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Over-Reaction to a Non-Event

The big story for today has to be the sudden strengthening of the U.S. dollar. The market activity throughout the day has been a continuation of the knee-jerk reactions to Alan Greenspan’s comments yesterday. The bond market has been selling-off in anticipation of interest rates moving higher much sooner than expected. Investors are speculating that the Fed’s “measured” rate increases can now mean an increase of 50 basis points rather than the originally expected increases of a quarter-percent at each Fed meeting. The expectation of higher interest rates lit the fuse and the dollar took off like a rocket today closing at 89.7 on the U.S. Dollar Index, a gain of 1.38%. Of the major currencies, the euro took the biggest hit by dropping 1.79% to 1.2023, the yen fell 0.73% to 0.9084 and the Canadian dollar also fell 0.73% to close at 0.7351. I have to sit back and wonder how much the threat of higher interest rates and the subsequent dollar strength has to do with window dressing for the G-8 Summit (a strong display of power) currently underway along with Treasury auctions worth $25 billion today and tomorrow.

Take a look at the chart of the U.S. Dollar Index and you can see the trading over the last couple weeks has developed into a broadening formation (a.k.a. megaphone). This chart pattern suggests a market that is out of control and unusually emotional according to John Murphy. The pattern is typically a bearish formation and backed-up with the fundamentals this suggests the dollar rally won’t last long. You can see the bounce was due to happen because the yield gains are overextended. There is a tremendous amount of overhead resistance in the 90-91 area, and assuming it holds the bearish scenario is still intact. A further bounce to the moving averages and even all the way to the blue support line (now resistance) would not be out of the ordinary for a continuation of the bear market decline.

After Mr. Greenspan was done talking, the media was out in force saying, “Greenspan says Fed ready to raise rates as warranted” and “U.S. Treasury prices ease on Fed inflation concern” and “Fed ready to do what is required.” Remember they didn’t really DO anything; they just TALKED about doing something should it become necessary. They are moving the market with their words, not their actions, and they have certainly moved the market! The quote I used last week is worth repeating. From the renowned trader, Victor Sperandeo, “The market was head-faked by Alan Greenspan talking about a bias toward higher interest rates…and believes the Fed is creating a purposeful inflation because that is the way to resolve several economic and social conundrums. Until the Fed stops pumping up the money supply (+14% last quarter) the threatened rate increases are camouflage.”

The talk is all there, but rate increases will be minimal. I originally expected the Fed to do nothing at the end of the month, but now it looks like they will have to take the Fed Funds Rate to 1.25% just to remain credible with respect to inflation. In the text of his speech, Mr. Greenspan also said policy makers have, “Provided ample liquidity (major understatement) to the financial system that will become increasingly unnecessary over time” and also said deflation concerns are “now presumably behind us.” If you recall, deflationary concerns were the primary justification for continued low interest rates and the addition of excess liquidity to the financial system. Greenspan also said there has been a “restoration of a significant degree of pricing power.” I suggest he is actually saying that a portion of the cost increases can now be passed along to the retail level. That means higher prices to come. Remember that inflation is an increase in the level of consumer prices (and asset prices) caused by an increase in available currency and credit. The inflation has already happened, now we will see if it has been enough to re-inflate the stock and bond bubbles and how much of the inflation will show up as higher prices to the consumer.

Treasuries and Mortgage Rates

The bond market’s over-reaction to the threat of higher interest rates worked to push bond prices lower thereby making the new issue of government debt more attractive to prospective buyers. The U.S. Treasury auctioned $15 billion of five-year notes today and intends to sell an additional $10 billion of 10-year debt tomorrow. The lower prices should help the overall demand for the Treasury auctions. To confirm my theory that words are used to lower Treasury prices before an auction, I will be watching to see bond prices move higher next week with the intended over-reaction out of the way.

Higher rates have not been good for home loan applications. The Mortgage Bankers Association said the purchase index for new homes fell by 6.0% and the re-finance index increased its rate of decline from 6.6% the prior week to 13.9% last week. The average interest rates on 30-year mortgages rose slightly to 6.25%. Re-fi money has been a huge source of stimulus for our pseudo-recovery. With higher rates it will be very difficult for the Fed to continue the increase of monetary aggregates. Please take a look at the recently updated chart from Michael Hodges, who writes “The Grandfather Economic Report.” For the whole story please click here for a link to “America’s Total Debt Report.” As you can easily see, the total debt in our country is going absolutely postal, and it has increased dramatically with interest rates at 46-year lows. This is the reason the Fed must inflate, but make it look like we’re maintaining a strong dollar policy. I must give credit where credit is due. These guys are really good at goosing the system along. They have increased the total supply of dollars, but keep the purchasing power from caving-in by saying they will raise rates in the future.

Last week I received some excellent emails suggesting the increase in monetary aggregates was not simply the Fed pumping the supply. It was pointed out to me that much of the increase in M-3 was due to mortgage originations. As the definition of inflation above suggests, the inflation can be a result of an increase in the currency or an increase of credit. Well, there you have it. We increase the value of our assets by borrowing more money. It’s not nice to see what will happen to our fragile economic recovery when we lose the stimulus from mortgage debt. In a Bloomberg article from yesterday a senior administration official spoke to reporters at the G-8 summit in Georgia and said the U.S. economy is strong enough to handle a “slight increase” in rates. I’ll translate the rest by saying a large increase in rates would be crushing to the economy. They just can’t do it…but they will talk a good story.

Dollar Impact on Precious Metals, Commodities & Stocks

In Mr. Greenspan’s speech, he suggested the Fed will shift part of its focus from the employment numbers to the latest data on signs of inflation. If the market intervention is as heavy as some analysts suggest, this will not be healthy for commodities in general. Even though the fundamentals point to much higher commodity prices, it seems there has been an effort to cool things off a bit. The rhetoric on higher interest rates put strength into the dollar and hammered gold and silver today with gold down 6.50 to $385.30 and silver down $0.13 to close at $5.63 per ounce. Copper was hit for 5.8%, down seven cents to $1.16. Crude oil actually added $0.27 today with a close of $37.55 per barrel after the crude inventory was reported with a build of 400,000 barrels rather than the one million barrels forecast for the increase. The CRB Index fell 1.19 or 0.44% to 270.55, not a big decline. We can only watch to see how much follow-through the dollar will have.

Tomorrow we get the numbers for the Producer Price Index at 3:00 pm Eastern. The markets won’t have much time to react since the announcement will come toward the end of trading for the week. Since the calculations were recently changed for the PPI, I will be watching to see how close it is to the inflation component in the ISM numbers released last week. The ISM survey index of prices paid, a measure of costs for purchased materials and services, rose to a high of 74.4 from 68.6 in April. If you do the math, you can see this is an increase of 8.4% month over month!! I’ll be shocked if the PPI numbers are anything close to the prices paid numbers.

Stocks certainly didn’t like the prospects of higher interest rates and a stronger dollar. The Dow Industrials lost 64 points to 10,368, the NASDAQ Composite was nailed for a loss of 32 points or 1.6% to close at 1,990, and the S&P 500 dropped nearly 1% to close at 1,131. It sure looks like stock bulls and bears are getting whipsawed into confusion. I see the supports for the broad stock indices, but I just don’t see much upside potential except for the fact we’re in an election year. If you missed yesterday’s WrapUp, Ike went through two scenarios for the Dow Industrials, but it looks like it could have been a false break-out to the upside. The Treasury auctions today (and tomorrow) didn’t do much to help stocks since money needs to get “funneled” into Treasury debt. Frankly, I don’t expect we will see much happen tomorrow either. Next week will be a much better indicator for the near-term direction of stock prices.

Employment and Future Employment

In an interview last week Vice President Dick Cheney said the U.S. economy is “in good shape” as the government reported that 248,000 jobs were created last month. The King Report said, “Of the 947,000 jobs counted by the BLS the past three months, 618,000 representing 65% of the ‘job creation’ are due solely to the Birth/Death Rate. Without going into much detail, it has to do with statistically created jobs, not real jobs where people get pay checks. I am wondering if that is part of the reason Alan Greenspan suggested to watch the inflation data more closely than the job numbers. Maybe they have exhausted all the gimmicks possible to create more jobs. At the same time, they just might have another answer.

Unless I’m crazy, there hasn’t been much in the news with regard to the twin bills in front of Congress. The bills are identified as “S.89” and “H.R.163.” I went to www.congress.gov and found the following summary of the two bills:

“Universal National Service Act of 2003 – Declares that it is the obligation of every U.S. citizen, and every other person residing in the United States, between the ages of 18 an 26 to perform a two-year period of national service, unless exempted, either as a member of an active or reserve component of the armed forces or in a civilian capacity that promotes national defense. Requires induction into national service by the President. Sets forth provisions governing: 1) induction deferments, postponements, and exemptions, including exemption of a conscientious objector from military service that includes combatant training; and 2) discharge following national service.” It also says the bill, “Amends the Military Selective Service Act to authorize the military registration of females.”

I suspect we aren’t hearing much about this because it probably won’t win many votes in November, but could be implemented as soon as summer next year. Did you ever think your daughter would be facing the draft? This could well be a solution to the ongoing job creation problems we are facing. The complete details of the Universal National Service Act are available on the website shown above. I sure hope this doesn’t happen, but is a distinct possibility for next year. Something to think about…

Hope you have a good evening,

Mike Hartman

Chart courtesy of StockCharts.com

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