The markets didn't act quite like what I expected last week but that shouldn’t be a surprise. The markets never act exactly like you think…even when you’re right. I thought we’d get a nice bounce in gold stocks at least, once the dust settled in silver, on account that they should be getting a countercyclical bid, and also appear oversold relative to gold itself. Instead, the homebuilders and gold stocks were the worst performing stock sectors on the week down from 3-5%. The winning performers on the week were the retail stocks, staples, foods and tobacco stocks – up an average 2%. The bearish flags on Wall Street gave the US Treasury market a lift, as did continued strength in the dollar’s foreign exchange rate –especially against the euro.

If the USD index gets past 77, last lowest high, it could spring up to 82-ish –or close to this year’s high, or even next year’s at 89.

Gold prices held up for most of the week but tumbled on Friday.

While the USD gold price does tend to perform better when the dollar’s exchange rate is falling against other paper currencies, it has tended to adjust to strength in the dollar’s exchange rate as well –perhaps depending on the nature of that strength. For example, if it is up because another currency has collapsed, or there’s a global financial crisis, gold rises in lockstep with the dollar as a safe haven currency, or increasingly faster. The last time the USD index rallied (during the first half of 2010 in the midst of the Greek crisis), gold initially backed off, but bottomed (in February) and rallied with the USD after that fueled by heavy European buying. The same could easily happen again if Portugal or Spain befell circumstances similar to the Greeks.

But, the main question on our minds this week is the gold shares.

Most of our readers are invested in the precious metals miners, as am I. But, they are not performing as well as we thought they would this spring. While gold prices have performed pretty much exactly as we expected them to, the HUI is nowhere near my 700 target yet.

The bears largely take this divergence to confirm their view that gold is in a bubble that will pop like the little bubble in silver – we say “little” because you ain’t seen nothing yet. Wait until the international dollar standard really starts to fall off its pedestal.

Still, although we’re not prepared to give the bears the time of day on the fundamentals question, the short term is another thing altogether. And so the question begs, have we missed our opportunity to sell in May and go away?? We’ve cautioned our readers against the silver trade after it began its near vertical ascent, and advised keeping cash levels at 20 percent just in case we get one of these unexpected corrections. My advice is to remain cautious in the short term and not to reduce cash levels quite yet, but also, not to panic either.

I expect a little more fall out in the short term for equities.

Consequently, for those who have been accumulating a position in Proshares Ultrashort 20+ Year Treasuries (NYSE: TBT) (a short position against Treasuries), the short term is likely to encompass some pain as well.

Let’s briefly recap the factors that are weighing on our gold related positions,

• Collapse in silver due to margin hikes and over-valuation relative to gold
• Recovery sentiment fading –weighing on equities and Tbond short
• Commodities under pressure generally as recovery trade unwinds
• Bounce in US dollar as Euro reels on fresh concerns over PIIGs
• ECB and Asian central banks attempting to reign in inflationary policies
• Fed talking about ending its QE program in June
• US politicians threatening to impose debt ceiling on themselves

These factors are in their own way likely contributing 80% of what is happening in your portfolio this month. None of them are fundamentally catastrophic for gold values. In fact, most of them have very little bearing on gold’s fundamental future.

Still, the odds of a deflationary shock in the interim are on the increase because:

1. Fed flirting with the idea of ending current QE policy
2. Chinese central bank is in midst of tightening campaign
3. ECB not providing liquidity, and EU money supply growth slowing

We should note that it is also possible for the Fed to lift reserve requirements without it actually having a real effect since currently the banks have something like 200% coverage of demand deposits (they are only required to have 10% by law).

But while these things all give deflation sentiment a boost, they also lack teeth.

The Fed must know what will happen to bond yields, the government’s budget deficit and economic growth were it to halt the purchase of Tbonds too soon.

We’ve argued that the Fed is in a weak position to begin a tightening, but that it would lean on rhetoric – which the market is increasingly not giving weight to.

Signs of a slowdown in lending in China as a result of several increases in reserve requirements and interest rates are beginning to worry policymakers about going too far over there – note the apprehension of South Korea’s bank to lower rates.

Meanwhile, the ECB has flinched in its tightening campaign as it doled out funds to Ireland last week, with Portuguese bonds reeling and Greece in dire straights again.

Perhaps the most relevant question for us is in regard to the Fed’s next move.

It has warned that QE3 is coming to an end, and it has telegraphed a date for the end of the easy monetary policy…or dare we say the beginning of a tightening campaign!

It is big on transparency. It is working too because worries over the consequences are helping it boost Treasury prices. That will continue so long as equity values fall, and the dollar is up. The view that it would extend QE3 after all was working against efforts to boost bond values. But would the Fed risk letting another financial crisis grab hold of the economy just in order to save the Treasury market? Not likely in our opinion – not at these yields. Bernanke would have to be way past insane. The Fed knows that if it stops buying Treasuries the gig is up… but if it doesn’t stop buying them, the dollar is going to get crushed. It is doomed either way unless the boom it has been busy trying to create has gained enough traction to keep going without its nurturing.

As a matter of fact, the measures taken by the administration and the central bank to boost the economy (QE and otherwise) cannot really work...they can "create jobs", boost confidence and economic “activity” only for as long as they are not withdrawn. In this case, the Fed could slow its impetus (reserve creation) if it had confidence the banks would create money without it.

This may happen in the future but it is not happening yet, at least not enough. The Fed is not yet confident that the banks can go it alone and keep the lending cycle going.

So it definitely risks a deflationary shock if it puts off extending its T-bond purchase program too long. In a previous commentary I predicted the Fed would continue QE3 on a month to month basis past June but that it is probably going to prep the market for a tightening campaign that it hopes to start by Q4 sometime.. .and to the extent the market is focusing on the QE’s its ending is being somewhat discounted, like in the market is climbing a bit of a wall of worry with respect to that, at least to the extent everyone is discussing it.

Five things gold investors can hang their hats on:

1. There are enough reserves in the system for the banks to quadruple money supply
2. Many investors have ALREADY sold in May and gone away – perhaps prematurely
3. We are in that phase of the presidential cycle where an economic boom is essential
4. Gold continues to be the most widely recognized and under-owned bubble ever
5. The coming collapse of the dollar system –regardless of short term Fed decisions

We have had 5 intermediate rallies in gold prices since the 2008 low at around $685 –the average duration between intermediate peaks in the last four rallies has been about 7 months (with the average intermediate rally lasting 4-5 months and the average correction 2-3 months).

Prior to 2008, the average time between intermediate peaks was between 10 and 12 months, but the composition was inherently different with the advance occurring within relatively short bursts of between 3-4 months and the corrections spanning the rest of the time (6-9 months).

The last highest high in the current intermediate sequence (see first chart above) occurred only four months after the last intermediate peak in December. That is, if this is it, it came 3 months earlier than the average and 1.5 months earlier than I expected, while the rally itself lasted only 3 months – making it the shortest such intermediate advance in years –since 2002 in fact.

In summary, the markets are in the process of discounting a deflationary type event – whether it is another crisis in Europe, the end of QE3 in the US, or too much tightening in Asia. The chalk marks suggest an unwinding of the recovery trade. None of the events are bearish for gold, but it is not a time for leverage… at least not on the long side. Our view is that the current trends are likely to persist for several weeks, but that afterwards the gold trade will kick in again, perhaps on a dollar failure in late June. It’s not easy to tell where the bottom will be but we urge caution not panic. In our outlook, a $27-35 bottom in silver and a reversion of the gold-silver ratio back to the 50-55 level suggests a gold price target of between $1360 and $1925. So it is conceivable that we get a one-month correction – like we did in January or last summer – perhaps down to the $1400 level, and then spring up towards $2000 in the summer time when nobody expects it.

This could occur alongside a general advance in shares, and a reeling Tbond –setting up for a potential 1987 anniversary scenario in the fall.