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G-7 MEETS OCTOBER 1^st 

Interest rates moved higher today after the Commerce Department revised second quarter GDP to 3.3% growth versus the forecast of 3.0% and the previous estimate of 2.8%. Given today’s economic growth rate above 3%, most analysts agree that bond yields are simply way too low, and too much bad economic news has been priced into Treasuries. Bond guru Bill Gross of Pacific Investment Management Company who runs the largest bond fund in the world came right out and said the government is understating inflation in their official figures. He believes inflation is running about one percent above the stated CPI rate of 1.7% excluding food and energy. According to the Bureau of Economic Analysis, the personal consumption expenditures index rose 2.4% in the 12 months ended July. The August data will be released tomorrow. For the bottom-line answer Mr. Gross says if investors bought bonds on a “benign outlook for inflation, they had better cash some of them in, especially at today’s 4% yield for 10-year Treasuries.”

The recent decline in yields has increased activity in the mortgage arena. The Mortgage Bankers Association said its application index rose 4.9% with the purchase index gaining 2.7% and the refinance index jumping higher by 7.7%. Even though refinancing activity has picked-up, it is still 12% behind last year’s pace.

Our daily dose of information on energy prices came today with the Energy Department reporting crude inventories increased by 3.4 million barrels after analysts were anticipating a decline of three to four million barrels. I’ve been looking for the data from the American Petroleum Institute, but haven’t been able to find it. I was curious to see the discrepancy in data from the Energy Department and the API since traders tend to rely more on the API numbers. Investor’s Business Daily had an article with the API data, but the link came back with a message that the article was no longer available. Crude was sitting right at $50 per barrel when the news hit the wires and quickly took the price down about $1.50. The sell-off didn’t last long as the price bounced back to $49.51 for the close, a loss of only 39 cents.

The decline in oil was offset by a dramatic price increase for natural gas. Hurricane Ivan knocked out platforms in the Gulf of Mexico and caused at least 13 pipeline leaks. Output from offshore fields in the Gulf provide about one-fourth of the natural gas for the U.S. and current production is running 19% below normal. Just two weeks ago gas hit $5.15 per million BTU’s and today hit an intra-day high of $7.23…that’s over 40% higher in ten trading days! By the end of the session the November gas contract settled at $6.91. (I must admit I’m kicking myself a bit over this as a “woulda-coulda-shoulda!!!” Two weeks ago a banker friend emailed me to see what commodities I was looking at. I told him to take a look at nat-gas, but failed to pull the trigger myself…oh well…John, I hope you made some good money!!)

Energy Prices, Economies and Currencies

Yesterday a Bloomberg article ran with the headline, “Yen Declines With Japanese Stocks as Oil Prices Reach Record.” The article goes on to say, “The yen fell to a four-month low against the euro and traded near a six-month low versus the dollar as rising oil prices and declining Japanese stocks fueled speculation investors will shun the nation’s financial assets. Japan’s economic expansion is at risk from a sustained rise in oil prices according to Japan’s Economic and Fiscal Policy Minister…” Higher oil prices are especially bad for Japan since they import nearly all of their oil. Have a look at the chart of the Tokyo Nikkei Average and it looks like stocks in Japan are ready to roll over just as they are for the Dow and NASDAQ. I’ll be keeping an eye on the red support line. If broken to the downside with continuing weakness in the yen, hot money could end up running away from Japan.

Remember that the Bank of Japan at the direction of the Ministry of Finance went through extraordinary measures to deliberately weaken the yen and support a falling U.S. dollar. In the twelve months to March of this year Japan spent 33 trillion yen ($301 billion) to keep its currency from strengthening. Now the yen is weakening on its own with reports of economic weakness and a struggling stock market. The Japanese have been forced to weaken the yen in order to maintain competitive export industries relative to China. The Chinese yuan is pegged to the dollar, so every time the dollar falls the yuan goes right along with it. The U.S. must devalue the dollar to correct the enormous trade deficits, but can’t do it with a yuan peg. Based on the U.S. Dollar Index, the dollar has dropped 30% since the beginning of 2002. With the peg from China and the deliberate devaluation from Japan, the euro has been forced to bear the brunt of the dollar devaluation.

Now have a look at the chart of the euro/yen relationship. As U.S. investors we don’t usually look at foreign currencies relative to each other, but this chart clearly shows the political stresses between the currencies of Europe and Japan. If the euro breaks out to the upside versus the yen, it will create even greater imbalances between the two countries. The yen really needs to strengthen relative to the euro and dollar, but Japan can’t let it happen or it will cause their export industries to suffer with higher export prices compared to China.

Three Primary Goals

The G-7 countries of the U.S., Japan, Germany, the U.K., Canada, France and Italy meet on Friday in Washington to solve all the world’s financial problems. It is noteworthy to see the G-7 has also invited policy makers from Saudi Arabia, Kuwait and China. It is widely assumed that one of the big topics will be how to control rising energy prices globally, so it makes sense to see Saudi Arabia and Kuwait. Treasury Secretary John Snow this week said G-7 members will be putting pressure on China to change its currency policies. What will China do? It looks to me like they are in the driver’s seat. My best guess says they will give good lip-service for allowing the yuan to strengthen, but will drag their feet in actually doing anything. If they refuse to let their currency float or at least move in that direction with some sort of “trading bands,” it will keep Japan between a rock and a hard spot with forced devaluations.

If Japan is forced to devalue the yen further, look at the possible implications for the yen price of gold to breakout big on the upside. This could possibly create some huge investment demand out of Japan as the yen falls. Also note the Japanese are talking about removing deposit insurance from their banking system. The Japanese citizens have huge savings and if the banks won’t guarantee the deposits, investors could move into gold as currency insurance. Again, look at the chart of the yen gold price and tell me if you see a breakout.

For the most part, investors seem to look at gold as a safe haven in times of rampant inflation. I believe we have more inflation than official figures reflect, but inflation won’t be the driver for the next leg up in the gold bull market. I believe gold will regain its glitter as an investment because of the turmoil in the currency markets and geopolitical tensions between countries that can’t agree on the best course of action for global finance. GATA reports that the Chinese might even have a surprise announcement that they are in the gold market in a large way (possibly a purchase of 1,700 tonnes) to diversify a portion of their foreign exchange reserves out of U.S. dollars. It will be fascinating to see what kind of announcements we get from the G-7 players.

The subtitle above says they have three goals for the G-7 meeting. Actually two of them are one-in-the-same. The pressure on China to let the yuan strengthen is actually driven by the need for the U.S. to devalue the dollar even more. This is where John Snow will come out and say something about how we got China to break the peg, but have no fear America, because we always maintain a “strong dollar policy” even when we are covertly trying to bring the dollar down. The big trick for the Fed and Treasury will be how to bring the dollar down further without triggering the signs of inflation…for now the stated inflation is all blamed on high energy prices with little accountability to monetary policies. The inflation genie must be kept in the bag or interest rates will surely rise which could easily crush our feeble economic rebound.

This whole thing gets even more interesting when we see that we need all of these foreign countries, especially Japan and China because they are the ones financing the U.S. deficits. We have to borrow money internationally because we don’t have enough savings to finance our own government deficits. Today the Treasury borrowed another $24 billion with the auction of two-year Treasury notes. Here is how Stephen Roach of Morgan Stanley describes the situation. “In short, America is no longer using surplus foreign savings to support “good” growth. Instead, it is currently absorbing about 80% of the world’s surplus savings in order to finance open-ended government budget deficits and the excess spending of American consumers.

Actually, if you want to read an excellent analysis of the global currency turmoil, I strongly urge you to read all of “Collision Course” by Stephen Roach. To whet your appetite a bit more, here’s a few of the opening sentences. “The world economy is on a collision course. The United States – long the main engine of global growth and finance – has squandered its domestic saving and is now drawing freely on the rest of the world’s saving pool. East Asian central banks – especially those in Japan and China – have become America’s financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk. Breaking points are always tough to pinpoint with any precision. Most serious students of international finance know that these trends are unsustainable.” If you have a chance to read “Collision Course,” it will be easier to understand the challenges that face the G-7 as they meet at the end of the week. Next week could prove to be quite interesting in the currency markets.

Next week could also get a bit more volatile in the stock market here at home. We close the books on the third quarter tomorrow, so we will get a chance to see how much effect the quarter-ending “window dressing” had in keeping stock prices inflated. I believe there will be pressure for stocks to move lower next week now that the third quarter is closed, but remember there is a great deal of money in retirement accounts that goes into mutual funds on autopilot at the first of each month. Overall for today broad stock averages showed gains. The Dow Industrials flopped around breakeven for most of the day, the like magic at 2:00pm Eastern the market got happy and rallied. The Dow added 58 points to close at 10,136, the NASDAQ Composite was higher by 24 points to 1,893 led by the semiconductor group which was higher by nearly 2%, and the S&P 500 added four points to 1,114. There could be a small bear trap tomorrow to close the quarter and paint the tape for the presidential debate…remember the mantra…the economy is improving and there is no inflation. We’ll see how true it is after November 2^nd.

Tomorrow we get data on personal income, the Chicago Purchasing Manager’s Index, initial unemployment claims, and the Bush / Kerry debate. Time to take off the gloves and let Mr. Bush and Mr. Kerry get it on tomorrow night! In the meantime…

Have a Great Evening!

Mike Hartman

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