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DOLLAR DAMAGE CONTROL IN FORCE

The tone for the markets was established early this morning when the Labor Department released the data for the Consumer Price Index. Expectations called for a gain of 0.2% in both the headline CPI number and the core rate. The index cooperated by posting a fourth consecutive monthly gain of 0.2% to the core CPI, but lower than expected for the headline number at 0.1%. This is no big news as the numbers tend to be massaged to mute inflation within our monetary system and economy.

The second piece of news that came early had much to do with damage control after yesterday’s announcement from South Korea that they intend to diversify foreign reserves away from the U.S. dollar. This morning the dollar gained after Japan and South Korea said they have no plans to reduce their holdings of U.S. dollars. Taiwan also jumped on the bandwagon by saying they haven’t been selling the U.S. currency. There you have it…now South Korea is telling us they were just kidding around with talk of reducing their exposure to U.S. dollars.

South Korea is the fourth largest holder of U.S. Treasury debt following Japan, China and Taiwan. It’s interesting to see three out of the four countries come out to rescue the dollar. Toshi Honda, a currency strategist in London was quoted in Bloomberg today saying, “They’re trying to put out the fires caused by the comments on diversification yesterday.” The way the markets are trading right now, it doesn’t look like they believe today’s backpedaling comments. The dollar index is higher by 0.42 to 82.83, but gold is also higher by a dollar from yesterday’s close. This looks like some decent follow-through from yesterday’s gain of $7.20 an ounce, considering the dollar is stronger today. With gold holding support at $432, we should be poised to test the prior high around $455 before moving on to the next level around $480 to $500. Spot silver moved lower this morning to find support at $7.26 before bouncing back to $7.41 for the close. I thoroughly expect both metals to move higher as the dollar weakness continues to unfold through the balance of the year.

As I said earlier, the CPI report set the tone for the day. Bloomberg played the party line by saying all is well with inflation being tame. This of course supports Mr. Greenspan’s comments in front of the Senate Banking Committee last week when he said, “The economy seems to have entered 2005 expanding at a reasonably good pace, with inflation and inflation expectations well anchored.” This morning Bloomberg reasoned that the gains for stocks and bonds are due to tame consumer inflation with the following lead sentences: “U.S. stock-index futures rose after a government report showed prices paid by consumers increased less than forecast in January, raising optimism that inflation may stay in check.” The article on bonds led with, “U.S. Treasury notes rose the most in more than two weeks after the government said consumer prices climbed less than forecast in January, easing concern about accelerating inflation.”

The Fed has been VERY active in managing our “inflation expectations.” Perception becomes reality when they continue with this constant mantra that inflation is well contained. Now Mr. Greenspan is saying inflation is “well anchored.” I read well anchored as meaning it’s here to stay for a while. Nobody can twist the meaning of words or find more descriptive generalities that leave much room for interpretation than the Fed. So much for transparency…how is the word “anchored” to be translated into financial terms? Inflation should be anchored here in the U.S. to remain for quite a long time.

Richard Russell posted the notes from a meeting in late January of one of his subscribers with Warren Buffett. I find it timely that in the meeting notes there is a subtitle that reads, “Inflation and the CPI.” Since the markets supposedly reacted in a positive manner today due to the CPI report, let’s see what Mr. Buffett has to say specifically.

Inflation and the CPI:

• CPI is flawed as a measure of inflation

• Average person’s CPI has a very different composition than the weighted CPI used to calculate inflation

• CPI understates human consumption

• Businesses often have contracts that range from 90 to 360 days, therefore inflation lags substantially

• Eventually higher raw material costs will get passed through to the consumer

• Health care is 6% of CPI, but 14% of GDP

• Home ownership was taken out of the CPI 20 years ago and replaced by an imputed rent amount Rental rates have not risen since then but home prices have…the increased burden of higher home prices has been fortunately offset for a while by lower interest rates

Mr. Buffett simply states the facts as he sees them. The cost of housing and healthcare are clearly understated in the inflation statistics. Energy prices are downplayed as they are not considered part of the core prices, yet we all have to pay for gasoline, home heating and electricity. Remember that just last week we got the biggest increase in the core Producer Price Index in the last six years. Core PPI was expected to rise by 0.2%, but instead shot higher by 0.8%. Crude oil is now above $51 a barrel with unleaded gas, natural gas and heating oil all headed higher. Here is what the King Report had to say yesterday about inflation, the Labor Department statistics and energy prices:

“The big rally in oil and gasoline is not reflected in the January PPI. BLS actually has energy prices down 1.3% for January, with crude energy prices down 4.5%! Absurd! The below charts show crude oil rallied from the low to high $40 handle; gasoline and heating oil surged while natural gas traded sideways.

This means the big increases in energy and industrial commodities – the Goldman Sachs Industrial Metals Index made a new high last week – should be reflected in the February PPI. The operative word is "should". ‘Who knows what evil lurks in the hearts of the BLS?’

We are including the BLS tables on adjusted and UNADJUSTED stages of production to demonstrate just how big adjustments are. The UNADJUSTED prices of "Intermediate Goods" increased 8.7% in January. Unadjusted ‘fuels & products’ prices increased 11.4% in January!”

There have also been some recent comments on Mr. Greenspan being in a “conundrum” as to why long-term interest rates have been declining since he began raising short-term interest rates. He told Congress last week he was puzzled by the recent action in the bond market. Mr. Greenspan stated, “Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience….The broadly unanticipated behavior of world bond markets remains a conundrum.” If Alan Greenspan is having a difficult time understanding what is going on in the global financial markets, we should all be concerned. This is what Mr. King had to say about the Fed Chairman’s confusion:

“Friday’s unexpectedly ugly PPI also demonstrates the foolishness of Easy Al’s "measured" response to inflation. The "measured" increases in fed funds, which still render real rates negative, will not inhibit inflation. This pressures Easy Al because he is, and has been for years, positive rear rates or contracting reserves because it would likely induce the dreaded debt deflation.

Easy Al testified that he cannot determine the ‘neutral rate’ for fed funds. Yet no one has rebuked him for this stunning confession. To know if the Fed’s policy is expansionary or contracting is his main job; the other is to bailout the system when needed. People spend years in school and in professions trying to ascertain real rates of interest. Easy Al’s inability to determine the real rate of interest is like an umpire saying he cannot determine the strike zone. It’s the essential requirement of the job. Yet The Street is mum. After decades of glorifying the self-confessed doofus, The Street must now ignore Easy Al’s obvious faults because they have invested so much of their own self-esteem and integrity in praising him.”

The Mortgage Bankers Association said the 30-year fixed mortgage rate rose from 5.5% to 5.67% with the average one-year adjustable rate mortgage at 4.18%, higher by eight basis points from the prior week. Nearly one-third of all new mortgages are of the “variable rate” nature, so why are homeowners taking such a big risk? In two years time the variable rate could easily be higher than 5.7%. Don’t take the unnecessary risk of higher mortgage payments down the road. You can still lock a fixed-rate below 6%! Aside from rates, the MBA said their applications index declined by 0.6% with purchases falling by 1.3% and re-fi’s showing a slight increase of 0.1%. Jim Puplava went into a great amount of detail in his essay, “The Day After Tomorrow” to show what can happen in a hypothetical situation when it comes time for another “mortgage adjustment” in the lives of John and Terry Wheeler. It’s a good read with lots of food for thought.

The Energy Department usually releases their inventory data every Wednesday, but due to the President’s Day holiday it will be released tomorrow morning at 10:30 eastern. Crude dropped $0.24 per barrel today, but didn’t lose much ground by closing at $51.18. Unleaded gasoline was fractionally higher today with natural gas and heating oil higher by 3%. Yesterday South Korea said they were going to diversify their foreign reserves and today that backtracked by saying they are not going to sell dollars. We had a very similar dose of disinformation in the oil sector the last two days. Yesterday the president of OPEC said they would cut production if crude prices fall, and today Kuwait’s oil minister said soaring prices may lead OPEC to boost production.

Last year OPEC raised output to the highest level in 25 years to meet the biggest growth in demand in almost three decades! The International Energy Agency has raised its demand forecasts in 12 out of the last 15 months. The IEA said oil demand in China grew 16% in 2004 and is projected to rise 6.3% this year. China is now the number two oil consuming nation behind the USA. The way I understand it, the per capita consumption of oil in China is roughly two barrels per year. The U.S. consumes roughly 28 barrels of oil per person per year. If China were to double its consumption to 4 barrels per capita per year, they would be putting some serious upward pressure on global oil prices for all the foreseeable future! No wonder they are trying to get the supply from Venezuela that we are currently receiving.

On the energy front, many have emailed me to ask if I have re-bought my unleaded gasoline positions. Please do not take this as investment advise…trading commodities is not for all investors or speculators. I did, in fact, buy the positions back last week. I bought the original positions at $1.10, sold at $1.35 and re-bought at $1.30. I plan to take profits when we get to the premium prices for the summer driving season. Last year with high prices at the pumps, consumers just kept on pumping. Driving patterns changed very little as motorists consider it a cost of doing business to have the independence to drive anywhere we want to when we want to. Last year during driving season, the unleaded wholesale price topped-out at $1.47 a gallon. I’ve got $1.70 as my target for this year.

Most of the Financial Sense readers know that I have been very bullish on silver for a long time. I’ve been happy to see both gold and silver moving higher, but especially silver. More and more investors are becoming savvy to examine the Commitment of Traders Report to track commercial and speculator positions in the futures markets. I will leave it up to silver expert Ted Butler to give you his take on the recent structure of the COT report as follows:

SILVER MARKET UPDATE
By Theodore Butler

Here’s a quick update on where we stand in the silver market. I prefer that investors approach silver on a long-term basis. There are not many better situations than establishing a long-term holding at an exceptionally opportune point. I feel that we are at such a point.

We are still in a remarkably positive position in silver (and gold) in terms of market structure, as defined by the Commitment of Traders Report (COT). The just-released COT, for positions held as of Feb 15, indicated a surprisingly small deterioration in both silver and gold. In other words, the amount of tech fund buying and dealer selling was nowhere near historical levels, given the strong price surge in silver (the report covered the 3-day, 75 cent pop). We are now above every popular moving average in silver (and I’d guess soon to be in gold) and the tech funds have not gotten long in a big way. This is something I have never seen before.

In fact, we have never been at this high price, in either silver or gold, with such a correspondingly small tech fund long/dealer short position, in all the years I have followed these markets. As long as this condition persists, the very real possibility of a price explosion is greatly enhanced. In the past, severe sell-offs have occurred in the silver and gold markets when the tech funds were up to their eyeballs on the long side and the dealers were massively short. That isn’t the case now and that’s very unusual, and I think, very exciting. We could see a major move soon.

I’ve been long ten silver contracts since $6.50 back in January and intend to stay long until I see the price breakout above the resistance at $8. The silver stocks have performed very nicely the last week or so as I continue to hold my core investment positions. I’m very pleased to see the junior mining shares come to life! With a quick look at the daily chart for silver, you can easily see the consolidation that I expect to resolve to the upside.

From the chart you can see the long-term trend-line for support held nicely at $6.50 back on February 8^th and 9^th. Since then we launched through $7.00. Today we saw a pullback to $7.30 that was bought very quickly. We could still see a test at the point of breakout near the $7.00 level, but if we do I believe it will be very short lived. From the chart, notice the horizontal blue lines that define the gaps that were left back in April 2004. If you were invested in silver at the time you should remember it well. Notice the silver price spent roughly five months “healing” the lower gap, and is now headed for the higher gap to mend the prior damage. I expect we will dwell in the gap to build a strong base before taking out the resistance at $8.00.

If the foreign central banks around the globe ever get serious about divesting U.S. dollars as the South Korean announcement said yesterday, I’ll be prepared for the dollar carnage with exposure to precious metals and commodities. Even without the “waterfall” decline of the dollar, we are in the midst of a true bull market in commodities. Twenty years of under-investment in infrastructure to harvest raw materials has created the shortages we see today. Until we get additional production of raw commodities, especially in metals and energy, it will be up to the mechanism of PRICE to allocate the available resources to a hungry world! The world grab for commodities is well under way!

Have a Great Evening!

Mike Hartman

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