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FLATTENING THE YIELD CURVE

Good news came today from the Institute for Supply Management when they announced their index of non-manufacturing companies rose to 63.1 from 61.3. The median forecast called for a drop to 61, so the report was clearly stronger than expected. New orders, the backlog of orders and new export orders all showed gains, but the warning flag pops up when we see that employment slipped fractionally and prices paid rose to 71.4 from what was considered a high level at 71.0. In a separate report Challenger, Gray & Christmas said announcements for job cuts were in excess of 109,000 in December. Announcements of job cuts are now 17% higher on a year over year basis and this is the fourth consecutive month of announcements in excess of 100,000. Many analysts and investors are looking for strength in the employment numbers to confirm the signs of economic improvement. The softness in the ISM employment numbers and the Challenger report could be sending a clue as to what we will see on Friday when the job creation number for December is released.

It seems to me the jobs number on Friday will have a direct impact on the strength of U.S. dollar and interest rates as reflected by bond prices. It was interesting to see the bond market react to yesterday’s release of the minutes of the December 14^th FOMC meeting. The minutes revealed that the Fed believes interest rates are still too low to keep inflation in check. More importantly, the Fed believes low rates are fostering an atmosphere of risk taking and rampant speculation. The bond market sold-off hard yesterday, but today is saying the sell-off may have been overdone. Weakness in the job report on Friday will help to keep a bid in Treasuries and the two reports above imply we could see a weak number Friday. In a nutshell, I believe the Fed will go ahead and raise the target Fed Funds Rate when they meet on February 2^nd to 2.5%, but it won’t have much affect on the longer maturity ten and thirty-year bonds. The Fed needs to flatten the yield curve further to reduce the amount of financial speculation. We can afford higher rates on the short end, but if long-term interest rates take off to 7% or 8% the economy, and especially housing, will come to a screeching halt! The Fed needs to flatten the curve to reduce the amount of arbitrage and speculation by the big-boys, but must be delicate (call that a subsidy via monetization of the long end along with help from China and Japan) with the longer maturities to keep the housing and bond bubbles from going bust. The Fed is walking a very fine line!

A few weeks ago new home sales showed a decline of 12% and for three out of the last four weeks the Mortgage Banker’s Association has witnessed a decline in mortgage applications. For the week ending December 31^st, the MBA’s application index declined 10.6% (the biggest decline since October 2003) with the purchase index falling 13.7% and the re-finance index down 5.7%. The average 30-year fixed rate moved down slightly from 5.72% to 5.67%, but will obviously need to decline further if we are going to see another round of economic stimulus via cash-out refinancing. It was interesting to note from a Bloomberg article, “Mortgage rates are lower now than they were when Federal Reserve policy makers began raising their target rate for overnight bank lending in June of last year (flattening of the yield curve!). In the last week of June 2003, the average 30-year mortgage rate was 6.21%. The National Association of Realtors expects 30-year fixed mortgage rates to rise this year as high as 6.5%.” The MBA noted that adjustable rate mortgages made up 32.6% of applications last week and rates are expected to go higher…go figure. Variable rate mortgages were great to have the last two decades as interest rates have been declining, but variable rate loans could well be the equivalent of financial suicide over the next few years!

One of the analysts interviewed by Bloomberg said high home prices are the cause for slowing sales, not rising mortgage rates. According to the National Association of Realtors, home prices have averaged gains of 4.5% over the last twenty years and they expect the appreciation of home prices to slow down to 8% from the average gain of 9.7% for 2004. Since the forecast came from realtors, I consider it overly optimistic. If we keep up the 8% to 10% annual gains in housing, it will take many years of below average gains to bring the average back to the 20-year norm of 4.5%.

Crude Oil and finished energy products came under pressure today when the Energy Department said distillate supplies, which include heating oil, rose two million barrels with unleaded gasoline also adding two million barrels. Crude oil stocks came down 3.3 million barrels, but the inventory build on heating oil and gasoline took center stage today in the energy trading pits. By the end of the session crude was down 51 cents (1.2%) to $43.40 a barrel, heating oil came down 2.2% to $1.217, natural gas closed 1.1% lower at $5.83 per million BTU’s and unleaded gasoline finished the day basically unchanged.

Stocks and the Dollar

The economic picture as painted by the ISM report came in better than expected and energy prices moved lower, but the stock market still struggled for most of the day. We now have the first three trading days of 2005 off to a rough start, especially with the high-flyers in the NASDAQ. On Monday, the NASDAQ Composite had an intra-day high of 2,191 and closed today 2,091. That’s a 100 point haircut in three days when we are supposed to see new money moving into mutual funds on auto-pilot via monthly IRA contributions. For me this proves the great efforts at “window dressing” the final results for 2004 as stocks were kited in the two weeks leading up to the presidential elections, pumped them again with the Bush win, and continued pumping to the end of the year. As you can see from the last three days in the stock market, the action from November and December will be a tough act to follow. On October 25^th the Dow Industrials closed at 9,749 and on December 28^th, just two months later it closed at 10,854. The DJIA opened 2004 at 10,452, so without the 1,100 point run in the last two months the market would have closed the year with roughly a 700 point loss. Like I said, that’s a tough act to follow…stocks are showing it again today. By the end of the session the broad indexes went skidding out on the lows for the day. The DJIA lost 32 points to 10,597, the NASDAQ Composite fell 16 points to 2,091 and the S&P 500 dropped four points to 1,183.

For now the consensus view on the U.S. dollar is “rally time!” My head is telling me it’s not really rally time, just stop the bleeding time. The dollar has once again been saved from falling below the super-critical 80 level on the U.S. Dollar Index. The last time the dollar bottomed after a significant decline was back in mid-February last year when it closed at 86.25. Three months later it topped-out on 5/13 at 92.86, a total gain of 6.61 points or 7.7%. Five months later in late-October it broke down again to new lows and put in a low of 80.60 on December 30^th. If we use 80.60 as the starting point and give it the same 7.7% increase, it would put the dollar index at 86.6. I believe we are going to see the dollar stay range-bound between 80 and somewhere around 86 if it can ever get there. In the meantime, gold and silver are still working through the current consolidation that I expect to be done in another week or two. This is where I believe gold and especially silver will be decoupled from their inverse relationship with the dollar and move into a bull market in all currencies. The dollar could crumble further, but in the short-term it will be range-bound in the low to mid-eighties. Once this consolidation is done and the commercials are done picking the speculators' pockets, we’ll be off to higher gold and silver prices even without a collapse of the dollar.

If you are an investor in silver, you probably already know that silver production from mining has been in deficit to commercial demand for roughly 14 years. If you have a few more minutes, please take the time to read this most excellent posting by Ted Butler. If you have read Mr. Butler’s work, you will know that he is “pound-the-table-bullish” on silver, but he just cranked it up a notch with the “Izzy Theory.” (Click link to Investment Rarities website and go to Ted Butler's Weekly Commentary in the upper left of the screen.) Precious metal means RARE metal and RARE means SCARCE (not very much), but silver has been treated like iron ore and copper. This is really going to be a fun ride when industrial users recognize the scarcity of silver and begin to compete for available supplies. As that happens, investment demand will grow to also compete for available inventory. Price will allocate available product and believe me, there just isn’t all that much available. Exciting opportunities in silver, especially the quality junior mining companies!  Got Silver?

Have a Great Evening!

Mike Hartman

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