Katrina and the Waves

By: Brady Willett | Tue, Sep 6, 2005
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The giant waves Hurricane Katrina has sent through the global financial markets - like roads less traveled - will make all the difference for the remainder of 2005.

Energy prices are near record highs, the yield curve recently inverted (2Y vs. 3Y), and the Federal Reserve Board may be done tightening sooner rather than later. Welcome to the aftermath of Katrina: the devastating Hurricane that left death, human suffering, and chaotic financial markets in its path.

Notwithstanding how important energy prices and interest rates are to the US and credit drenched global economy, one of the biggest topics following Katrina is the price of gold. After dropping early last week the price of gold zoomed ahead by more than $12 an ounce for the three days ended last Friday (October contract). The culprit behind gold's resurgence was the falling dollar.

It goes without saying that Katrina has instigated a period of uncertainty. But whether not rising energy prices will cause a recession or falling US interest rates will add fuel to the already hot housing market is unknown. What is known is that any further rally in gold - to levels not seen in 16+ years - could quickly act to restore the dollar crisis fears that were running amuck in late 2004.

Katrina Not Found In Any Textbook

While Northern Trust Director of Economic Research, Paul Kasriel, is correct in that 'Katrina Had No Silver Lining', Mr. Kasriel's intellectually rigid conclusions fail to grasp how important Katrina could be on an international scale. Moreover, what Mr. Kasriel ignores when he calmly states that because of Katrina 'There will be a change in the composition of spending, not in its total', is that a major disaster can ignite an incredible chain of events. As an example, 9/11 will suffice:

Following 9/11 stocks crashed, the Fed quickened its pace of interest rate cuts, companies introduced new incentives to try and spur sales, and consumers went from saving more of their money (in June, July, August, and September 2001) to spending all of their money and then some in October 2001. In other words, 9/11 impacted financial markets, policy decisions, and business/consumer spending/confidence trends.

Whether or not Katrina proves to be the type of disaster that stalls but then kick starts the US economy* remains to be seen. Regardless, with energy prices near record highs, bond prices and Philadelphia Fed boss, Santomero, suggesting that the Fed may soon end its campaign of measured rate increases, and President Bush having released oil from the Strategic Petroleum Reserve, it is clear that Katrina has already had a deep impact on the financial markets and policy decisions.

In short, from a macro perspective Katrina is not about the destruction of 'real wealth' and the 'postponement of current consumption' on a localized scale. Rather, Katrina is all about setting into motion a chain of events that will lead to gains or losses in 'paper wealth' and the threat that energy expenditures will cannibalize consumption on a global scale. Unfortunately, given that the effects of Katrina have the potential to initiate self-fulfilling prophesies (i.e. as businesses/consumers start to think that a slowdown is near this alone brings about a slowdown), no textbook can answer what total impact Katrina will have until after the fact.

* The policy decisions in response to 9/11 aided the quick recovery in the American economy rather than the tragedy itself.

Commercial Facts & Go Figure

After holding a record net short position (as a % of open interest) in each of the two weeks ended August 23, the commercials covered a massive 49,257 contracts (futures & options) in the latest COT report. Since the COT report was compiled on August 30 the price of gold has rallied strongly, and it is almost certain that the commercials have begun accumulating short contracts again. Accordingly, and to reiterate last weeks sentiments : 'the commercials are having to exert more energy to curtail the price of gold with each rally...This suggests that the commercials are closer to losing control of the market than ever before.'

Since 2002 no major move higher in gold has started, much less been sustained, when the commercials were as short (as a % of OI) as they were last Tuesday (using futures & options). This, combined with the fact that gold is entering a seasonal strong trading period, could mean that the end to commercial rigging is near. And yet gold is near a key price level that the commercials have proven increasingly keen on protecting. Uncertainty in the gold market...Go figure.

Conclusions

The hope is that those still suffering because of Katrina will be attended to, and that the prolonged period of rebuilding will proceed quickly and smoothly. Similarly, the hope is that the US financial markets will retain their integrity; that Katrina's negative impact on US energy prices/infrastructure is temporary; that the upcoming meeting between the Fed and banks relating to derivatives goes smoothly; that the price of gold does not skyrocket as the US dollar sinks. Yet while the hope is for calm the reality is that the death toll from Katrina is likely to be staggering, and a major financial crisis is always around the corner.

Keeping in mind that the seemingly unquenchable appetite for US dollars is what keeps the global economy afloat, that Katrina runs the risk of curbing growth via an energy crisis is worrisome. However, that gold is threatening to unhinge from its traditional role as a hedge against inflation and become a legitimate currency choice for central bankers and safety minded investors is ominous. If gold zooms to new highs the commercials risk, at minimum, a mad rush to cover their paper short positions. At the maximum, the commercials would start defaulting, which could lead to an even further run on gold.

History is riddled with instances when fiat money has lost out to gold (unfortunately with the history of Greenspan hogging the limelight the history of gold as the safest of all investments rarely sees the light of day). Skyrocketing gold is a significantly more menacing prospect than $100 oil or a crashing US housing market. A run to gold equals a run out of the US dollar. Look out if this happens.

In short, despite the fact that the price of gold is overextended unless the dollar's demise is near, the only conclusion is to own some gold and forget about it. There will be another financial storm.


 

Brady Willett

Author: Brady Willett

Brady Willett
FallStreet.com

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