST IT IS NOT SUSTAINABLE AT THE CURRENT RATE. Drilling more oil is like putting more straws in a cup -- it doesn't make your cup any bigger.
Any nation with 3% of the world's reserves of ANYTHING can never expect to continue consuming 25% of the world's reserves of that substance for long. Especting, as you do "Mr. truthbetold" that the US could be the number one oil producer if we just drill more holes, is like expecting that North Dakota will suddenly become the world's orange grower if they just plant enough trees -- North Dakota doens't have the climate for oranges, and the US has already used up God's allotment of oil through our relentless drilling over the past 150 years.
The only solution, like it or not, is conservation and energy efficiency (EE). You can put your head in the sand and pretend the US could produce more oil than Saudi Arabia "if we only tried," but that doesn't change geology or depletion rates.
Face it, the US is in for a load of hurt from our glutonous ways.

[Florin]

I do not think that yield on US treasuries will go much higher than say 5.25%. The FED will cap interest rates at these levels similar to the 40's, buying large amounts of treasuries.

[truthbetold]

Get real, you are sadly mistaken and don't do enough research and just believe liberal talking points. We have more oil locked in oil shale than all of saudi arabia's proven reserves. Once Shell determined an inexpensive way (profitable at $30 a barrel oil price) to extract said oil, the Dems in congress put the oil shale areas off limits. Brazil found oil reserves offshore to reach energy independence - supplying 80% of their total energy via oil. We don't know what's there until the shelf is explored. Also, there is an existing inactive rig off the coast of California that could be pumping oil in a little over 1 year if ban is lifted. We'd see significant increases in 5 years from off shore and less than 10 from ANWAR (incedentally, Clinton vetoed Anwar 10 years ago - sure would be nice to have that up and running now). All due to failed demcrat's policies of the past. Vote the bums out! The environmental insanity is now just a restriction on capitialism (politically motivated) and has no basis in protecting the environment.

[NewJersey]

wow, i think a few above posters are dellusional. the dollar is losing its footing as the reserve currency of the world because the federal reserve is being exposed as a horrible institution. it has 2 tools, the fed funds rate and the printing press. rates cannot go much lower and the printing press has been in over drive. $160 billion "liquidity injection" end of 2007, $120 billion bear bail out, $5 TRILLION fannie and freddia bail out, the list can continue.
Bush has prevented the International monetary fund from auditing the money supply because he knows he is printing the US$ into ruin.
Once this audit happens after he leaves office we will see 1970's era inflation.
truthbetold: the dems have not created our current problems the GOP has maintain a majority in congress for the majority of the recent past 10-20yrs

drilling will only prevent the inevitable END OF OIL, and the benefits would not be seen for 5-10yrs. The USA has drilled more holes in its soil and pumps out oil faster than any other country. more oil is not the answer.

[Daniel M.Ryan]

The real upward kicker for gold would come if price inflation keeps getting worse and bond yields do not rise all that much. A sustained negative real rate implies that the bond market has largely given up on its inflation-watchdog role. That sea change would allow the Fed to get away with more monetization of debt (money-supply expansion) than it has over the last 25 years. Given the current financial squeezes, the Fed might well take advantage, although initially with trepidation.

[Optimist E]

The short term answer to oil problems in the U.S. might be oil shale. True the U.S. only has 3% of the world's "proven" oil reserves, but that does not include shale, since it is not currently considered a "proven" resource. However, as long as sweet crude prices stay aboe $100, shale is feasible.

en.wikipedia.org/wiki/...

It might take a few years, but if prices stay high, it's sure to happen. Another alternative is solar energy:

www.inc.com/magazine/2...

www.nytimes.com/2008/0...

Kurzweil, an extremely accurate futurist in the past, predicts solar will be competitive with oil within 5 years. 5 years. People have been predicting the death of the human race for centuries, but a remarkable thing keeps happening. We keep inventing technologies to fix our problems. Humanity is not perfect and we do tend to stick it to each other too often, but we also have remarkable traits as well, and the ability to invent technologies to solve our problems is one of them.

The world is not coming to an end. No apocolypse is on the horizon. And remember, the U.S. economy will be at the heart of a lot of these technological changes so expect improvements there as well. Sure we are losing lots of manufacturing jobs, but we are moving into the next great infotech age: genetics (biotech), robotics, nanotechnology. Hold on!

[dgrayson]

Inflation protected bonds (TIPS) and managed futures is where its at. Actually all alternative investments are where one should look. Alot less risk and negative correlation to the market and all of these arguments. Manged futures funds make money whichever way oil or gold goes. The idea is to make money in all types of markets and altrenative investments is the way to make this article and the arguments attched null and void to the individual investor.

[jayz]

Agree, BTW, truthbetold - what an idiot

[jayz]

truthbetold - you're a f***ing moron

[buyitcheap]

a lot of good points in the posts and in the article: we'll be printing money for decades to absorb the bailouts of the ibanks, Fannie, Freddie, and then more boomers will be retiring, and that means even more money being printed which kills the value of the dollar and will likely require higher interest rates on the long end of the curve for certain.

As to "who" is at fault, it's the lot of them, the dems, republicans and the fools who elect them.

Instead of restricting drilling, let's restrict voting to people who know what the heck is going on? :-)

The solution is 3 fold, drill now, build nukes now, and do a rapid conversion to hydrogen. It would be a MASSIVE infrastructure building effort, but look at all the practice we're getting in rebuilding infrastructure in Iraq. :-) Believe it or not Newt Gingrich (I know, I know) has a very very interesting approach to this. I'm sure its on youtube.

[PastTense]

Inflation protected bonds (TIPS) are not in fact inflation protected; they use government statistics which vastly understate the true rate of inflation in this country.

[growthvalue]

Dollar is bottoming for a rise into 2009.
Pimco's Bill Gross likes U.S. dollar over euro
Posted Jul 15th 2008 12:24PM by Zack Miller
Filed under: International markets, Forecasts, S and P 500, DJIA, Federal Reserve

Investors have watched the precipitous fall in the U.S. dollar over the past few years with trepidation. Investors in Israeli stocks trading in the U.S. have witnessed the once-lowly shekel dominate the dollar (and most other global currencies) over the past two years. It looks, at least from some uber-investors' perspectives, that the dollar may be set to reverse -- a boon for those companies with significant sales in the U.S.

Bloomberg has an article out this morning saying that bond guru, Bill Gross, the manager of the world's largest bond fund, the $129 billion Pimco Total Return Fund, has turned negative on the euro for the first time since its inception in 1999. According to the article, Gross's firm, Pimco, believes that according to purchasing power parity, a measure used to account for differences in exchange rates across countries, the euro is overvalued by 30%.

And Gross isn't the only one who is concerned that Europe may suffer a bigger slowdown than the U.S. in a world confronted with slowing growth and financial snafus. The same Bloomberg article says that according to a recent poll conducted by Bloomberg of global strategists, many think that the euro has seen its day and that the dollar is poised for a rally (hard to believe in the face of Fannie Mae and IndyMac).

Europe's Trichet-led Central Bank has signaled that it may be done raising rates. In fact, given the choice between fighting inflation and re-energizing a sputtering economy, some are betting that the ECB may need to actually lower rates. With a Fed-led plan to bailout the U.S. banking system and the bottoming out of the dollar, it looks like Gross and Co. are betting against the euro for years to come.

[dgrayson]

Bill Gross is great. I use his Total Return Bond fund and his foreign bond fund hedged and un-hedged quite a bit for my clients.

What you say about TIPS are true, but it is an area that is showing positive returns and has the potential to continue to do so. Just and idea to make some returns in this market...

[starkoski]

Great article and don't forget about silver because it will do even better then gold!!!!

[nevket240]

I cannot believe ANY financial adviser would be so inept as to think that US inflation is around 4%. You must smoke the same weed as Al Gore.
Regards.

[Rhett]

Not much insight from the commetns so far.

[paultaut]

Rhett, yours is a very good insight.

[ussmls7]

When Americans realize who is really running the Fed & why so many in Congress are so ready to jump at what the Fed & Paulson are doing, things might change. The naked short selling should have apply to all forms of the market. The miners where left out for a reason,PMs are a way for the Fed to let certain traders to target & bring down PMs at a perfered time!
Not only are the Nancy & Harry dog & pony show a slap in the face to all Americans, it will bring more pain to the middle & lower class! There will not be any way to bring oil back to the real tradeing range ,with out all of the different energy sectors working in concert, putting all to work! The more delays from the gutless,selfish Nancy & Harry show, the more wealth that leaves for our friends in the middle east!
A whole county & city in AL., has converted all but a few vehicles into bio-des! They have cleaned up creek,ponds,junk yards & farms for old tires, 1 14 in tire yeilds 2.5 gallons of fuel, plus the steel is recycled, the county has no fuel bill for & what recoverd steel is not sold overseas, it is being used here, because of the high prices of steel. A home town boy, return fron school, with help, set this system up, & has now filed for the patent, now he did not wait on a bunch trying to get re-elected, what would happen if more chose to leave Congress out of the mix, more would get done!
As for the Enviormental bunch, its time they are banned from DC & any contact with any Elected Offical, let them fight the fires,fill sand bags, and work for a living , instead of takeing tax payers money to line their pockets!
There is a list posted on jsmineset.com, if you want to do your part, & get real change out of Congress & take back control of Americas resourses from the grips of the Huge I-Banks that have complete control of how our money is used! Goldman Sachs has bought the Fed,lock,stock & barrel. While Fanny & Freddy bought off Congress in the tune of Billions, Goldman was doing the same with the Fed,along with many others that are never listed in any MSM. This dead cat bounce, will be a chance to put more phyical PMs in your holdings, those ETFs are used in Naked Short Selling, just like in Comex, but did they stop that? No, why, its the few tools left for price surpression in PMs & its a crime!!
Look to history, it is repeating itself, but this time its different! Banks failing, FDIC has not the resourses to cover the coming flood of Failings, but thats not what is told by the Fed? The Fed can't stop inflation when they are causeing it by way of the printing press! Ron Paul hit it out of the Park, but He is Shunned by others in Congress,because they know He is right,but they have to many public records of donations from Goldmans,Fanny & Freddy, LA RAZA, GREEN MACHINE & the list goes on, sounds like a song!!
If each one of you would put as much energy into weeding out the scum in Both Houses, & work to get them outed for what they are,Americans might have a chance to realize how to vote for a person that will follow the Constitution & Bill of Rights! At the rate we are going, the Fed will Die in 2 to 4 years! As Nancy & Harry keep the Senate floor open to only Harrys way,Americans fall behind in the process that is so important to our Security & Well Being! I reference these web sites, goldseek.com,jsmineset.com,www.foll..., also if you like to see how bad the senate works, c-span.org

[Emerald]

Check the coastline of the U.S. and the governors. Republican (CA), Republicans (TX, MS, AL), Republican (FL), etc. Republicans have dominated congress for most of the last 20 years. We the people have no rational plan for energy independence. Obama is not the great answer, but more of George Bush/Dick Cheney policies will bankrupt us. Most citizens don't know that we are the third largest supplier of oil to ourselves! New jobs will come from infrastructure and alternative energy. Germany, of all countries, is the current leader in solar research. Wake up America!

[User 30121]

The Republican party is a party of BAD ideas, and the Democratic party is a party of NO ideas. Together, with the greedy bastards that feed them (special interest groups), the USA is in SHAMBLES. You out there, BUY and take PHYSICAL POSSESSION of gold and silver! Get your $$$ out of the banks! Then wait for the dust to settle! God save us!

[Kunst]

Sooner or later, the US is going to have to get by on a whole lot less than 25% of the world's oil production. A lot less.

And yes, truthbetold is an idiot. Oh well.

[bocacassidy]

The "Bakken" formation (Williston basin ) ...MT & ND has been recently ballyhooed to contain 500 billion barrels of recoverable crude ...
Is this by any remote stretch a fact...or rather an orchestrated propaganda ploy to."scare down" the price of oil" ?
It appears that Josef Goebbels ...or his Ghost....is alive and well !

[bocacassidy]

Truthbehold may be a student of Josef Goebbels !.
Well packaged fantasy will sell better than fact , if it is what the audience prefers to believe .

[Calvin C.]

If the historical ratio of gold to oil is 10:1, shouldn't gold be <$1000 by now? How much longer can the IMF & central banks keep gold down? It is poised to shoot above $1000 in the coming weeks.

[Calvin C.]

correction: >$1000