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Take a Few Steps Back

The big news that got everybody excited today was the release of the Consumer Price Index for March indicating inflation worries are back on the radar screen. The Labor Department said consumer prices increased 0.5%, a fourth straight monthly increase led by rising energy, transportation and clothing costs. Seventy economists polled by Bloomberg News expected an increase of 0.3%, so they missed the mark once again. It may look like a small difference, but on an annualized basis the number implies inflationary pressures at 6% versus the forecast of 3.6%. Treasury bonds reacted strongly to the downside while the dollar moved higher with expectations the Federal Reserve would be forced to raise interest rates sooner than expected. Take a look at the daily chart of the Ten-year Treasury Note Yield and you can see the sharp increase in the last week and a half.

In the last nine trading days we have seen extraordinary market volatility attributed to three key pieces of economic data. The one thing that occurred to me above all is that the economists’ forecasts have been way out of the ballpark on each one, and each release has sent interest rates noticeably higher. The first knockout number came two Fridays back when job creation for March was expected to come in at 120,000, but the reported number was 308,000. Yesterday economists were expecting an increase in retail sales of 0.7% and the number came in more than double at 1.8%. Today the CPI was reported 40% higher than anticipated, and once again the bond market sold off forcing interest rates higher.

No Surprise

The higher than expected increase of consumer inflation should come as no surprise since we all know commodity prices have been screaming higher over the last year. Inflation has been in the pipeline for at least two years with the age-old indicator of gold moving from $250 an ounce to over $400. It all began when the Fed went on an unprecedented rate cutting spree in 2000 along with increased liquidity via open market operations. The result of the Fed’s inflation was a rescuing of the stock market and higher commodity prices.

Once the loose money policy was put into place, prices began to rise at the producer level although it has been more difficult to see since we haven’t had any reliable data from the Producer Price Index. We first saw the inflation show up in financial assets with money moving into bonds rendering the historically low interest rates we have today. Last year we continued to see higher bond prices along with a rising stock market and commodity prices. Finally we are seeing the expected end result with higher consumer prices. We would have seen the CPI go up sooner, but it has been held in check with less expensive foreign labor and still a mountain of excess manufacturing capacity globally.

A Turning Point?

We have now seen three stellar economic reports depicting economic recovery and forcing interest rates higher, but I am not fully convinced it will be sustainable. I believe the market is telling us a major turning point is near at hand, but I don’t think we’re there quite yet. While interest rates have shot up to their highs for the year, they are still at historic lows. When we have all this market noise of big news headlines it forces me to take a few steps back to look at the big picture. Back to the top of the Wrap-Up, you can see the spike in interest rates from the recent economic data, but you should also notice the relative strength indicator stands in overbought territory. By the inverse relationship this also means that bonds are oversold on a short-term basis, ready for a rebound. Now take a look at the longer term weekly chart.

You can see the 10-year yield is right against the downtrend resistance line that began in 2000. We will have to watch closely over the next week or so to see if there will be significant follow-through to prove we are at the critical turning point for higher interest rates. Remember we are still in an election year and the Fed has promised to drop us “helicopter money” if that’s what it takes to keep the party going, or rather to ensure the economic recovery will be sustainable. If they were convinced, we would see the Fed raise short-term rates in the next few months. The bond market is not pricing in a rate increase in June, but with the recent sell-off, bond traders are pricing in an increase of 0.25% in August.

If rates could just soften up one more time it would also spur another round of cash-out mortgage refinancing. According to the Federal Home Loan Mortgage Corporation, cash-out refinancing put a whopping $139 billion into consumers’ pockets last year. As it stands, mortgage activity is drying up rapidly. The Mortgage Bankers Association said today its application index sunk 22.1% last week, with a 30.7% decline in refinancing and a 9.5% decline in applications for home purchases.

Guaranteed Inflation

The Fed has virtually guaranteed they will err toward the side of inflation, and they must. Our monetary system is based on debt where money is borrowed into creation. I still maintain the belief that the bond market is far more important than the stock market. The Federal Government MUST continue to borrow money just to pay their bills from month to month. They can’t afford a meltdown in bonds! From the previous graph you see the downtrend in rates is still intact, but now look at the weekly chart for the Dow Jones Industrials.

The blue support line has been violated to the downside, and the red line shows the overhead resistance. If this is a new bull market as many of the mainstream analysts are saying, the index will need to build a much stronger base to break through the enormous resistance. I think we are going to see stocks slide sideways over the next few weeks as we make our way through earnings season, but then what? The comparisons from a year ago are pretty easy to beat since the market was faced with pressures from the onset of the war in Iraq. Once earnings season is over, where will the next round of stimulus come from? I expect the stock market to weaken and see more money move back into bonds with a renewed flight to safety. Today the Dow Industrials dropped three points to 10,377 and the NASDAQ Composite fell five points to 2,024.

Safe Haven of Last Resort

When stocks begin to tumble again, I don’t expect as many investors to ride it out as they did in the 2000 to 2003 period. People will head for the exits in a hurry! If I’m wrong about bond prices holding up, there won’t be many places to hide. U.S. investors are not enough to keep bonds at their current high levels. We must have foreign participation.

Japan and China are now starting to realize they are paying much more for raw materials, and there has been recent talk of allowing their currencies to strengthen against the dollar. When their currencies strengthen relative to the dollar, commodity price increases will be dampened in their respective currencies. Their currency interventions have also propped-up our bond market, because once they sell their own currencies to buy dollars, they have to put the money somewhere. They end up buying our government bonds.

So far there has been very little participation from the average retail investor in the precious metals arena. When stocks begin to tank again and bond prices head lower due to lack of foreign purchases, we should see round two of the precious metals bull market take off (getting closer…). After the pounding gold and especially silver took the last few days, you could be gun-shy to pull the trigger with new purchases, but remember the key is to buy on weakness. You should be averaging your purchase prices on pull-backs just like we have had. When the inflation genie really comes out of the bottle later this year, geopolitical pressures continue to mount, and money has nowhere to hide, the metals will be off and runnin’ again!

You can see from the weekly gold chart, the uptrend in gold is completely intact. We may have a bit more consolidation to go and a flushing of the weak hands as we have seen recently, but that’s all part of the game. Sound knowledge of the fundamentals and a longer view of the future will guide you more comfortably through these tough times! Keep the faith!

The last weekly chart I have to show is the U.S. Dollar Index. With the release of today’s CPI and the subsequent tumble in bond prices, it was said the dollar “surges higher” because of anticipated rate increases from the Fed. The Federal Reserve has promised inflation and that’s what a weaker dollar is all about.

We must devalue our currency to pay back our national debt (or continue refinancing it) with dollars of lesser value. Additionally, a weaker dollar will help to bring our trade balance back in line by making U.S. goods less expensive to foreigners and making imports more expensive to Americans.

The dollar has surged recently, but long-term it must go lower. The downtrend is still intact, so it will take more to convince me a new dollar bull is underway. At best it could slide sideways until we get closer to the elections, but overall it has at least 20-30% more on the downside over the next few years. The more helicopter money, the merrier! Investors will be forced to protect their wealth with the security of tangible assets led by the king of money, gold. If you like even stronger fundamentals, and more leverage, then jump on some silver during this pullback. June gold closed just over the $400 mark at $400.80 and June silver closed at $7.02. By the time the elections are over, this will look like a bargain too good to be true!

Have a great evening!

Mike Hartman

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