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Debt, Jobs and Inflation

Alan Greenspan was very friendly to the financial market yesterday with his statement of taking a “measured” pace in raising interest rates. Where I really think he missed the boat is when he said, “Inflation is low and resource use is slack.” Inflation has been buried in a bunch of statistical mumbo-jumbo, but is more than obvious to anyone that buys gas or groceries. Also remember that a key resource that remains slack is human labor. Without jobs and increasing wages, it will be very difficult to service the higher costs of debt. According to Bill Gross of PIMCO, “Inflationary pressures build as long as we have this emergency less-than-zero percent real interest rate.” From the looks of it, the bond market is not buying Mr. Greenspan’s assertion of low inflation. The Fed Chairman is actually between a rock and a hard spot between artificially low interest rates causing inflation and higher interest rates piercing the debt bubble. He is forced into a position of being patient, even though he took the word out of the Fed statement. The bond market will have its final say as bonds drop in value forcing market interest rates higher.

The bond market has been pricing-in the anticipated rate increases. It looked like bond prices would head back up a bit since Mr. Greenspan implied rates won’t move higher until later this year, and even then they will only go up a little bit at a time. This morning bond prices began to rise as an adjustment for delayed rate increases, but about mid-day they did an about-face and headed lower. The longer maturities are protesting to the stated lack of inflation by selling-off to higher yields. Bonds are saying they need a higher rate of return to compensate for the inflation risk that lies ahead. The yield on the ten-year Treasury note rose today to 4.58%.

The Mortgage Bankers Association reported its application index rose 4.4% in the week ended April 30^th as borrowers rush to lock their rate before moving higher. The 30-year fixed rate moved higher again to 6.1% from 6.01% the prior week. I expect the purchase of big ticket items will decline without the benefit of cash-out refinancing, which has been a huge source of fuel for our present economic recovery. As time marches on it will become increasingly difficult for people to continue supporting their households with more debt. While it will be difficult for consumers to keep on borrowing, the government at all levels will continue to expand debt to pay the bills.

Government Debt

In California voters approved Proposition 57, which authorized the sale of up to $15 billion in bonds, which was subsequently cut back to $12.3 billion. According to the Mercury News, this is the biggest municipal bond sale in U.S. history, and the bonds are being called “Economic Recovery Bonds.” The title sounds positive, but it was done purely for survival. The bond sales began on Monday with the first portion of $6 billion that is supposed to carry them through to the end of June. Most of the money will go to paying-off short-term debt that was used as bridge financing so they wouldn’t have to shut down government operations.

It’s a good thing California decided to go to market this week to refinance their debt because otherwise they would have been competing with the Federal Government for whatever cash is available in the market. Last week the Treasury sold $26 billion in two-year debt and today they announced plans to auction $54 billion in Treasury debt next week. They will start on Tuesday with $24 billion of three-year notes, then $15 billion of five-year notes on Wednesday and another $15 billion of 10-year notes on Thursday. Wow, that’s a lot of billions. For emphasis, please put a million dollars in your mind’s eye and multiply that times one-thousand. That’s a billion dollars. Now look at how many billions there are in the preceding sentences. This year alone according to the Bush Administration, the Federal government will have a deficit of $571 billion, and that doesn’t include roughly $200 billion they will borrow from social insecurity.

More on Debt

I am not an expert on debt, but one thing I know for sure…it is not a good thing! In my mind, it’s a form of slavery. We even coined the cute cliché, “I owe, I owe – so off to work I go!” We are at the point now where we have to borrow over $1.5 billion per day from our friends overseas; funny how we’ve been alienating many of them lately. This is absolutely unsustainable!

From someone who has much more experience than me, this is what Richard Russell had to say yesterday. “The debt situation in the U.S. is ballooning. At the Federal level the national debt is rising at almost a 10% annualized rate. The total debt in the U.S. is now about 300% of the U.S. Gross National Product, a situation never seen before. A goodly chunk of the debt has been financed at the Fed’s low 1% rate. The situation, as I see it, is extremely dangerous. I’ve said that the Fed, in keeping rates at 1%, has built a fantastic “debt-bubble.” When this bubble bursts, and it will burst, the U.S. could go into a long period of deflationary “unwinding,” a period which would see panic for liquidity and dollars with which to carry or pay off debt. This is the frightening situation that now faces the Greenspan Fed.”

Recently I urged everyone to read the weekly “Credit Bubble Bulletin” by Doug Noland of the Prudent Bear. This week I strongly urge you to read Mr. Michael Hodges’ Grandfather Economic Report. To wet your appetite, please take a look at the chart of Total America Debt versus National Income. On Mr. Hodges website, one of his many reports includes “America’s Total Debt Report.” In his summary, he states, “This report covers the most dangerous picture, that of all debt in America (government debt plus all private debt, including debt of households, financial sector, and business) – now $37 trillion and soaring faster than growth of the total economy, and most of that total debt was created since 1990 – showing America more debt-dependent than ever.” Flash back to picturing 1,000-million = one billion, then somehow try to visualize what $37 trillion looks like! You might as well start counting grains of sand on the beach.

Back to the Markets & Inflation

Reuters carried an article today about the rising cost of milk and how it would be good for the organic dairy industry, since the prices of organic and non-organic are moving closer together. “Milk prices are at their highest levels in years as production has fallen, mostly due to a halt in imports of Canadian dairy cattle after the discovery of mad cow disease in Canada a year ago. Increased slaughter of dairy cows due to strong demand for beef has also curtailed milk output, sending prices soaring.” The way I understand the situation, the dairy farmers were going broke with rising costs and no ability to pass the higher prices along to consumers, so they killed off part of their herds in order to survive.

If they drive a tractor on the farm, their costs certainly have gone higher since oil, gas and diesel prices are soaring. It’s easy to start seeing the ripple effect that higher fuel costs are having. I heard recently that truckers are protesting again where they were blocking a freeway in Southern California so someone would to listen to them. We depend on trucking to get all of the products to market and they are finding it more difficult to make ends meet. Crude oil continues to storm upwards approaching $40 per barrel with a close today of $39.62, up 64 cents from yesterday.

Stocks & Dollar

Stocks remained in a narrow trading range today as the broad market averages flip-flopped around break-even throughout most of the session. The Dow Industrials dropped six points to close at 10,310 and the NASDAQ Composite added six points with a close of 1,957. The averages have held up recently with more weakness seen in the NASDAQ issues relative to the big guns in the Dow. Market technicians have been citing internal weakness with anemic volume on rallies and declining issues outpacing advancers. It’s an election year, so all we can really do is watch to see how long they can keep things propped-up. From a historical perspective P/E ratios need to come back closer to 15 and probably much lower before the excesses will be purged from the system. Nobody can say with certainty when stocks will break all supports. I’m prepared to go short, but I learned from the last year and a half to not underestimate the powerful forces of market intervention. The laws of gravity will clearly hit stocks; it’s just a matter of when!

Like Treasuries, the dollar has reacted poorly to the Fed’s revised statement. The dollar followed through with more weakness today, declining 0.6% on the U.S. Dollar Index to close at 89.5. The euro strengthened to 1.2157 and the yen added nearly one percent to 0.9216. Warren Buffett continues to increase his exposure to foreign currencies as he seeks value wherever he can find it.

Gold, Silver & HUI Index

I was glad to see gold and silver both go out on the close with the longs finally showing the upper hand. It gets really old after a while to see the pounding of gold and silver at the open and again in the last half-hour prior to the close. Gold added $2.20 per ounce to $394.00 and silver added eight cents to $6.13. The HUI Gold Index dropped four points or 2.2% to close at 184.74 after the nice gains from yesterday. It appears many gold and silver investors are still a bit tentative to reenter the market since the slaughter in April. I still view this as a buying opportunity since we buy on weakness and sell on strength. The dollar has resumed its downward course and the Federal Reserve is more than friendly to inflation. The fundamentals haven’t changed at all. Mine supply can’t keep up with demand, so when the paper shorts are done fleecing the specs, they will flip it again to cover some of their short positions. In the end, the fundamentals will reassert themselves.

For now, it appears the most recent bashing of the precious metals has run its course, but I don’t expect a big explosion to the upside for another week or so. If the shorts decide to get aggressive again, I suspect it will be on Friday or Monday just prior to the hefty Treasury auctions next week. Last week the two-year debt auctions didn’t see strong demand, so I expect the auctioneers to soften up the market for next week.

The employment report will be watched closely on Friday. A strong report will cause bonds to fall further, while a weak labor number will be favorable for Treasuries. I will also be paying attention to see what the revision will be from the March report that claimed an increase of 308,000 jobs. In any case, I expect the sales of Treasury debt to command first priority from market participants, otherwise the Federal Reserve will have to buy the debt themselves. The day they begin to monetize Treasuries will be the day gold sprouts wings and flies!

Have a Great Evening!

Mike Hartman

Charts courtesy of StockCharts.com and Mr. Michael Hodges’ Grandfather Economic Report

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