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CONFLICTS WITH INTEREST RATES AND ENERGY PRICES 

The Dow Industrials and Nasdaq opened the day in negative territory with higher oil prices and bad news from Google cutting their IPO price by 25%, but stocks turned around and moved higher right away as the bulls came charging in. Conversely, Treasury bonds began the day higher on concerns of high oil prices causing a slowdown in the economy as they put a damper on consumer spending. The dollar spent the morning with narrow gains, but also rolled-over and turned negative toward the middle of the afternoon. Overall the markets were mixed as traders struggled to find direction and a clear interpretation of just exactly what the near future holds in store with oil moving above $47 to yet another new high. It was virtually impossible to find any news in stocks, bonds, or currencies without hearing something about the record high prices for crude oil.

Traders waited anxiously this morning for the Energy Department and American Petroleum Institute to release their weekly data on inventories. The Energy Department reported a decline of crude inventory of 1.3 million barrels to 293 million while the API calculated the decline at 1.5 million barrels to 292.8 million. The API also reported gasoline stocks falling by 3.5 million barrels with distillates adding 1.6 million barrels. After the announcements crude popped higher to $47.40 then fell back below $47 and finally settled the September futures contract at $47.27. The big quandary for bond and stock investors alike is whether the record high oil prices are inflationary or deflationary. On one side it is argued that higher prices move through the system and increase costs across the board driving inflationary pressures, while the advocates of deflation insist that high energy prices remove discretionary consumer spending thereby forcing the economy to slow.

As I have said many times before, I believe we will see prices inflate for tangible, physical goods and deflation in financial instruments. We have had enormous inflation of financial assets over the last decade in higher stock prices, higher prices for mortgage backed securities, and higher prices for corporate bonds and Treasury bonds. Most of the money creation in this new age of financial engineering has found its way to financial instruments bidding the prices higher and higher. While there has been too much speculation to make fast and easy paper profits, not enough money has been invested in productive assets. We don’t have enough infrastructures devoted to the growing global demand for raw materials such as oil, natural gas, base metals, and soft commodities. We haven’t invested enough money in natural gas pipelines, added oil refining capacity, or upgraded our electric utility grid for two decades. The excess money creation has caused a misallocation of assets where hot money searches for quick paper profits instead of the slow build to start up new mining operations or build enough new plants to generate electricity. We’re beginning to pay the price for it now!

As far as I can see, we can’t have it both ways. If input costs continue to rise, we will either pay higher prices which means inflation, or corporate earnings decline because companies are not able to pass along the higher costs to retail. So far the gap has been made up by less expensive foreign labor and excess production capacity to keep the costs down for most retail items. A good example came today from Nestle, the world’s largest food company. Their top line sales increased by 2.5%, but the bottom line earnings increased by only 2.1%. According to Bloomberg, the company’s shares fell as much as 5.3%, the most in more than 17 months. The lower earnings were attributed to rising costs for sugar, milk, and packaging (probably oil, too).

The dollar and interest rates didn’t change much today. The U.S. Dollar Index gained .02 to 88.17, losing ground to the yen, but rising versus the euro. The 10-year Treasury note moved higher in early trading, but ended the day slightly in the red which brought the yield up to 4.23%, still historically very low. I doubt bonds will have legs to move much higher unless the economy really goes into the tank or we have a big problem in the stock market. If you plan on staying in your current home indefinitely and you still have a variable rate mortgage, this is a great opportunity to lock-in a fixed rate below 6 percent! The Mortgage Bankers Association reported its application index moved higher by 11.9% with the purchase index up by 6.2% and applications for re-financing up by a big 20.9% from the prior week. The 30-year fixed mortgage rate fell from 5.8% to 5.75%...get ‘em while they’re hot!

Speaking of hot…I was very pleased to see the price action in the silver pits today! After moving to an intraday low of $6.63, the September silver contract closed $0.11 higher at $6.84. The last three trading days have been significant for silver because it has moved higher while the dollar has also moved higher the last three days. Normally they move opposite to each other, just like gold and the dollar tend to have an inverse relationship. If silver can make it convincingly through the current resistance at the $6.80-$6.85 level, I see the next pause around the $7.30 area. It’s nice to see silver move higher in light of the temporarily firm dollar. Gold also held it’s ground fairly well closing at $404.30, so it will be interesting to see how they perform when the dollar declines. Gold still has a few layers of resistance to work through, but in my mind it’s only a matter of time. The caveat, of course, is if we tumble into a serious deflationary spiral; if that happens, we’ll have debt defaults the likes we’ve never seen and I don’t think anybody wants to see that happen.

We need a lower dollar to jump start our export businesses and slow import purchases to improve the balance of trade. The current trade deficit is clearly unsustainable! How much “stuff” can we keep buying with increasing amounts of debt? The Federal government would probably also prefer a lower dollar to make it easier to pay our offshore debt. Who wants to be a slave to the lenders? When Japan and China decide they have enough U.S. dollars and assets we could have some big problems with the international purchasing power of the dollar. In the meantime, they continue to diversify their customer base away from the U.S. as much as possible. In June, Caribbean banks bought $17 billion of U.S. debt, but can the economy (or offshore bank accounts) of those little islands continue to come up with big bucks to support the U.S. deficits? We shall see. We gotta' get real about this at some point in time!

It looks like there are some big conflicts between the oil price, the bond market, and the stock market. Energy prices point toward higher costs and inflation, but bonds are pricing-in an economic slowdown. With all that, the stock market booms off to higher prices. The Dow Industrials popped back above 10,000 by adding 110 points today to close at 10,083 and the NASDAQ Composite sprinted-off with a gain of 36 points to 1,831. It’s a big up-day for stocks considering all the uncertainties in the marketplace. CNBC says we can sum it all up with, “What the heck is going on!? The answer is, we don’t know.”

You will probably be hearing much in the news about the record oil price in conflict with lower interest rates, so I’m including the following graphs so you can see the relationship in your mind’s eye as you hear the spin in the media. Notice how the relationship has changed significantly since the beginning of 2002. This is not normal!

In the final analysis, we all must decide for ourselves if the current cycle is moving to a sustained period of inflation or deflation, then invest accordingly. These are very complicated issues in a complex global environment…throw in the geopolitical tensions of war with election-year politics and stir the pot some more! These issues do not bode well for the stock market, so be careful…it will be difficult to sell stocks if everyone is headed for the exits at the same time. Who could ever fault you for being prudent and putting some money on the sidelines…there’s a time for every season!

Have a Great Evening!

Mike Hartman

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