US Dollar

The dollar dropped sharply in FX late last week, reflecting
a sharp rise in the Fed's portfolio through repo activity.
The primary dealers who handle FOMC orders are also major
FX market makers. So, the dealers are anticipating the Fed
will now go on to provide additional, needed liquidity for the
holiday season. I have pointed out over the course of the
year that the Fed would need to be poised to provide
liquidity should business credit demand fall off. Now
data show a flattening in mortgage generation and a sudden
$12 billion dip in C&I loan demand. In addition, currency
and checkables in the system have been running at low levels.
To round out the preamble, dealer FX earnings help pay the rent,
and dealers count on some volatility in the dollar to make it
happen. Dollar volatility has been restrained this year until
lately, and the dealers are pushing their advantage.

At present, the Fed, as most economic observers, sees slow
economic growth in this quarter followed by a recovery back
to 3.0 - 3.5% growth as 2007 progresses. Moreover, since
there has not yet been a decisive break in the uptrend of
inflation less commodities prices, the Fed may provide seasonal
liquidity for the current holiday season in as measured a fashion
as it can.

The dollar is headed to oversold levels, but it can clearly go
lower. In fact, at 83 and change, the $USD is only a tad over 3
points above major long term support at 80. I do not have a
strong view of whether the dollar will fall to long term support,
but I suspect if it does, the test would receive tremendous
attention, as a decisive break below support would excite traders
and foreign holders of dollar denominated assets. For a $USD
chart, click here.

Gold -- Further Thoughts & Conjecture

This article is a supplement to yesterday's post on the
gold price.

Let me start with the macro-indicators I follow to track
gold. First is the activity of the Fed's Open Market Committee.
The Fed's Treas./gov.related/repo portfolio determines the
growth of monetary liquidity. Growth of this portfolio is an
important precursor of inflation and the direction of the US
dollar. From 1998 through 2004, the FOMC portfolio compounded
at a 9.2% annual rate. That was rapid and strongly inflationary
growth. It set up the trashing of the US$D and helped trigger
the bull market in gold. Since the end of 2004, the FOMC
portfolio has compounded at a low 2.8%. So the Fed has been
tightening up on monetary liquidity. For the entire 1998 -
2006 period to date, the portfolio has grown 7.2% annually --
still on the high side -- but the inflation potential is
coming down and the case for a stable US$D has improved.
One reason gold tends to do well late in each calendar year
and early into the next is the fact that the Fed tends to
add extra liquidity to the system for the holiday season.
That has yet to occur this season.

The second main factor I follow is a broad composite of
sensitive materials prices. With global economic recovery and
then expansion, this index has moved up sharply since 2002
and is still holding a firm uptrend. However, this industrial
commodities composite has been flat since the spring of this
year mainly reflecting a slowing of economic growth. The index
does have a moderate seasonal bias favoring late autumn -
winter. So far, the composite is treading water.

The oil price is the third major factor I track regarding gold
as it is an inflationary linchpin. As you know, oil has been
retreating since this summer. The oil price has a strong
seasonal component favoring December - February. It remains
to be seen whether the first good cold snap will trigger a
significant price rally.

I would have to say that the gold price has diverged markedly
from my composite macro-indicator in 2006, the retreat from
the blow-off May high notwithstanding. With the recent rally
in gold, that divergence is accelerating again. Now, since
there is abundant historical evidence documenting the
occasional high volatility of gold, no one can say this
current seasonal rally will not be fulfilled. I would say
to watch FOMC activity, and how oil and sensitive prices hold
up if you are long, since I think there is $100 - 120 per oz.
downside price risk.

As mentioned yesterday, gold enthusiasists with a geopolitical
bent might do well to watch the current political struggle in
Lebanon. Today's assassination of Pierre Gemayel only
underscores the growing instability in this small but critical
corner of the world.

Gold Price -- $621oz.

The long term price uptrend dating back to 1999 remains
intact. The gold price price became hyperextended at the
outset of this year. The price has corrected substantially
since the May cycle peak of $734oz., but the hyperextension
uptrend still appears intact. To get back into the long term
channel, gold now would have to drop a little inside of $560.

The market has held support well at $575 so far in the second
half of 2006, and this has led traders and mavens to regard
the normal November - February period of seasonal strength in
gold as an opportunity to add to positions in the early going
(see chart).

My micro fundamental model still has the equilibrium gold price
at $470. The macroeconomic price model remains in an uptrend
dating back to year end 1998, but has been flat for six months
and continues to suggest a gold price only in the range of
$500 - 520. The indicators show a modest increase in monetary
liquidity, flat sensitive materials prices and a drop in the
oil price. So my reading of the fundamentals do not yet support
a rising gold price short term. At this point the analysis suggests
that if you want to buy gold for the short run, you may have to count
on other seasonal players to join you.

There is a complicated geopolitical tension situation slowly
unfolding in Lebanon as I recently discussed. That might be worth
watching (see note of 11/13).

Liquidity Situation

The Fed has been slow to provide incremental monetary
liquidity to the system for the forthcoming holiday
season. So far, the Fed has been wary in view of
continuing very strong bank loan growth. The real
estate loan book of the banking system continues to
grow at close to 10% yr/yr as banks pick up residential
re-fi business and enjoy strong demand for commercial
real estate mortgage and development needs. Moreover,
despite the economic slowdown, commercial and industrial
loan demand has remained very brisk, now reflecting the
sharp rise in order backlogs for long completion cycle
real estate and commercial aviation projects. Even
HELOCs, or home equity loans, have accelerated after a
lengthy quiet period. Banks have also added moderately
to Treasury positions as well. Overall, the larger
measures of bank funding have grown 9.1% yr/yr in aggregate.

When broad liquiidity growth exceeds broad economic growth
as it has been doing in recent months, some of the excess
tends to find its way into the stock market, as it has this
time out. I have to admit that the working capital needs
for the long completion cycle projects caught me by
surprise, leaving a significant extra fillip to excess
liquidity.

Two Notes

STOCK MARKET

The stock market is slightly overbought short term and
is manifestly overbought for the intermediate term (6 -8
weeks). The SP 500 could well move up in the recent hesitant
fashion for another 10 -12 trading days, but by then a
correction will be well due. I say this because my six week
selling presure gauge, although trending down, is at low
levels reflecting a powerful advance in the NYSE cumulative
a/d line. This is a caution flag as regards the next
couple of weeks.

GEOPOLITICAL TENSIONS SET TO RISE

The pro-Syria ministers in the Lebanon cabinet have taken
a hike as Lebanon's leader Seniora prepares a legal bill
to pursue the alleged ringleaders of the Hariri assasination.
One of these guys is Assad of Syria's brother and another
is his brother-in-law. Hezbollah has suggested it could
take to the streets in protest and the Christian and Druze
contingents are openly angry with Nasrallah and the Boyz.
The UN troops south of the Litani river have a heavy
French contingent and Chirac remains coldly furious over the
killing of his close buddy Raffik Hariri. Syria will be
put out about all of this and the long distance puppetmaster
Iran may also have plans to deflect Lebanon. Nasrallah
in particular will be under pressure to shine as the jack-
in-the-box troublemaker after the fiasco he precipitated
this summer. This is a sensitive area and a sensitive time.
Be alert.

Thumped

GWB's runaway plutocracy has been lassoed by the public.
They have sent in the Dems to be a counterweight and to
probe the administration's conduct. Both parties have
power now, particularly if the VA senate seat holds up
for the Dems. The voters in their wisdom have created
a horse race for 2008. The pundits are left to analyze
it all to a fare thee well.

What is left unanswered is what kind of political shape
the public is in. Folks across the fence have become so
antagonized and frustrated with each other that talking
politics and political ideas has become a no-no. Too
many people out there have become closeminded and that is
a bad thing, as Martha might suggest.

I'll feel better when people start talking again about
these issues and when politics can return as a fit
subject in the community. The great divide started with
the Johnson / Nixon years and has widened and intensified
ever since. We are at the point where it is sensible
to ask whether differences on the major issues are so deep
that they cannot be reconciled. If so, that would be a
bitter and miserable outcome.

While the parties duke it out in DC and try to gain
ascendency, I'll be watching to see if folks can be moved
to sit around the table and again discuss the issues
in a context of all realizing we are in the same large
boat.

Sermon over.

The US Dollar

I traded currencies over the 1975-1980 period. I
stopped because I had more pressing priorities. I did
alright with it, but it often gave me a headache and a
strained bladder because it was not smart to wander
away from active screens. Globally, ForEx is one of
the biggest games in town and has become ever so
sophisticated.

I will not be returning to trade, but the subject of the
dollar is interesting. My view of the dollar is too
simplistic for the average ForEx whiz, but thinking about
it rounds out the view.

To me, the dollar retains value if a dollar saved earns a
decent premium over the rate of inflation here and if the
Fed is not printing too much currency. Regarding the latter,
I watch FOMC activity and the monetary base. The FOMC has
been stingy for months now, and with a 91 day T-Bill yield
of 5.1% against an inflation rate now around 3%, the dollar seems
ok to me. I think the record will show the dollar tends to
hold its value when there is a decent real risk free rate
available. The dollar tends to fall when the Fed accelerates
the growth of the basic money supply and when the T bill %
falls relative to, or worse, down through the inflation
rate.

It is obviously important that monetary policy should protect
the value of savings, and provide that stability through time.
Deviations should be brief and only reflect the need to counter
significant economic risk.

Many observers believe the exchange value of the dollar must
fall sharply to reflect our large and growing deficit on
current account. The simple idea being that the world is
approaching a point where there are so many dollars offshore
that the dollar must eventually fall relative to other
key currencies as well as to gold -- sort of a hefty discount
for excess. Surely the dollar should fall in relative value
if it is poorly maintained at home. Whether the exchange
value should plummet even if we maintain a good standard at
home eludes me.

But, since a fair number of visitors to this site are currency
players, I'll stick my two cents worth in on occasion.

Employment Situation -- Observations

Based on the employment report through October, the
labor force grew 1.3% measured yr/yr. That represents
slightly faster growth than in the recent past, but it
is rather slow. This modest growth limits US economic
potential, and with more Boomers set to retire in the
years ahead, growth of the labor force will remain
constrained. Importantly, the slow growth of the labor
force also takes pressure off the Fed to provide economic
stimulus and leaves it more leeway to attend to inflation.

Growth of civilian employment has accelerated in recent
months, and was up 1.9% yr/yr through October. the service
sectors have strengthened, as falling fuel costs have led
to stronger bookings, particularly in the growing export
sector.

With employment outpacing the growth of the labor force, the
unemployment rate has dropped to 4.4%. This is low, and signifies
a tighter labor market. Because hiring has picked up nationwide
as the economy in total has slowed, productivity growth has slipped
and unit labor costs have accelerated. Corporate profits have
still progressed nicely, because pricing power has improved.
Profit margins may not fare as well in the months ahead, because
inflation pressures have receded and pricing power will follow
suit. On the plus side, wages are rising around 4% yr/yr, and
with less inflation pressure, basic consumer purchasing power
is improving quickly. In all, wage earners can probably sustain
real economic growth of about 3%. That represents the strongest
reading in a number of months.

Note that I have referred to employment data from the BLS monthly
survey of households in preference to the payroll data. The
former is far more fresh and tends to lead the latter.

Stock Market

As mentioned in posts of 10/13,10/16 and 10/24, the
stock market rally had become overbought and mildly
overextended as well. The overbought is now in the
process of being corrected.

The rally reflected a recovery of the market's p/e
ratio as investors began to factor in a deceleration
of inflation in an expanding but slowing economy.
But since the 10/26 interim high, the market has
weakened as evidence has accumulated that the economy
is slowing more rapidly than expected. This provided
a nice rationale for a bout of profit taking.

I have cautioned about a slowing economy for some
months as have most observers. The ISM report
for manufacturing supply managers released today
showed a drop from October's 52.9 to just 51.2%. This
confirms sluggish manufacturing. Readings below 45%
often signify recession. So the index has a fair way
to drop before a downturn would be an issue, but the
downtrend in this index has reached a point which has
induced jitters in the market. Also of interest here
is the fact that the Fed has often cut the Fed Funds
rate when this ISM index has dropped below 50%. If
the next reading of the index in early Dec. drops
below 50%, talk of a Santa Claus rate cut will no
doubt perk up and it would be interesting to see how
the Bernanke Fed might react.

For now I am stuck with a continuing expectation of
slow growth as the leading indicators I follow have yet
to show the kind of break that would suggest something more
serious might be in store.

That leaves me with the view that we are merely witnessing
the unwinding of an overbought situation.