Central Bankers' Worst Nightmare - the Gold and Bond Vigilantes
Former Fed chief "Easy" Al Greenspan's immortal legacy remains intact, after existing from center stage at the pinnacle of his success. And timing is everything.
The champagne is on ice, and Wall Street is ready to celebrate the return of the Dow Jones Industrials (DJI) average to its former record high of 11,750, last seen in January 2000. The DJI has been on a wild rollercoaster ride, plunging to as low as 7200 in October 2002, just months ahead of the US invasion of Iraq. In the months leading up to the invasion, global equity markets were tumbling as crude oil prices approached $40 per barrel, fearing Saddam would sabotage Iraq's oilfields.
Today, crude oil is hovering near $70 per barrel, yet the US economy expanded at an annualized 4.8% rate in the first quarter 2006, the fastest in more than two years, led by resurgent consumer spending and the biggest jump in business investment since 2000. Consumer spending, which accounts for 70% of the US economy, sped ahead at a 5.5% annualized rate, the most since the third quarter of 2003, and compares with an average of about 3.3% over the last two decades.
The US and global economies are seemingly immune to massive oil price shocks, and not afraid of the "Commodity Super Cycle" which has lifted base metals to stratospheric levels and gold to $680 per ounce, its highest in 25 years. Global equity markets are still riding the massive wave of liquidity injected into the money markets by G-10 central bankers over the past five years.
Global central bankers are still inflating their money supplies to keep borrowing costs low, in the face of strong loan demand, especially for corporate takeovers. Globally, 5,800 takeovers valued at $859 billion were announced in the first three months of 2006, the fastest start since the record M&A year of 2000. The Euro zone's M3 money supply is 8.6% higher from a year ago, and the UK's M4 is 12.2% higher. China's M2 money measure is 18.8% higher. The US M3 is off the charts.
However, the global markets have become increasingly sophisticated over the past few years, and much to the chagrin of G-10 central bankers, traders have imposed a de-facto gold standard on worldwide exchanges. In other words, clandestine attempts by G-10 central bankers to pump up their equity and housing markets by increasing the money supply would be confronted with higher gold prices.
As gold becomes more widely accepted among global investors as the best measure for valuing exchange traded assets, the G-10 central bankers' worst nightmare would begin to materialize - the resurrection of the global bond market vigilantes.
The infamous bond market vigilantes of the 1980's and early 1990's had displayed such awesome power, with their ability to jack-up long-term bond yields by a quarter to a half-percent on short notice, disciplining central bankers when they printed too much money, or when political parties spilled to much budgetary red ink.
Bond market vigilantes could eventually restore global bond yields to wide and positive real rates of return, i.e. well above inflation rates, thus forcing G-10 central bankers to tighten up on the broader measures of the money supply.
In the US, the Greenspan Fed inflated the M3 money supply by 72% or a whopping $4.3 trillion over six years to a record $10.27 trillion, and then decided to stop publishing the M3 measure on March 24th, 2006. Greenspan's magic formula for dealing with global crises and restoring the DJI to record highs was his ability to inflate the US M3 money supply, while keeping the bond market vigilantes under wraps. The Fed had plenty of outside help from Asian central bankers.
But while the DJI is celebrating its hard fought recovery to record highs, the DJI has also lost 60% of its value to gold since its peak of 42.5 ounces in 1999. Investors were much better off owning an ounce of gold, than a share of the Dow Jones Industrials over the past six years. Nowadays, the gold vigilantes are stubbornly tracking the direction of monetized stock indexes around the globe. Someday, Greenspan's magic formula could turn into Bernanke's worst nightmare.
"If your question is do I look at gold prices?' it's on my screen, I look at it every day. I think there is information in the gold price as there is in other commodity prices. But there are also other indicators of inflation, which suggest that inflation expectations are relatively well controlled," said Fed chief Ben Bernanke, on April 27th, before the Joint Economic Committee of the US Congress.
"The puzzle is why are gold prices rising so fast? There is probably some fear of inflation. There certainly is some speculation about commodity price increases in general, which is being driven by world economic growth. But clearly, a factor in the gold price has got to be global geopolitical uncertainty, with the view of some investors that, given what is going on in the world today, that gold is a safe haven investment," Bernanke explained.
The Dow Jones Industrials are immune to a possible military attack on Iran's nuclear installations that could ratchet oil prices above $100 per barrel. Traders are confident that Fed chief Bernanke would provide a safety net for the equity market, in the event of a war, by lowering the fed funds rate and increasing the US money supply. An easier Fed policy would also push up the price of gold.
Bernanke presented his strategy on dealing with oil prices shocks in a speech given on October 24th, 2004. "If inflation expectations are low and firmly anchored, then less urgency is required in responding to the inflation threat posed by higher oil prices. In this case, monetary policy need not tighten and could conceivably ease in the wake of an oil-price shock," he said.
Bernanke's Reputation as a Super dove
On May 2nd, CNBC reporter Maria Bartiromo revealed that Bernanke finds "'it's worrisome that people would look at me as dovish and not necessarily an aggressive inflation-fighter." But since President Bush appointed "Helicopter" Ben to replace "Easy" Al, the price of gold has soared by $210 per ounce to its highest in 25-years. The yield on the US Treasury's 10-year note climbed 80 basis points to 5.15%.
Bernanke's reputation as a super dove is engraved by his most infamous speech delivered in November 2002. "The US government has a technology, called a printing press that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
Bernanke's second tragic error was his collusion in hiding the M3 money supply figures, obscuring the transparency of the Fed's monetary operations. It is very dangerous to have the US dollar printing presses in the hands of political appointees, without the accountability of M3 reporting. Such a situation demands a higher risk premium for holding the US dollar and long term US bonds. Instead, US investors are flocking to gold as safe haven from the US central bank.
Then on October 24th, 2005, after accepting his nomination by President Bush to lead the Fed, Bernanke tried to brainwash the gold and Treasury debt markets, and said that there was little reason to fear that the sharp rise in energy prices would feed through into wider inflation. "The evidence seems to be that it is primarily in energy and some raw materials and has not fed into broader inflation measures or expectations. My anticipation is that's the way it's going to stay," he said
But gold vigilantes were not persuaded by Bernanke's weak arguments, and decided to bid the yellow metal $210 /oz higher over the next six months. The bond market vigilantes sprung to life and lifted 10-year yields by 75 basis points, in reaction to the inflationary signals emanating from the gold market.
Six months later, on May 5th, 2006, President Bush was forced to come to Bernanke's defense. Asked if the soaring price of gold, accompanied by higher bond yields, and a falling US dollar meant that the Fed chief had a credibility problem, Bush told CNBC television, "No. This guy's sound, he's smart, he's capable. You might remember, when I first nominated him, he was well received by most accounts as being a sound thinker who will be independent from the politics of Washington."
Bernanke Signals a Pause in Fed Rate Hike Campaign
But one should remember, that every Fed chairman is presented with a financial crisis or two during his tenure, and the former Princeton Economics professor, Ben Bernanke will probably be tested with some real world turbulence, far removed from the ivory towers of academia. The Bernanke Fed is now signaling a pause in its 23-month rate hike campaign at 5% to avoid bursting the US housing bubble, and already the US dollar has come under heavy attack.
The US dollar index has tumbled 6% against a basket of foreign currencies, including, the British pound, Euro, Japanese yen, and Swiss franc, since Fed officials telegraphed a pause in their 23-month rate hike campaign. The US dollar could crash to new lows if the Bernanke Fed were forced to lower the fed funds rate to re-inflate the US housing market. A plunging dollar could in turn, lift gold prices and energize the US bond market vigilantes.
Whereas the Greenspan Fed primarily targeted US equity markets in its monetary policy decisions over the past six years, the Bernanke Fed is likely to target US home prices, the goose that lays the golden eggs for US consumers. A fourth to a third of home equity cashed out by households is being used to finance consumer spending, the biggest driver of US economic growth. Another 25% goes to repay credit card debt for goods and services already purchased.
Higher home prices and mortgage rates have taken its toll on US home buying, which began to soften after the summer. Since July, US home builder Toll Bros, TOL.N has lost 47% of its value. Toll Brothers cut its forecast for the number of homes it expects to sell in fiscal 2006 and said quarterly orders fell 32% on softening demand and a build-up of homes on the market. But TOL.N rose more than 3% on May 5th, on high hopes the Bernanke Fed would stop raising interest rates.
With US home prices at risk of turning lower, the Fed wants to move to the sidelines and sub contract the job of fighting global inflation to other central banks, such as the Bank of England, the European Central Bank, and the Bank of Japan. But these foreign central banks are playing a game of smoke and mirrors, guiding rates higher at a snail's pace, while allowing an abundance of local liquidity to drive commodity and equity value through the roof.
Bank of England Targets UK home prices
The Federal Reserve hopes to engineer a soft landing for US home prices, similar to the feat performed by the Bank of England. The BoE began its mini rate hike campaign a year before the Fed, lifting its base rate 125 basis points to 4.75% until August 2004. Then, the BOE left its base rate unchanged for a year at 4.75%, and slowed home price inflation from an annualized 25% to zero percent a year later.
But the BOE panicked in August 2005 at signs of a possible decline in UK home prices in August 2005, and lowered its base rate by a quarter-point to 4.50%. The rate cut halted the slide of British home prices, and according to Nation-wide mortgage brokers, prices are now moving higher again into record territory. London futures markets are pricing in a tiny quarter-point BOE rate hike to 4.75% by year's end, taking back the bank's insurance against lower home prices.
However, more Britons than ever were unable to pay back their debts and tens of thousands faced the threat of losing their home in the first quarter of 2006 as the nation's trillion-pound debt mountain claimed even more victims. Consumer insolvencies in England and Wales leapt 73% on a year ago to a seasonally adjusted 23,351 in January to March, up 13% on the previous three months and the highest quarterly total since comparable records began in 1960.
Simply put, the BOE cannot afford a decline in UK home prices, which could wreck havoc on an economy dependent on asset inflation. But the BOE's quarter point rate cut to 4.50% in August 2005, and signals that lower rates were in the pipeline, convinced gold vigilantes that the BOE would do whatever was necessary to prevent deflation. And so, the gold standard was imposed upon the BOE over the next eight months, as the British pound collapsed by 65% against gold.
Ironically, the market's re-introduction of the gold standard in the UK, occurred five years after the Bank of England thought the gold market was dead, when it sold two-thirds of its gold, or 415 tons below $300 per ounce in 1999 thru early 2001.
Loan demand for UK mergers and acquisitions was strong in the first quarter, with the value of UK-targeted M&A volumes at $101.6 billion, compared with $42.7 billion for the same period in 2005. The BOE held down local borrowing costs by increasing its M4 money supply by 1.1% in March to stand 12.4% higher from a year earlier. Thus, a tiny quarter-point rate hike to 4.75% won't slow the growth of M4, and eventually, the British gilt vigilantes must jack-up long term UK rates high enough to force the dovish BOE to tighten its money supply.
European Central Bank Pursues Ultra-Easy Money Policy
Bundesbank chief Axel Weber was careful not to encourage speculation of a half-point rate hike at the next ECB meeting in June, but neither did he rule out the possibility. "I don't want to be misunderstood, but all options are always open. I have said that we are in an environment where we have a very strong liquidity dynamic. It has increased despite the two rate moves, and we have more liquidity than is needed to finance non-inflationary growth."
"Because of that, we have to brake the liquidity dynamic and that will play a role in our decisions." Yet at the last two ECB meetings in April and on May 4th, the central bank balked at hiking is repo rate, which stands at 2.5%, or roughly 3% below the Euro zone's producer price inflation rate. The Euro M3 money supply growth rate expanded at an annualized 8.6% in March, its highest since July 2003 and the third straight rise in the pace of expansion after an easing last year.
Loans to the private sector, which the ECB is concerned will further push up liquidity, grew 10.8% in the year, the fastest growth since 1992. It was driven by strong borrowing by firms as well as households, with both rising at their fastest in five years or more. Mortgage growth topped 12.1%, the highest since 1999. An increase in Mergers and Acquisitions was most pronounced in Europe, more than doubling to $454 billion in the first quarter from a year earlier.
Demand for loans, especially for long-term credit, is rising strongly in Germany and questions must be asked about whether global interest rates are appropriate, said the next ECB chief economist Juergen Stark on March 28th, 2006. "We are dealing with a global wave of liquidity today. One must ask oneself whether key interest rates are sending the correct signal here." Stark said the expanding money supply was a problem in Europe and that, "This development is unsustainable," he said.
The ECB has pursued a policy of "asset targeting" guiding Euro zone equity markets higher by inflating its M3 money supply, and keeping the cost of borrowing low. In turn, negative ECB lending rates nurtured $1 trillion of mergers and acquisitions across Europe in 2005, lifting equity markets even higher. The gold vigilantes in Europe took notice of the ECB's scheme in September 2005, and lifted the yellow metal 60% higher to 538 Euros per ounce. Meanwhile, the EuroStoxx-600 lost 21% of its value relative to gold, falling to a three-year low.
On March 30th, 2006, ECB chief Jean "Tricky" Trichet tried to derail the gold market and hold down an upwards spiral in German benchmark bund yields. "We are still and will continue to be credible, as we were at the first day. Our anchoring of inflationary expectations remains impeccable because markets know we are very, very serious when we are speaking of preserving and maintaining price stability."
Trichet also gave a boastful speech before the Federal Reserve's Monetary conference on October 1st, 2005, just days after gold rose above a four year resistance level of 350 Euros per ounce, and was set to explode towards 538 Euros a few months later. "Our credibility has enabled us to regain full control of inflationary expectations with remarkable efficiency over the last two years. And this was because observers and market participants rightly had the intimate conviction that we intended to be absolutely ready to act at any time if needed," he declared.
"Stability in long-term inflation expectations was restored without engineering policy actions." Trichet added the ECB remains ready to change rates whenever the inflation outlook makes it necessary. "I have very regularly made the point that we were not making any promises to the markets about future policy moves and that we stood ready to act as soon as is necessary to maintain price stability," he said. Yet the ECB refused to lift its repo rate at the April and May 2006 meetings
But the collapse of the Euro against gold awakened the German Bund vigilantes in Frankfurt for the first time in two years, which presents a major dilemma for "Tricky" Trichet. The ECB's failure to follow through on its tough anti-inflation rhetoric at the April and May 2006 meetings, quickly sent gold up 50 Euros higher to 538 Euros/ oz and sent German bund yields a quarter-point higher to 4.00%. Behind the curtain, the ECB wants to stick to a three-month time table between rate hikes.
If correct, the next quarter-point rate hike to 2.75% in June might be the only ECB tightening over the next four months, and unlikely to put a dent in the explosive growth rate of the Euro M3 money supply. Beyond its desire to keep equity markets buoyant, the ECB also aims to slow the Euro's advance against the US dollar and Chinese yuan, to protect Euro zone exporters and multinational profits from abroad.
Japanese Bond Market Returning to Normalcy
The Bank of Japan abandoned its super-easy monetary policy on March 9th, switching from a policy of flooding the banking system with an excess of 26 trillion yen to a more conventional policy of controlling interest rates. Still, "we aren't ending the zero interest rate policy immediately after we have absorbed excess funds from the market. It is possible the zero-rate policy will continue for a while. We will keep interest rates at extremely low levels even after ending the zero interest rate policy," said BOJ chief Toshihiko "Freebie" Fukui on April 27th.
Whatever tightening the Bank of Japan may have in store for 2006, it is not expected to start until the second half of the year, and would still keep Tokyo as a cheapest source of funding in the global market-place. Japan's financial warlords aim to safeguard the spectacular 40% gains of the Nikkei-225 rally from a year ago, and loathe risking any action that could break its bullish psychology.
As such, the Japanese gold vigilantes are closely tracking the Nikkei-225 index, recognizing a greater "wealth effect" on consumer spending and inflationary pressures in the local economy. Japan's wholesale price index has been in positive territory for 25-months and stands 2.7% higher from a year ago. But Japan's 10-year bond yield of 1.96% offers a negative real rate of interest, presenting Nikkei stocks and gold as the better hedge against inflation.
Without the daily injection of morphine from the BOJ, the Japanese bond vigilantes are starting to flex some of their own muscle for the first time in five years. Fukui noted on April 21st, that Japan's long-term interest rates are reflecting the economic recovery and rising stock prices, noting that long-term interest rates were rising in the United States and Europe by about the same amount.
Japan government 10-year bond (JGB) yields have surged toward seven-year highs of 2%, partly on speculation that the BOJ would raise short-term interest rates from zero by year's end. JGB yields started to track the price of gold in August 2005, when "Freebie" Fukui told bankers that the core CPI rate could move above zero percent in December or late January.
But inflation expectations remain deeply entrenched in the Tokyo money markets, after five years of zero percent interest rates, and gold has surged 20% to a record 78,000 yen per ounce, even after the BOJ signaled an end to quantitative easing. The BOJ still has many turf wars to fight with the Ministry of Finance, which is strongly opposed to higher Japanese interest rates. Every one percent rise in JGB bond yields increases Japan's debt servicing costs by 1.5 trillion yen.
On May 7th, Fukui said the BOJ was likely to finish draining the excess liquidity of 26 trillion yen from the Tokyo money market in the next few weeks, pushing the US dollar to an eight-month low of 111-yen. The Ministry of Finance lives in eternal fear of a weaker yen, which could subtract profits of Nikkei-225 exporters and undermine the beloved Nikkei-225 and broader Topix stock markets.
Japan borrowed 35 trillion yen in the five quarters until March 2004, and bought $US300 billion in the foreign exchange market in a desperate attempt to prevent the dollar from falling below 110-yen. Tokyo has not intervened since March 2004, and is probably reluctant to borrow more yen to support the greenback, with the BOJ lifting interest rates on short-term bills. If the dollar continues to weaken further against the Japanese yen, the MOF would ratchet up the pressure on the BOJ to maintain overnight loan rates at zero percent for an extended period of time.
The Resurrection of the Global Bond Vigilantes
Global bond yields have been abnormally low for the past three years due to the irrational buying habits of Asian central banks, mostly China and Japan, and more recently, Arab oil kingdoms in the Persian Gulf. Arab oil kingdoms may have recycled up to $150 billion of US petro-dollars into the US Treasury bond market since January 2005, when the US dollar was showing some signs of stability.
Should Beijing, Tokyo, or Riyadh decide to curtail their purchases of US bonds or turn into net sellers in the months ahead, it would provide greater freedom for the bond vigilantes to lift long-term yields. Ironically, any attempt by the Bernanke Fed to cushion US home prices with a lower fed funds rate could backfire, if the US dollar comes under heavy speculative attack, and foreign central banks sell US bonds.
A flight to safety following the collapse of Gulf stock markets in over the past six months, linked to fears of an eventual US-Israeli military attack on Iran's nuclear installations, persuaded Arab oil kingdoms to step-up purchases of US bonds through their London based brokers. Arab oil kingdoms are committed to the US petro-dollar in exchange for oil exports abroad, but could quickly sell the greenback and US Treasuries for British gilts, German bunds, or Gold, to avoid foreign exchange losses.
With the demise of Persian Gulf stock markets over the past six months, Arab oil kingdoms turned to gold, lifting its price from a low of 6.7 barrels per ounce in September 2005, to 9.7 barrels /oz at last week. Still, gold is cheap relative to crude oil, situated far below its historic peak of 26 barrels and below the midpoint of the 10 to 14 barrel range that prevailed in 2002 and 2004. Read our January 16th prediction on the gold to oil ratio, http://www.sirchartsalot.com/article.php?id=13
The People's Bank of China (PBoC) has been an active purchaser of US bonds assets in connection with intervention to maintain its yuan-dollar peg, held $527 billion, of which $485 billion was in long-term US debt and $40 billion in short-term debt as of June 2005. These numbers have increased by over $100 billion in the past year.
But on December 30th, 2005, Yu Yongding a senior adviser to the PBoC warned that the Federal Reserve might stop raising interest rates in 2006 and start guiding the US dollar downward, putting upward pressure on the yuan. "More seriously, China's economy would take a big hit if the US dollar weakened sharply due to such factors as a bursting of the US property bubble. The loss for China's foreign exchange reserves would be extremely serious," he said.
Yu said the US dollar, which has strengthened on global markets in recent months, would be vulnerable as long as the United States ran a huge current account deficit. Then a week later, China's foreign exchange regulator said one of its targets for 2006 was to "improve the currency structure and asset structure of our foreign exchange reserves, and to continue to expand the investment area of reserves."
"We want to ensure that the use of foreign exchange reserves supports a national strategy, an open economy and the macro-economic adjustment." But as of March 31st, the PBoC indicated its foreign exchanges reserves had jumped to $875 billion, but only 1.1% of its reserves were held in gold. Beijing's position in the US Treasury's two-year has lost 37% of its convertibility into gold from a year ago, and will continue to erode if gold climbs against all major world currencies.
Dangerous Divergences ahead or False Alarms?
Former US Treasury secretary Robert Rubin was once asked by his boss Bill Clinton, if he could be re-incarnated, what would he like to be? Rubin replied, "The bond market, because it controls everything." Cheap long-term borrowing rates provided the glue that held the world economy together in 2004 and 2005, but the risk of a sudden rise in global bond yields could see an otherwise upbeat outlook for stock markets come unstuck.
Among the myriad influences on the global economy, it is hard to overestimate the pivotal role that persistently low global borrowing rates had in fueling the most rapid world expansion in three decades. Super low interest fostered a climate for the biggest corporate spending spree since the Internet bubble burst in 2000. Global equities were buoyed by $1.1 trillion in takeovers in the US, followed by Europe with $1.04 trillion, and Asia with $312 billion in 2005. Leveraged mergers and acquisitions injected fresh cash into global markets, pushing stock indices to 5-year highs.
Low long-term rates supercharged a US housing boom that saw national house price indices rise 15.8% on a national level and above 20% in over one hundred major American cities in 2005. Greater wealth from US home price appreciation is a primary reason why US consumers have stopped saving any of their after-tax income, and instead are tapping into their home equity to keep their spending alive.
But the tight linkage between gold and the Dow Industrials (DJI) presents a dilemma for the Bernanke Fed, which is aiming to pump up the equity markets with a cheap dollar policy. A stronger DJI could translate into higher gold prices, so while the DJI could rally to 11,750 in the weeks ahead, gold could tag along and touch $700 per ounce. But higher gold prices could weaken US Treasury Note prices and lift long-term yields. The DJI and the T-note market could continue to go their separate ways for long periods of time, but in the end, the bond market controls everything.
On May 8th, 2006, G-10 central bankers called for "very special attention" to prevent ongoing global economic growth from turning inflationary. Jean "Tricky" Trichet, admitted that inflationary expectations were starting to rise during a period of high commodity and energy prices. "It is not the time for complacency if we want this global growth to be sustainable. We have to be careful to see that this period of global growth does not end up in inflation," Trichet told a media briefing.
But Trichet has the reputation of a radical inflationist, after expanding the Euro M3 money supply by 8.6% in a brazen effort to lift Euro stocks higher. Gold has attached itself to the EuroStoxx-600 index, recognizing Trichet's scheme. And if current trends extend into the future, a stronger Euro-Stoxx index, accompanied by higher gold prices, should translate into weaker German bunds and higher Euro zone yields.
"We have to look at the inflationary risks with great attention. The prices of imported consumer goods in the industrialized economies was going up a little bit," added Trichet, four years after the emergence of the "Commodity Super Cycle".
Pinpointing the end of deflation has been a tricky issue for the Bank of Japan, with the ruling LDP party wary that as consumer prices recover the central bank could raise interest rates prematurely from current levels near zero. "We see improvement in the Japanese economy, led by domestic demand, and it is likely to continue. But deflation still moderately remains. We haven't fully overcome deflation," argued Japanese finance minister Sadakazu Tanigaki on April 8th.
While Tanigaki attempts to brainwash the Japanese bond vigilantes with talk of deflation, the price of gold in Tokyo has soared by 170% to 76,000 yen per ounce, from its lows of 28,000 yen in 2000. But with the BOJ draining excess reserves from the banking system, and waiting for the opportunity to lift the overnight loan rate, Japanese bond vigilantes will have greater freedom to challenge the mighty MOF.
No doubt, central bankers are aware of the dangerous divergences developing between global stocks and bonds, which can move into opposite directions for long periods of time. Unless G-7 central bankers can devise a clever trick to break gold's linkage with benchmark stock indexes, global bond yields could continue to rise to higher levels. Perhaps, a peaceful solution to the Iranian nuclear crisis could do the trick, as Bernanke suggests. But then again, gold's rise may have more to do with global liquidity provided by G-10 central bankers, than gyrations in crude oil.
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