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FEDERAL RESERVE OPENS DOOR TO "SLOW" MEASURED RATE INCREASES

The broad stock averages struggled throughout the day as money moved out of stocks and into the perceived safety of the bond market. A climate of rising interest rates and more importantly, the prospect of an economic slowdown have put a bid of caution into stocks as rising bond prices signal a slowdown ahead. Technology shares were under the most pressure after Cisco System’s earnings rose, but missed some Wall Street targets and Merrill Lynch said, in spite of some progress in clearing swollen inventories, oversupply could continue to haunt chipmakers through 2005. Cisco shares fell $0.61 to $17.63, Intel dropped 11 cents to close at $23.30, and the Sox Index led the pack of decliners with a loss of 2.2% to close at 417.92.

On the plus side for stocks, resource based shares are reporting record profits. (Bloomberg) “ConocoPhillip’s net income more than doubled to a record $2.43 billion, Valero Energy Corp’s profit more than tripled after the third-largest U.S. oil refiner spent $1.1 billion to add capacity to process high-sulfur crude, and Exxon Mobil said fourth-quarter profit rose 27% to a record $8.42 billion. Metals companies, including steelmakers U.S. Steel and Nucor Corp. and Freeport-McMoRan Copper & Gold, Inc., owner of the world’s biggest gold mine, led the materials group to an average profit growth of 79%. U.S. Steel, the biggest steelmaker in the Americas, had a profit of $462 million, compared with a loss of $22 million a year earlier. Freeport’s net income rose to a record $227.6 million following $2.4 million a year ago." Gold and silver shares finally saw some gains today with the HUI Gold Index higher by 1.5% to 195.55. When the dollar rally fades, as it surely will, the metals and their shares will be off and runnin’ again!

The resignation of Carly Fiorina as chief executive of Hewlett-Packard gave a very brief boost to the Dow Industrials as HPQ shares gapped higher at the open, but it certainly wasn’t enough to keep the Dow in positive territory. By the end of the trading session the DJIA fell 60 points (.56%) to 10,664, the NASDAQ Composite fell a much larger 1.6% or 34 points to 2,052 and the S&P 500 shed 10 points to close at 1,191. Fourth-quarter earnings have been decent, but not enough to push stocks higher after the run-up in November and December. Earnings should be tougher to come by as the consensus leans toward a slowing economy.

Crude oil rose to $45.51 a barrel after the Energy Department reported an unexpected decline in U.S. oil stockpiles, boosting concern that refineries will have insufficient supplies to produce gasoline in the coming months. Expectations called for a 700,000 barrel increase of crude supplies, but the data revealed a decline of a million barrels. Similarly, analysts expected an increase of a million barrels for unleaded gasoline supplies, but they only had a build of 415,000 barrels. Unleaded gas closed the day 1.9% higher at $1.239 a gallon. We may have seen the near-term bottom for unleaded, but I’m still waiting to confirm, before reloading my unleaded option positions.

Also on the energy front I have some follow-up information on the situation out of Venezuela. A couple weeks ago I said it looked like President Chavez could be pulling the plug on energy supplies for the United States. A good follow-up article comes from the Houston Chronicle on February 5^th titled, “Chavez Sets Off Energy Worries; Citgo Sale Talk Could Be Politics.” The article begins with, “Aftershocks from Venezuela’s energy earthquake are being felt in Houston. Rumors are ricocheting around the industry that Citgo, the Houston-based refining and marketing arm of Petroleos de Venezuela, could be sold off. That’s because earlier this week in a speech in Argentina, Venezuelan President Hugo Chavez hinted that he might liquidate assets in the north, including refineries…Crazy or not, there could be method to the madness.” If you are interested in reading the full article, here’s the link.

Dollar, Bonds, and Fed-Speak

Treasury notes and bonds are catching a decent bid today with the five, ten and thirty-year prices higher by roughly 0.45% across the board. This is a good thing for the U.S. Treasury in lieu of their need for financing this week. Yesterday the Treasury sold $22 billion of three-year notes and indirect bidders, who include foreign central banks, bought 44% of the offering, down from 53.6% in the previous auction. The bid-to-cover ratio (a measure of demand) fell from 2.24:1 in November to 2.01:1 in yesterday’s auction. Today the Treasury sold $15 billion in five-year notes, but I don’t have the info yet on indirect bidders or the bid-to-cover ratio. The warning signs will come if indirect bidders fall below 40% or if the bid-to-cover falls below 2:1.

Tomorrow’s auction of $14 billion in 10-year notes will be closely watched for demand, as the longer maturities seem to generate less demand at the auctions. One particular quote in a Bloomberg article caught my attention with regard to expected demand. “There is no value in investing in 10-year Treasuries at these levels,” said Kazuaki Oh’e, a Tokyo-based bond salesman at CIBC World Markets Corp. “There is little need to buy and we don’t expect to see very much demand at the auction.” One of the CNBC commentators made an interesting statement this morning when he said, “They have to buy our bonds to support the dollar, and now they are buying bonds because the dollar is strengthening.” Not so fast Joe! The jury is still out on this little dollar bounce.

In fact, the dollar slid fractionally today after comments from Atlanta Federal Reserve President Jack Guynn suggested the Federal Reserve will change their language in future Fed statements by removing or changing the terms “measured” and “accommodative.” The market is interpreting his statement in a way that has the Fed slowing down on the rate increases. Guynn’s comments clearly had a negative effect on the dollar and opened the door for further gains in bond prices. The Feds would be crazy to invert the yield curve, so they are now softening their stance on measured rate increases. Long-term rates refuse to move higher as the bond market broadcast economic weakness down the road.

The Mortgage Bankers Association said its application index rose 4.2% last week with the purchase index only higher by 1%, but the re-finance index had a gain of 7.8% following a huge gain of 16.6% the prior week. The average 30-year fixed mortgage rate FELL last week from 5.61% to 5.48%! Just think, if the economy gets really slow and the stock market tanks badly, we could see more money move into bonds prompting another BIG-BIG round of re-financing across the country. Another 1% lower and all of America will re-finance the home-equity cash machine with 4.5% fixed rates! China and Japan want us to continue buying their exports. They could conceivably subsidize the U.S. consumer (they already have been) by buying our bonds even more aggressively. Another round of mortgage re-fi’s could keep the economy moving sideways for another six months, hopefully enough time to resolve the currency disputes between the U.S. and China with the yuan peg. This should prove to be a pivotal year in the foreign exchange markets, especially with the cost of money being so very low!

Have a Great Evening!

Mike Hartman

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