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Fed Cuts Discount Rate &
Fed Funds Rate 1/2 Percent
Dow Theory Analysis

By Enrico Orlandini - Economist
9-19-7

What a great day, at least for me. The US Federal Reserve in its infinite wisdom lowered both the discount rate as well as the fed funds rate by one half of one percent. The significance of this move is not lost on me and that's what I am going to talk about tonight. Today the Fed declared its true colors today as it lowered rates. Back in March the Fed said its main concern was inflation. Since then oil has risen from $66 to $82, gold has risen from $650 to $732, wheat has rallied from $4 to $7, soybeans have rallied from $6 to $9, and cotton has rallied from $56 to $65. I could go on but I think you get the idea. Today the CRB hit yet another new all-time closing high as well as an intraday high. By any measure the Fed was right to be concerned and their concerns bore fruit. The Fed's mission is to protect the US dollar. Therefore given an inflationary environment, the proper action would have been to raise interest rates in order to put a brake on inflation and protect the real value of the US dollar. That didn't happen.
 
On the other hand we have decreases in consumer spending and the housing sector is in serious trouble. Consumers are in trouble because they spent money they didn't have while housing is in trouble because large institutions loaned money when they shouldn't have. It would be fair to say that greed got the best of them. Bear Stearns and Goldman Sachs knew they made bad loans so they packaged them, gave them a fancy name (Collateralized Debt Obligations or CDO's for short), and then sold them to widows, orphans, and UK banks. About two months ago the world found out that these CDO's are pretty much worthless and the widows and orphans should have read the fine print. It is my opinion that the Fed's actions have one purpose and one purpose only; to save the Goldman Sachs of the world. I believe today's actions will be of little or no benefit to the US consumer.
 
Everything has a cost and the cost is considerable. In one swift move, the Fed drove a stake through the heart of the US dollar and the bond. It also mortally wounded commodity bears in general and gold bears in particular. Also, the Fed has probably managed to recycle an old bubble (the stock market) so that Goldman Sachs has a place to recuperate losses. Notice the emphasis on "probably" because I'm still not sure they'll get away with it. Let's start with the daily chart of US Dollar Index:
 
 
 
 
Today saw the December US dollar futures contract fall a large .48 to end the session at 79.06 and that is a new multi-decade low. There is now nothing between here and 76.45 support and I would say that it would not be unreasonable to see an initial decline down to support at 72.00. What is even more bearish is the fact that the December US Dollar Index actually made a downside reversal today and that is extremely bearish. Personally I think the US Dollar coffin was nailed shut today. Until the dust settles, I am long the Swiss Franc, Japanese Yen, Peruvian Sol, and Canadian dollar while being short the US Dollar.
 
The next victim is the US bond. The whole world is raising rates and even countries like Brazil, Chile, Argentina, and Peru are concerned with inflation and are raising rates. The US expresses concern about inflation but lowers rates. The US dollar and bond must compete with the rest of the world and the Fed has assured us that it will not be able to do so. Take a look at the daily chart for the bond below:
 
 
 
 
You can now see that RSI, MACD, and the histograms have turned down and I believe bonds have finally topped. But shouldn't bonds be rising if rates are dropping? In a normal world yes but rates are dropping for the wrong reason and bond holders are not stupid! No one is going to buy a high risk bond with a low yield when they can buy a lower risk bond with a higher yield! The real killer for the bond will be the Fed printing dollars to buy their own bonds and I believe the bonds will start to discount that now. I sold bonds short on Monday and again today.
 
I am not going to say a lot about stocks in spite of the fact the December Dow rallied a huge 332 points to close at 13,835 and is now within two hundred points of its all-time high. The Transports also rallied 186.23 points to end the day at 4,932.86 but still more than 500 points from its all-time high. Take a look:
 
 
 
 
 
I suspect the Dow will make a new all-time high soon but I seriously doubt if the Transport can confirm, at least not right away. Given the Fed's actions today, there is a chance the Transports could confirm and that would lead to a 3,000 to 5,000 point rally in my opinion. That sounds ridiculous but it could happen. I remember back in 1989 and 1990 Peru was experiencing hyperinflation and terrorist bombs were going off every day and yet the Lima Stock Exchange shot up like a rocket. I never saw anything like it and it is counterintuitive, but never the less it did happen. I still have to believe that the Transports fail to confirm and the stocks turn down and get ugly. I am on the sidelines until the market declares its intentions.
 
For those of you who are invested in commodities, I want to explain the significance of the Fed's actions today. You have just been given a blank cashier's check and you can fill in the amount you desire. In particular, anyone holding gold is about to be rewarded for all those years of suffering. The Fed has guaranteed you a double-digit inflation and now has its foot squarely in the hyperinflationary door. That is extremely bullish for gold in particular and commodities in general, and that is why commodities prices shot up when the Fed announced its rate hike. Gold rocketed up almost $11 on the news and oil was up over $1! Any chance the bears had of holding gold here went right out the window of the Federal Reserve building in Washington, DC. Take a look:
 
 
 
 
 
 
I know gold is overbought but I believe it will become a lot more overbought as the day's pass. Now remember how I drew the boundaries on the HUI chart last night and said how many times the HUI has tried to break out and failed? Well, guess what?
 
 
 
 
 
Today it broke out to the upside! I want to see some confirmation in the next day or two, but I truly believe this is the real deal. Buenaventura made a new all-time high today! So I would just sit tight with your gold stocks for the moment and let nature take its course.
 
In conclusion, we have been given a real gift, the perfect financial climate for commodities to rise. Now the best thing you can do is nothing. Cotton broke out above its old high today, oil made yet another new all-time high, copper made a major break out today, sugar is confirming that it is on the move, and coffee is surging. There will be reactions but it will be just that, a reaction. The course is set so just sit tight and do nothing.
 
ebo@dtanalysis.com
Dow Theory Analysis SAC
September 18, 2007
 
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