Looking farther back to 2001, we can see glean some interesting information.  The first hour of trading was consistently profitable beginning late 2003 during the last bull market.  It posted its high in July 2007, three months before equities actually topped.  It also bottomed concurrently with the markets in March 2009.  Similar to 2003, it was unable to trend up for most of 2010, but took off late in the year.  As previously noted, it has since retreated and we believe will need to start turning profitable if the January highs are to be taken out.

The only other time period that was consistently profitable during the 2003 to 2007 bull run was the overnight gap.  If it were to break its current trend line, that would be a very bearish sign.  What also emerges is that, contrary to popular believe, a profitable closing hour is not necessary to sustain a bull market, but may be necessary to start one.  The closing hour’s high was put in January 2004 and trended down thereafter.  The closing hour’s high in the current 2009 rally was established in September.  It may well be that smart money now trades at the open.

Accordingly, if we start seeing overnight gap-ups and profitable first hours, things may have turned around for equities.  If not, we’ll probably see lower prices in March.

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…[W]e have a quiet news week and the markets are sensitive to unscheduled news.  Overnight, equities are up on some bullish rumors regarding a Greek bailout.  Some have compared the situation to the Dubai events in late November that led to a quick selloff and rebound in world equities.  However, this situation is not to be taken lightly, as a Greek default would be three times as large as the Lehman bankruptcy, and could quickly devolve into another global crisis of confidence.  Accordingly, the markets are at the whim of the ECB.  If it bails out Greece, there will probably be a large short covering rally.  If it lets Greece default, there will probably be another selloff.  And, if it does nothing and Greece muddles through for the time being, there will probably be a series of minor rallies that lead to larger selloffs.  The moves generated by the first two scenarios will be very swift, so swing traders will need to be prepared to react just as quickly…

When news broke at about 11:30 am EDT that there was an agreement in principal for a bailout, equities rallied and the US Dollar fell, as expected.  However, a mere hour later, after the ES had rallied 19 points to 1077, Germany countered by saying it was not a done deal and there would be significant strings attached.  Accordingly, there is still much uncertainty in the markets.  For now, what likely would have devolved into a return to the 1040′s has been averted.  In the end, we believe a bailout with nominal strings attached (to save face) is very likely, but the intervening journey in the markets will be volatile as the details are filled in over the coming days and weeks. 

The 1080 to 1083 is the first critical resistance level that swing shorts will need to defend.  There is a historical tendency to clear important resistance levels overnight, evidenced by the fact that the gap accounted for fully 32% of the rally in the S&P 500 that began in March 2009.  Combined with the current news being generated overseas, if this area is to be exceeded, US traders should be prepared to wake up to a market that has already cleared it rather than experience it intraday.

There will be plenty of opportunities during trading hours, however, and a savvy daytrader can capitalize on these movements by correctly reading market signals, regardless of knowing the actual news that’s driving the markets.  A simple five minute candle chart with volume of the ES warned that the rumor would lead to a sustained rally when it closed nearly at its highs (within a tick) on high volume.   Ideally, volume would have been at least 100,000 (actual about 91,000), but the 8 point range that convincingly broke the downward trendline was sufficient to generate follow through short covering.  Also important was that the ES looked like it was headed for trouble and sentiment was very negative following the failure just above the previous day’s high.  The entry can be made on a stop basis one tick beyond the big range bar, with a two point stop loss. 

In general, the larger the wick or shadow of a big range candle, the less likely a continuation of the move is.  This so-called indecision area is just that–it conveys doubt and will encourage profit taking and counter trend traders, which will tend to halt the move.  This is why a short based on the big-down 12:45 pm candle was not a good candidate for a continuation move (besides the fact that the stop sell entry signal was not triggered).  The two point shadow at the bottom was enough to make a material retracement to the 50%-61.8% fib box likely.

The flipside to potential entries is that, in this environment, exit stops placed on day trades are crucial because it is easy to get caught on the wrong side when surprise news is announced.  Indeed, a long entered on the above basis would have given up 100% profits on the 12:45 pm bar.  Accordingly, on steep moves, a simple trendline break can be a profit taking cue, as can a move that exceeds an interim pivot bar on the 5 minute chart.

Moves like today do not occur frequently, but when they do, often follow a predictable pattern.  We should see more in the coming weeks, so be prepared.

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The US Treasury is benefitting from this, as the 30 Year yield finally broke through long term trendline and moving average support, which will make debt service costs a bit cheaper for it on the 10 and 30 yr issues its auctioning next week.  To put things in perspective, it took a 9% correction in equities to facilitate a 2% rally in T-Bond futures.  For now, it looks like this correction will eventually reach 15% or more, which makes for at least a 980 (ES) downside target.  That doesn’t mean there won’t be large up days, but the prevailing trade will be to sell bounces, and that will likely last for several more weeks.

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Above is Feb 94 to Dec 09, and below is a zoom in of Sep 08 to Dec 09.

For 2009, Jul 09, Oct 09 and Nov 09 were negative gap days.  The day sessions were positive Aug 09 to Nov 09, but negative Dec 09.  What’s interesting in the longer term chart is that day sessions were positive in SPY throughout must of the late nineties bull run, but were not so during the subsequent bull run.  Perhaps that’s indicative of the jobless recovery.  SPY bottomed in Oct 02 on a higher low in the day session.  After that, there was a rally in day sessions, but then there was a resumption in the down trend until Oct 08, that lasted even during the bull market into Oct 07. 
 
Meanwhile, the gap stayed mostly flat and resumed its uptrend in early 2005.  Further, during the entire recent down leg, the worst drawdown in the gap was 2.34 SPY points, with most of the losses to SPY overall coming during the day session.  Accordingly, holding overnight ahead of the report (at least since mid-2003) appears to be more profitable than holding during the day.  It should be noted that there are outliers where SPY has gapped down ~1.50 points and it is not uncommon to have ~1.0 point gap downs, so caution should always be exercised when holding into the report.

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Mondays have been clearly bullish since September, 2009, with weekend holders of long positions not being punished since the last week of September.  This suggests that traders may have become complacent and that the next down gap could be a bellweather of a material correction.

Tuesdays have been a mixed bag since September, offering no clear edge.

Wednesday has had a slight bullish edge since November, when the gap and day sessions are considered.

Thursday days have been bearish since late October.

The last two Fridays of December were holidays and the one previous was flat.  Prior to that there was a strong surge overnight ahead of December’s Employment Situation report, but then it was dangerous to hold longs from Thursday to Friday morning since late September.  However, Friday days have largely been kind to longs since November except for on the December Employment report.

As we pointed out in our morning trading report, Employment Situation Fridays have been turning points in 2009.  They have either sparked rallies or been used by institutions to sell into, marking interim tops.  As we are now at highs, longs should take heed…

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Leaders Analysis:  Big reversals yesterday in just about everything and overnight, mostly consolidation.  30 Year T-Bonds look poised for another test of the upward boundary of the downward trend channel, so we will watch them closely today to see if they can break out (equities bearish) or reverse down (equities bullish).

Medium Term Analysis:  We wrote toward the close yesterday that it would take a near perfect storm for bulls to reach new highs in the S&P 500 and that the deck is stacked against them.  However, they have pulled many rabbits out of their hats, so here’s how a rally would need to unfold.  Today and Monday are key because they contain the most likely negative reports–Chicago PMI, Consumer Sentiment and ISM Manufacturing–for nearly two weeks.  The second week of November features no major report until Thursday, and even then, nothing likely to be interpreted too negatively if equities are up.  The third week is much more difficult and begins with Retail Sales on Monday at 8:30 am, then PPI, Industrial Production, CPI and Housing Starts.  Back to the present, if bulls can get over this two day hump, and FOMC next Wednesday and Employment Situation next Friday support, there is a chance of another short covering rally with new material highs.  As we have written before, FOMC is unlikely to say anything that rocks the boat, and many of their policy changes are being announced in separate press releases.  Barring the perfect bull storm outlined above, we still expect sideways to down action for November.

Trading Today:  As we write, the two 8:30 am reports have not moved the markets much, so the two reports prior to 10:00 am today will be the catalysts if they are out of line with expectations.  We prefer to be…

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The anchored VWAP line in blue provided good support over the years, including the 2002 low after the tech bubble crash (8).  However, price clearly broke through the line at times, most recently in March 2009 (9).  The lower panel plots the percentage deviation of price from the VWAP line, beginning from the July 1932 low.  Interestingly, the % deviation to the down side has never exceeded the -16% to -24% support area, the lower end of which was precisely hit this March (-22%).  This support level also caught the major low in 1974 (5) as well as some early lows in the 1930’s (1, 2 & 3). 

Just as the yellow horizontal lines can act as support or resistance, so can the green trendlines.  The 1966 top came after a break through major trendline support (4) and retest of the 110% level.  On the 2000 top (7), there was no upward retest and this did mark the high.  Eventually, the current rally will peter a bit, and we would expect a long period of sideways action until the far right green downward trendline is finally broken.  Unfortunately, this could take years (points 5 to 6 span eight years). 

What will be the high of this rally?  We would expect it to come on a test of one of the two far right green trend lines.  If price were to continue up at the same pace, this would be at Dow 10,700 or 12,500.  However, if the trend slows or stops altogether, these figures will be less of course.  We will definitely be keeping an eye on this indicator for some time.  For background on the powerful support that anchored VWAP can provide (a component of the Paul Levine MIDAS method), please see our Free Resources page (includes free TradeStation indicator).

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During the crisis, the Fed created roughly $800bn of additional bank reserves to finance asset purchases and loans. This total is likely to rise in the coming months as the central bank completes its asset purchases and the Treasury unwinds financing it provided to the Fed. Fed officials think they could raise interest rates even with this excess supply of reserves by offering to pay banks to deposit their surplus funds with it rather than lend them out. However, they also want to use reverse repos in tandem to soak up some of the excess reserves. Policymakers call this a “belt and braces approach”. [The latter, clearly a nod to the great Gekko.] 

Tyler Durdan touched on this last Thursday, and we will expand upon it here as it is particularly relevant to our ongoing theory that it is the proceeds from permanent open market operations (POMOs) and their close cousins that are driving equities.  Though this may be received wisdom to ZH readers, the Fed has done us the favor of providing additional evidence through the FT story.  A bit of background, as we are new contributors to this forum:

Money Supply:  Based on our previous research on the effects of swings in M2 non-seasonally adjusted money supply (M2) on the stock market, we were a bit surprised in July 09 by the resiliency of the rally, which continued in the face of such a dramatic contraction in M2.  The dismal Durable Goods report from last Friday confirms that the capital goods sector is still under significant pressure as a result of a lack of money in the general economy.  With banks not lending to normal businesses and consumer credit contracting equally as violently, what is the basis for this rally and from where does the never-ending flow of equities juice flow? 

Bank Non-Borrowed Excess Reserves:  The Fed statistic that most closely correlates with the 2009 equities run-up appears to be bank non-borrowed excess reserves (bank NBER), which is a component of the monetary base (M0).  As explained by the Fed, bank NBER is simply total bank excess reserves minus bank borrowed excess reserves (bank BER).  This resulted in bank NBER going negative throughout much of 2008 because banks acquired most of their excess reserves through participation in Fed lending programs.  As the Fed has wound down these programs in 2009, bank BER has steadily declined and has been a drag on M0.  Concurrently, though, bank NBER has advanced since late March 09 with only one brief material pause in June, and reflects those excess reserves that need not be repaid as part of any Fed lending program.  The Fed purchases of MBS, Agency and Treasury securities netted $990 billion trillion since March 09.  The distinction between borrowed and non-borrowed excess reserves is critical because the latter would be ideally suited for leveraging and lending out to hedge funds and the like to “invest” in the high beta stocks that have led the rally.

The primary conclusion is simple—the stock juice flows from steadily increasing Bank NBER, which is hidden to even astute observers that focus on only M0 or M2.  Though we previously found no historical correlation between M0 (or its constituent components) and the stock market, we have witnessed an historically unprecedented set of circumstances.  Now that the Fed has become the world’s largest hedge fund, we are prepared to accept unorthodox conclusions.

So why not inflate both equities and the general economy simultaneously?  It was most likely a race against time.  The administration and Fed needed to replace the incredible evaporation of wealth that occurred in late 2008/early 2009 to quell the voting and investing masses.  They could not reflate the entire economy this quickly without jeopardizing their ability to borrow cheaply and restart the housing bubble.  To keep long term yields low, they reflated the stock market only, with the hope that the general economy would eventually catch up in 2010 and be able to sustain the stock market gains.  The problem with rising yields has not been solved, but was postponed. 

As we noted in previous research, we are toward the end of a seasonal drain on M2.  Once over the October hump, it should be easier for the holiday season to carry the market into March 2010, especially with the help of another $634834 billion in MBS and Agency POMO into next March (not to mention the possible Treasury SFP wind-down effect to the tune of $114 to 185 billion).  The Fed must be perfect, however, as any new panic will quickly feed on itself and likely lead to another mass exodus from equities.  This is quite simply because currently, there is absolutely nothing else to back up this rally in the general economy if the Fed funny money cannot do its trick.

Back to Money Market Funds:  If bank NBER is materially tied up in equities, then the Fed cannot drain from this source to mitigate inflation, or it risks the resulting cascade of sell orders that accompany the typical panic.  According to the FT article:

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets.  By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure [at gunpoint] from regulators and investors to stick to low-risk liquid investments. 

The Fed Helps Build Our Case:  As of September 17 09, bank NBER had increased by $563 billion since the March 09 rally began.  With M2 net flat during this period, the $563 billion has not made its way into the general economy by any stretch.  Perhaps it is sitting idle; however, the Fed says only $100 billion would be available from primary dealers in the future?  As the vast bulk of bank NBER is concentrated in primary dealers, this begs the obvious question of what will be tying up the remaining $463 billion (and we are not including the expected increases in bank NBER into next March, which could double this amount)?  Given a conservative lending leverage ratio of 10 to 1, there is potentially $4.63 trillion already sloshing around.  Even if we are much more conservative, given the roughly $2 trillion increase in the US stock market since Mar 09, it is not only easily conceivable, but probable, that a substantial portion was courtesy of the Fed ATM machine.

As Gekko closed his famous speech in Wall Street, “Greed – you mark my words – will save Teldar, and that other malfunctioning corporation, the U.S.A.”  While we have focused here only on coercive greed, it will be interesting nonetheless to see how this works out.

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This article was originally posted here on zerohedge.com.

Update:  A reference to “trillion” above was revised to “billion” and is marked.

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As we wrote two days ago, Treasury is effectively winding down its Supplemental Financing Program, the stated intention of which on its inception in September 2008 was to, “drain reserves from the banking system, and therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives.”  Delving into the mechanics of it, here is what happened:

Treasury announced special auctions for cash management bills, the proceeds of which were placed on deposit with the Federal Reserve in a special account (as opposed to the proceeds being kept by Treasury to fund the government).  This allowed the Federal Reserve to use these funds (which topped out at $558.9 Billion in November 2008) to borrow or buy securities primarily from banks and broker dealers to help “unfreeze the credit markets.”  The Fed could have simply borrowed or bought securities with money it printed, but this would have expanded its balance sheet by creating excess reserves in the accounts that banks are required to keep with the Fed.  These reserves can be multiplied by at least ten times and used by banks for lending.  At the time, the Fed was rightfully concerned about inflation becoming unmanageable once the credit markets thawed, and about being able to keep the Fed overnight lending rate (fed funds target rate) above zero.  Accordingly, Treasury’s SFP helped to keep the Fed balance sheet under control (if you can call a multiple hundred percentage increase “under control”).  The amount of money that flowed into the financial markets from the SFP was the same as it would have been had the Fed printed the money; however, SFP money could not be multiplied by banks.

Congress granted the authority to the Fed to pay interest on excess reserves held by banks on deposit with it as of October 1, 2008.  This new tool obviated the need for the SFP as the Fed could now simply incentivize banks to not lend against their excess reserves (by paying them interest to keep their reserves at the Fed).  Accordingly, in November 2008, Treasury announced it would reduce the SFP, and it has held steadily at $200 Billion for most of 2009.

On Wednesday, Treasury announced that it would allow the SFP to “decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over.”  As we wrote above, Treasury issued special cash management bills as opposed to its standard arsenal of regularly auctioned bills (such as the 4 Week, 3 Month and 6 Month Bills).  We have identified these bills (all were 70 day duration) by their CUSIP, auction amount, primary dealer take (to be explained later) and maturity date (each of which is a Thursday):

Upon maturity, the SFP account at the Fed will be deducted by the total auction amount with the funds returned to the purchasers of the bills.  The consequences of this are:

1. Should the Federal Reserve require additional funds to finance its buying and borrowing of securities (Agency POMO, MBS purchase, TALF, etc.), it will need to print money in the amount that the SFP has been decreased.  This is not too much of a long term issue since, as we wrote above, it is able to pay interest on excess bank reserves to keep inflation in check.
2. Treasury can now issue longer term Notes and Bonds to replace the shorter term 70 day cash management bills.  This is more important to Treasury’s long term objectives, especially as it quickly approaches the $12.1 Trillion debt ceiling this fall.
3. Without the rollover of the $185 Billion in cash management bills, assuming constant demand for shorter duration bills, the regularly scheduled Treasury Bill auctions (4 Week, 3 Month, 6 Month, etc.) should experience increased demand, which will put downwards pressure on short term rates and keep the US Dollar carry trade alive and well (a topic for another article). 
4. Because primary dealers will not be expected to buy any more of these SFP cash management bills, they may use these funds for other purposes. 

As to 4, above, what might these purposes be?  As we have seen with the permanent open market operations (POMO), it appears that much of the stock market ramp (at least for the first half of the 2009 rally) was demonstrably accomplished with POMO funds paid to primary dealers that plowed the money into stocks.  We have also correlated large increases in bank non-borrowed excess reserves (green in chart below) with stock market ramps.  The chart from the previous post is updated here:

Indeed, because the major primary dealers are US banks, most of the $114.1 Billion returned to them upon maturity of the SFP bills will end up in this category of non-borrowed excess reserves.  Some of it may be required to support future Treasury auctions, especially if Treasury ups the longer dated auctions that have less foreign support (primary dealers are required to soak up excess supply at auctions).  Indeed, next week, the 2 Year, 5 Year and 7 Year offering amounts have each been increased by $1 Billion.  However, the potential is for at least a sizable portion of the $30 to $35  Billion to hit the equities markets each of the next six Thursdays after having been leveraged by 10 to 100 times or more. 

Also, though quantitative easing in the form of Treasury POMOs is ending soon as it approaches the $300 Billion ceiling, the Fed is compensating with increased Agency POMOs (another $4 Billion bought today, $285 Billion to date), not to mention a total of $651 Billion in mortgage backed securities bought by the Fed this year.

The above is our warning to the shorts.  Now, our warning to the longs.  Below is our updated chart of M2 Money Supply Volatility, that we first brought to our readers’ attention in late July 2009.

The unprecedented contraction in money supply, as measured by 13 week percent change M2 non-seasonally adjusted money supply(yellow in chart), only intensified into early September 2008, as evidenced by the double dip at the far right edge.  What this tells us is that the equities rally is running on vapors (likely in large part from the bank non-borrowed excess reserves portion of M0), with nothing to back it up (in the form of money circulating in the broader economy) once the vapors disappear. 

Interestingly, Wednesday’s rally to 1074 in the cash S&P 500 touched a crucial level in the heavily traded SPY (S&P 500 exchange traded fund), which is the volume  weighted average price (VWAP) of the entire down move from the October 11, 2007 high.  The bulls and bears are thus at a crucial equilibrium point, and the coming weeks will announce the medium term winner. 

In short, traders should be mindful of the potential for massive buying sprees as the $114.1 Billion is returned to primary dealers over the next six weeks (along with continued Agency POMO and MBS purchases) and also of the potential for the floor to fall out from under this rally once the funny money dries up.  The next downturn will not be instantaneous, and there will be warning signs, which we will report on as always. 

We are neither perma bears nor perma bulls, but are fortunate to have the luxury of reevaluating the markets on a day to day basis and to be able to adjust accordingly.  True to history, it will be the longer term investors that will ultimately bear the brunt of this monetary and fiscal malfeasance.

Disclosure: No positions as of time of publication.

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September 17, 2008

Today, the Treasury Department announced the initiation of a temporary Supplementary Financing Program. The program will consist of a series of Treasury bill auctions, separate from Treasury’s current borrowing program, with the proceeds from these auctions to be maintained in an account at the Federal Reserve Bank of New York. Funds in this account serve to drain reserves from the banking system, and will therefore offset the reserve impact of recent Federal Reserve lending and liquidity initiatives. Treasury Announces Supplementary Financing Program

The program’s original purpose was twofold: (1) it was an accounting trick to help keep the Fed balance sheet in check, and (2) it helped the Fed keep the effective fed funds target rate from slipping to 0% (this was prior to the Fed’s ability to pay interest to banks on excess reserves which eventually allowed it to do the same thing).

In November 2008, as the program hit its peak amount at $558.9 Billion, Treasury announced it would wind down the program.  As of September 9, 2009, there was $199.9 Billion under this line item.  Just released this morning, Treasury will allow the Supplementary Financing amount to drop to $15 Billion as maturing bills are not rolled over, thus creating room for an eventual $185 Billion in longer term debt issuance to the public (emphasis ours):

September 16, 2009
TG-289

Treasury Issues Debt Management Guidance
on the Supplementary Financing Program

Washington – The U.S. Department of Treasury today issued the following statement on the Supplementary Financing Program:

“Treasury currently anticipates that the balance in the Treasury’s Supplementary Financing Account will decrease in the coming weeks to $15 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”

###

However, it will take Treasury some time to roll the $185 Billion into longer term issues (assuming that’s what it wants to do).  And, if the Fed does not concurrently offset the $185 Billion drop on its balance sheet, it will likely be reflected over the coming weeks as a $185 B increase in bank non-borrowed excess reserves (which are by definition total reserves minus borrowed reserves).  As we have noted before, we have found large increases in bank non-borrowed reserves to be correlated with equities gains in this 2009 rally.  The money will need to find a short term home somewhere and, if it is in the hands of the large financial institutions, it can easily be leveraged 100 times or more and pumped into the stock market.

Bottom line–though we believe in the possibility of a correction from the 1066 area of the S&P 500 by tomorrow, this development could be another shot in the arm to subsequently ramp equities in the face of dwindling permanent open market operations, with the side benefit of allowing Treasury to eventually rollover $185 B of short term debt into longer term as it approaches the debt ceiling.

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• Improvements seen in semiconductors, entry-level housing and, of course, autos
• IT services, health care/pharma, aerospace and discount stores remain solid
• Anything to do with finance, commercial and residential construction and high-end products remain weak

A LIGHTER SHADE OF BEIGE

The Fed’s Beige Book is a wonderful collection of real-time anecdotes and insights regarding the Fed districts’ assessment of the economy and financial markets. In particular, we have long used the report as a vehicle to isolate sector shifts.

Sectors that were WEAK but are now IMPROVING:
• Tourism
• Staffing firms
• Railroads (over trucking and air freight)
• Small parcel service firms
• Automotive (cash for clunkers)
• Paper products/containerboard
• Chemical manufacturing
• Semiconductors
• Entry-level housing
• Grocery chains
• Apparel retailing (youth)

Sectors that are SOLID and remain SOLID:
• IT Services
• Health Services
• Pharma
• Aerospace
• Discount stores
• Public construction (roads)
• Food manufacturing

Sectors that were SOLID but are now WEAKENING:
• Tobacco
• Oil and gas drilling

Sectors that remain WEAK:
• Financial services
• Commercial construction
• Luxury goods retailers
• Appliance manufacturers
• Home and garden centers
• High-end real estate
• Multi-family housing
• Commercial real estate
• Coal mining producers
• Electric utilities
• Heavy trucks
• Restaurants

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NEW YORK, Sept 2 (Reuters) – The CME Group will not list additional futures contract months for the New York Harbor No. 2 Heating Oil Futures contract beyond the August 2012 contract due to proposed sulfur-content specification changes.

“The proposed legislation, currently pending in New Jersey and New York State, intends to reduce the sulfur level in heating oil,” CME Group, which owns the New York Mercantile Exchange, said on its website.

“The existing New York Harbor No. 2 Heating Oil Futures and corresponding Option contracts, listed below, will continue to be listed for trading through August 2012.”

We have not been able to confirm the rumors that the CFTC will lock out speculators, though they have certainly made overtures to that effect before, and the belief in the rumor would be justified.

Once again, we repost our three scenarios and revise the conclusion slightly:

1)  Recent correlations hold and gold is simply forecasting another inflation-led [stock] rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a declining stock market would be definitive evidence for this scenario.

As to 3, because the move in gold may be a result of large investment funds looking for the most liquid commodity play that is the least likely to be subject to overt government interference, a breakdown in the correlation between equities and gold is no longer remote, and it would be possible for gold to advance, equities to decline, and the US Dollar and bonds to rally.

To confirm that gold is advancing on its own merits and not the result solely of US Dollar weakness, we want to see eventual confirmation of an up move in gold priced in other currencies.  Below shows gold priced in the Canadian Dollar (CAD), Australian Dollar (AUD), Japanese Yen (JPY), and the Euro (EUR).  When gold began its last advance in November 2008, it was confirmed by higher lows in the commodity currencies of the CAD and AUD, as well as the EUR (even though there were lower lows in the JPY and USD gold).  Eventually, there were higher lows in the JPY and USD gold at the beginning of December 2008.  Accordingly, for the gold bull case, early confirmation would be to see current lows in AUD, CAD and EUR gold respected on the first pullback, especially in the former two as they are commodity currencies.

* Thanks to the members of the Value in Time group for their comments and postings on this issue.

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http://www.321gold.com/charts/seasonal_gold.html
http://www.tradersnarrative.com/gold-seasonality-turns-positive-2909.html

We did our own analysis and confirmed this is indeed the case (see chart below).  Over 20 years, there is an expected push beginning in early to mid-September that tops in mid-February of the following year.  We can see that the predicted seasonality for the past year (red) was changed very little after adjusting to add the current year’s data (white), so seasonal factors should definitely be given weight in our analysis.  However, it is very difficult to time markets based on seasonality.  For instance, last September had a huge rally that was reversed in October, only to be reversed again (to the upside) into February.  So, while the seasonal pattern held, there was much consternation for the small and short term traders.  Accordingly, we believe it takes at least two weeks of data to confirm a seasonally-induced move.  Today may simply be the beginning.

Does all this change our previous analysis?  Only slightly because we must still wait for confirmation, but we now have a slight bias in the three three possibilities we previously outlined:

1)  Recent correlations hold and gold is simply forecasting another inflation-led [stock] rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a decling stock market would be definitive evidence for this scenario.

If today’s surge in gold has follow through and is the beginning of a seasonal move, then scenario 1 is most likely, which means the current stock market correction will be shallow and we will have another short covering rally that has characterized this year’s run up.  However, the if’s must be confirmed and, as we said before, all we can do is watch closely for now.

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Gold has broken above its consolidating wedge and previous swing high of Aug 6 09.  The significance is that it is in the face of a declining stock market.  A strong distribution day in equities suggests deflation, which should push gold down.  Gold was our only leader yesterday that did not move as expected (according to correlations that have held for the last year).  Markets needn’t move in lock step even when they are correlated; however, today’s action must be paid heed.  To break an important technical level in a direction when the reverse is expected is significant.  The three likeliest explanations are:

1)  Recent correlations hold and gold is simply forecasting another inflation-led rally that will begin in the next few days (meaning yesterday’s correction is not the bearish bellwether everyone thinks it is), or

2) Recent correlations hold and the move today in gold is a bull trap that will be reversed in the next few days, or

3) Recent correlations have broken and gold is decoupling from other markets, including equities.  Because correlation-changing paradigm shifts are rare, this is the least likely scenario; however, should it end up being the case, the significance is tremendous.  A break above 1,000 on a decling stock market would be definitive evidence for this scenario.

We’re assigning equal weight to scenarios one and two for now, watching closely gold and the S&P 500 for clues as to which will play out.

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US banks are required to keep money in reserve based on requirements set by the Federal Reserve (the Fed).  Anything beyond that is considered excess reserves and is generally held on deposit with the Fed.  Since last September, with the myriad Fed programs initiated, excess reserves have exploded (and along with it the Monetary Base, which includes excess reserves).  Some of these excess reserves are borrowed–for instance, the Fed may lend money to a bank based on collateral posted by the bank to the Fed, which could be a Treasury Security, an Agency Security, or even a Mortgage Backed Security.  Eventually, this money must be repaid and the collateral is returned to the bank by the Fed.  However, banks also maintain non-borrowed excess reserves, which is money on deposit with the Fed that they can use for any purpose without the need to repay it.  Banks might lend it out or, as seems to be the case this year, use it to ramp the stock market.  This money has come largely from permanent open market operations, whereby the Fed purchases Treasury, Agency and Mortgage Backed Securities from banks and deposits the proceeds from the sale in the banks’ accounts at the Fed.  As is demonstrated by the thick green line, non-borrowed excess reserves have increased dramatically over the past year and appear to be correlated with movements in the stock market.  We will soon be posting a more detailed analysis of the ramifications of this correlation along with how this may aid market timing.

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