North American markets are losing momentum

At 4:30pm ET (GMT-5) last Thursday the U.S. Federal Reserve Bank reported the total money supply numbers for the week ending Jan-02. M3 continues to rocket ahead. That caused some major swings out of the USD and into Euros, gold and oil.

Seemingly anticipating this, the U.S. Bond Market, which had been nervous until Thursday, rallied sharply as yields collapsed from Wednesday's levels. I am presuming that this action was probably started by Fed open market operations ahead of the terrible (exploding) M3 numbers.

The rest of the North American equity market has lost momentum heading into the U.S. Martin Luther King holiday on Monday.

That in a nutshell is what is happening today.

The message here continues to be: If there is going to be a recession in the U.S. in 2006, which is an indication of a flat to inverting yield curve, then bonds ought to relatively out-perform equities. Still I would not expect too much. Total return from bonds in 2006 will likely prove a disappointment.

There was a major move up in long-term yields Tuesday and Wednesday, which, as I say, dropped back Thursday and Friday.

In fact that seems to be the pattern for many weeks now. Bonds (i.e., the 10-year) start and end the week strong, but sell off mid-week. Not being the Bond King, I don't have an explanation.

On Thursday, the short-term U.S. T-Bill yields began to climb very rapidly, putting the 10-year T-Notes minus 3-month T-Bills yield spread at just 3 basis points, and the differential on the 30-year T-Bonds minus the 3-month T-Bills to be just 39 bp. That is really extreme.

So, bank margins continue to narrow, which will obviously present profitability growth challenges in 2006, as noted by an analyst downgrade on JP Morgan (NYSE: JPM) this week.

The downgrades in the financial sector are to be expected. Banks can no longer borrow short and lend long, at a profit, so now they have to make their profits by trading against their clients.

A flat or negative Treasury yield differential is also an excellent long-term predictor of economic slow-downs and recessions. But with the U.S. economy still cranking on at least three to four cylinders, it's easy to see the large numbers of skeptics who refute any talk of recession.

If you happen to be one of those, please give me the latitude to at least say that an inverted yield curve does not represent the picture of a healthy economy.

Total U.S. money supply grew by an annualized rate of +9.5 pct for the quarter-ended Jan-02-06 compared to the quarter-ended Oct-03-05. For all of 2005 compared to 2004, the money supply grew by +7.8 pct. The U.S. economy, measured by GDP, grew by half that.

So, the Administration and the Fed are being more than accommodative to economic needs. They are also paying for a foreign war and for meeting the other special (one-time) costs, such as hurricane recovery and reconstruction.

With the economy slowing in the U.S., the monetary authorities are in a tight bind here. The quite narrow Treasury yield differential on the 10-year and 3-month paper means that at present there is no economic return from new bank loans.

That is a situation not unlike the typical U.S. consumer who presently cannot spend on an economic basis, i.e., from income. Consumers today are dipping into savings or they are borrowing against assets.

Both situations can continue for a while, but not for long without a recession.

So now the focus will be on the Fed this week. It can either stop raising overnight rates at which commercial banks borrow, which would make the yield curve positive, alleviating very difficult operating conditions for banks, but shooting gold up and the USD down, which surely is an indicator that inflation is returning, or they can raise more, which protects the USD but hurts exports, hurts the housing market, and probably for sure sends the economy into the tank.

Choose your poison.

A week ago, I came to the conclusion in my blog that: "Instead of rampant inflation, I (now) think the economic engine of the world, which is the United States, or, more accurately, the American consumer, will hit the wall (due to credit problems) and a recession will ensue. That recession will spill over into the major trading partners of the U.S., such as Canada, China, Mexico and Japan... The 2002-2006 bull market in U.S. equities will soon end as more capital leaves America in pursuit of markets in Japan, Asia Pacific, India and Latin America. But making gains on equities there too will be difficult. The final blow will be marked by a spike in gold, which I see taking place this 1Q06."

In a world without currency controls, independent traders will take their capital wherever and whenever they please. The American consumer, in choosing foreign goods for good reason, has sown the seeds of future economic hardship in the U.S. The second act in that drama will soon be played out, as and when American Moms and Pops redirects capital to foreign markets.

It's no longer a matter of "if"; this drama has already been scripted.

Last week, all U.S. broad markets sidetracked again. Of the major indexes, the Dow 30 and S&P 500 were close to losing on the week, whereas only the Russell small caps did well (+1.3 pct W/W). The same thing happened in Sept-early October 1987, and in the summer of 1982, when small cap promoters cranked up the fax machines to sell as much stock as possible before the ultimate crash.

As to the Dow 30 lat week: 15 were up and 15 down. But if you look at the 15-minute charts for Dow 30 components Proctor & Gamble and AT&T (NYSE: PG and T), you'll see some high closes that kept them in the plus column for the week.

For the ten U.S. Sector ETFs I monitor closely, there were 5 up and 5 down. No winner, but this could have been 8 down because IYZ (Telecom Services) and XLU (Utilities) closed Friday with an unexplainable burst to the upside, and the XLF (Financials) gained 7.5 cents in the past two hours, which was greater than the 5 cents it gained on the week.

Energy (XLE) was the big winner last week due to Friday's gains. XLE was up +1.87 pct W/W (including +1.2 pct Friday) to close at 54.46. Was it the weather forecast (of a storm) or the spin coming out of Washington regarding Iran's nuclear (or as they say in parts of Texas, "nuke-u-lar") intentions or possible intentions or whatever?

Last week, NY Crude Oil gained $1.56 (+2.5 pct W/W) to close at $64.42 for Light Sweet Crude. The 200-day Moving Average and the 50-day MA are now at $59.31 and $59.86 respectively, so it appears that $55 oil will hold for a while.

Gold jumped yet again to set fresh 25-year closing week highs at $557.24. Friday was a breakout to the upside for all precious metals.

That gold price rally took the U.S. Goldminers ($XAU) up +1.5 pct and the Canadian Goldminers (TSX: XGD) up +0.5 pct W/W. Until then these prices had been stalling.

Basic Materials (XLB) was the biggest loser by far when companies like Dupont Chemical, Alcoa (aluminum) and Phelps Dodge (copper) all dropped swiftly mid-week. XLB was down -2.70 pct W/W to 30.58.

Alcoa (NYSE: AA -4.2 pct W/W) and Dupont (NYSE: DD -6.6 pct W/W) both took a bath after reporting earnings "issues".

For AA, analysts were projecting between 35 and 37 cents earnings for 4Q05 and the number came in at 26 cents. This was a major story in NY this week. Consequently there were several analyst downgrades.

The trade-weighted USD was up +0.05 pct, while the Euro was down -0.16 pct W/W, which is quite flat. But on Friday there was a major shift from USD to Euro, probably due to U.S. M3 numbers, and flight to precious metals and oil.

As I say, the Fed may now be forced to slow or stop short-term interest rate hikes and to watch the USD decline and gold really take off, which will keep the equity rally going a bit longer.

If they continue to raise the overnight commercial bank lending rate, then mortgage loans and other asset-backed loans will have to be priced higher, which will soon reach a tipping point where loan demand will fall, bad debts will rise, and the price of the mortgaged assets will start to deflate. That will be enough to start the inevitable 2006 bear phase in equity prices.

Yes, I remember 1990 when the Fed took the latter alternative.

As for me today, I'm playing it both ways today: I think negative GDP growth will likely happen within six quarters in the U.S., and a bear market start within two quarters. But well before that I think gold is going to run up much higher as evidenced by the breakout on Friday, which is confirmation that the secular bull market is intact for gold.

So I think gold will outperform bonds, which will outperform most equities. Canadian equities will likely outperform U.S. equities because they are more natural resources oriented. And for the same reason the Canadian Loonie will outperform the USD.

Just remember, the seeds of economic booms and busts and stock market bulls and bears are planted slowly and do not spring up overnight. Occasionally the process takes 12 to 18 months to get to see the end result.

My crystal ball is telling me that 2006 will be a challenging year for traders.