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Markets on Hold for Fed Announcement

Observing the markets today has been akin to watching water slowly come to a boil or spending the afternoon watching grass grow. Market participants are sitting on their hands as we await the interest rate decision and accompanying policy statement from the Federal Reserve, and later tonight we get the State of the Union address from President Bush. Markets are calmly expecting a 25 basis point increase from the Fed and will look to the statement for any change of rhetoric signaling the Fed’s intent for future increases. Economic and financial analysts are looking forward to the President’s speech tonight in hopes he will unveil some of the detail behind his proposal to overhaul Social Security. To date there has been a great deal of generalities with Social Security reform, but very little on the detailed implementation of the proposed changes. Analysts want to see the specifics so they can put a pencil to the financial impact throughout the economy.

Stocks, bonds and currencies are all trading with very little volatility. The Dow Industrials dipped eight points at the open, was higher by 44 points about two-and-a-half hours into the session, and has been treading water in a sideways chop since then. Five, ten and thirty-year treasury debt have been lower for most of the session, but down by only a tenth of a percentage point. The U.S. dollar traded lower at the open, but it didn’t last for very long as buying came in to push the dollar slightly into positive territory. The dollar index is just hovering one-fourth of one-percent higher, with all the major currencies lower by the same fractional amount. The age-old currencies of gold and silver have been held in check, especially since the weak GDP report on Friday. The dollar should have tanked with precious metals rising, but you won’t see much change until we get through the Fed-speak today, State of the Union address tonight, and the G-7 meeting this weekend in Switzerland.

Silver tried again to break through the $6.80 level today, but was snuffed after three attempts this morning, just like last Friday. Spot gold and silver closed today exactly the same as yesterday with gold at $420.50 and silver at $6.71. I don’t expect much to change until we get beyond the G-7 meeting over the weekend. Silver is usually quite volatile, but in the last three weeks it has remained within a 42 cent range from $6.47 to $6.89. I expect gold and silver to break their shackles sometime later next week once the high-profile speeches and meetings are out of the way…but then again, we have some huge Treasury auctions scheduled for Tuesday, Wednesday and Thursday next week, so the metals and the dollar will most likely remain “on hold” until the week beginning February 14^th.

Every time I turn to CNBC for any breaking news, they bring out another stock analyst to talk about Google’s earnings and P/E ratio. They had some great numbers with sales doubling to over a billion and net income moving from $27 million in Q4 2003 to $204 million last quarter. These are some really good numbers, but I’m not so sure they will continue to support the P/E around 140. Jim Puplava featured Google in his WrapUp on Monday and used them to illustrate that rampant speculation and day-trading are now back in vogue. On Tuesday last week Google closed at $176.29 and today gapped-up to $215.55 and has been sliding lower all day. The chart is looking bearish to me. I can’t understand who would want to buy this stock with so much risk to the downside. The chart is showing a broadening formation (bearish reversal) since late December which indicates a high level of emotionalism in the shares. Additionally, I see a divergence with the stock price moving higher since October, but the relative strength index has been trending lower during the same period. I read some analysts calling for the price to advance to $265-$275, but I believe it will fill the gap at $150 before we see anything north of $250 a share.

As expected, the Fed raised the target Fed Funds rate a quarter-point to 2.5% with no change to the accompanying policy statement. With the announcement stocks got a small bounce higher, but sold-off within a few minutes to remain slightly in positive territory for the balance of the session. By the closing bell, the DJIA added 44 points to 10,596 the NASDAQ Composite moved six points higher to 2,075, and the S&P 500 gained three points to close at 1,193. Bond prices got a small bid after the Fed announcement with 30-year treasuries actually moving lower in yield (five and ten-year yields moved higher today). The Fed has now moved from 1.0% to 2.5% on the short end of the yield curve, but their actions have had very little effect on the long end of the curve, and therefore little effect in the real economy.

Mortgage Debt and Treasury Debt

The proof in the pudding that long-term interest rates haven’t changed much comes from the Mortgage Bankers Association announcement today with the 30-year fixed rate moving three basis points higher last week to 5.61%, still historically very low. The bigger piece of news from the MBA shows refinancing applications surged 16.6% higher last week as consumers work to re-liquefy their balance sheets (pay off Christmas credit card bills) to lower cost debt. Overall the MBA’s applications index increased 7.3% with the purchase index only growing by 0.3%.

Fed Raises Short Rates with Long-Term Rates Moving Lower

Roughly one-third of all mortgages are adjustable-rate mortgages. Last week the average contract rate for one-year adjustable mortgages was 4.08% and 30-year fixed rates stood at 5.61%. When long-term interest rates really begin to rise in earnest, I suspect many homeowners will want to lock-in a fixed-rate or they could see their variable rates adjust much higher over the coming years. If variable rate borrowers move to a fixed rate, they will see their mortgage payments go up substantially. If they don’t fix the rate, they could easily be paying 8% or 9% four or five years from now. The best case scenario would be to switch from a variable rate to a fixed rate before long-term rates break higher. To make the change right now, a borrower with a mortgage of $250,000 would be paying $1,205 per month with a variable-rate at 4.08% and the move to a fixed-rate at 5.61% would take the monthly payment to $1,437, nearly a 20% increase in the monthly payment. Combine the higher mortgage cost with higher energy prices and moribund wage growth and we get a recipe for lower consumer spending, the backbone of our economy.

Today the Treasury said they will sell $51 billion in securities in its quarterly refunding auctions next week with $22 billion of two-year notes on Tuesday, $15 billion of five-year notes on Wednesday and $14 billion of 10-year notes on Thursday. They will use $11.44 billion to pay back maturing or called debt and the balance of nearly $40 billion is new cash for the government to spend. This is the way all of the quarterly auctions work. Each quarter we have to borrow enough money to pay back the money we previously borrowed plus finance the current deficits. I read a rather shocking statement in Jim Puplava’s WrapUp from Monday when he said, “Close to 70% of all federal debt matures by the first quarter of 2007.” WOW!!! That means we will have to borrow two-thirds of our current debt outstanding, plus the current federal deficits, plus the additional costs to finance the war in Iraq and Afghanistan…all in the next two years. We will truly need some extra help from our foreign friends in the next two years to pull this one off! It sure makes one wonder why the government stopped issuing 30-year bonds back in October 2001. We have been re-financing 30-year debt with two, five, and ten-year debt.

In the near-term, shortening the maturity of our national debt brings down our cost of interest payments, but for the long-term this is not good. It is the same as the government taking out a variable rate loan when they should be locking-in historically low rates for the longer-term. This tells me there is no real intent to pay back the previously borrowed money…just keep re-financing the debt. Based on Jim’s statement above, this should all come to a head in the next two years, but probably sooner than later as the quarterly refundings promise to grow much larger as each quarter passes. Hopefully we can get past all of the huge debt problems we have in this country. My biggest concern is simply that we will not come to a peaceful resolution with our foreign creditors. A non-peaceful resolution will start with currency wars, then trade wars, and finally to military conflict. The international conflicts we face today are not getting any easier, especially as we compete internationally for available energy reserves. At the same time, we depend on the international financial community to loan us $2 billion a day to keep things afloat.

Looking ahead…we hear from the President tonight; be alert for the closely watched employment report coming out on Friday, the G-7 meets this weekend, and next week the Treasury auctions will be top on the list of priorities for the financial markets. Bond prices (interest rates) and currency valuations are the top priorities for our policy makers at the Fed and in Washington. We didn’t learn much new from the Fed statement today, so maybe we can glean some tidbits for the financial markets from the President’s speech tonight. One thing’s for sure; these markets will not stay “on hold” forever.

Have a Great Evening!

Mike Hartman

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