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TREASURY AUCTIONS IN THE SPOTLIGHT

The biggest news of the day came from the U.S. Treasury Department with their announcement they are considering new offerings of the 30-year Treasury Bond. The Treasury will give their final decision for the 30-year bond on August 3^rd when they announce the auction details for the third quarter refunding to take place on August 9, 10 and 11. It is expected the government will conduct the first sales of the bonds in February 2006. Timothy Bitsberger of the U.S. Treasury said, “We are doing this because times have changed, and our debt portfolio has changed.” Simply put, we have more debt and less time to pay it back.

When the long-bond was discontinued in October 2001 it was suggested the government was operating with a budget surplus, and they were in fact out in the open market buying back 30-year debt. Since then, tax receipts have dried up and government spending has increased, causing record deficits. Times have changed significantly since 2001 in that our debt has become much bigger than expected and the maturity of the debt has been shortening. With increased issuance of two-year, three-year and five-year debt, we have to pay back the money sooner than when the government was issuing 30-year debt. To pay back the money that was previously borrowed, the government simply borrows enough today to pay back the old debts plus enough cash to keep the government running. With the recent massive issuance of 2-year and 3-year debt, the government is facing “rollover” in 2008…massive debts coming due that will need to be refinanced.

Today the Treasury announced the details for the quarterly refunding to take place next week. The Treasury plans to borrow a total of $51 billion, of which $39.6 billion will be used to pay back prior obligations and $11.4 billion will be raised as new cash. On Tuesday they plan to sell $22 billion of 3-year notes, Wednesday they will sell $15 billion of 5-year notes, and on Thursday they will sell $14 billion of 10-year notes. These debt auctions next week are a very big deal, as it is imperative the government be able to borrow money. Think what would happen to the government’s finances if they were unable to sell the auction…no more government checks…the system comes to an immediate halt! It can’t happen.

To get the market ready to receive Treasuries next week it is important for investors to know the stock market is under pressure so stay away, the commodity boom is coming to an end so don’t go there, and of course precious metals are no place to invest with a slowing economy and a good scare of deflation around the corner. Last week I got upset because I felt strongly that gold and silver were being capped in price. I still believe it’s true…but I’m also speculating the powers that be will stop leaning on gold and silver once the Treasury auctions are out of the way. With the U.S. dollar notably lower today (84.01 on the USDX, down 0.45) gold was poised to move higher, but it remained in lock-down all through today’s session. After firm overseas buying, gold came into New York at $428.80 spot, and saw a low of $427.80 and a high of $429.20…a range for the day of a measly $1.40. I liken that kind of containment to being in a vice-grip, clamping down tighter and tighter.

www.kitco.com

I saw much of the same in the price action for silver through most of the day. On the Kitco chart, note that silver came in six cents higher than yesterday’s close and shows a three-cent gap from yesterday’s high. This had all the looks of a break-away gap to move the price higher, but note the horizontal lines at $6.91. Someone was in there with sales to absorb all the buying, until the longs finally popped the price higher during the lunch hour. To make a long story short, I believe the market managers will attempt to keep gold and silver in check (along with crude oil and gasoline) until the auctions are complete, then the metals will be free to move higher. I wanted to see if there is any credible evidence to show gold is held in check during government debt auctions, so I circled the auction dates on the following chart.

www.StockCharts.com

Looking at the chart I see gold moving lower in most of the weeks and days going into each auction. Gold was brought down to below $400 just prior to the first quarter auction in 2004, hit a spike low for the second quarter auction, and popped back below $400 for the third quarter refunding. In November, it didn’t matter much because everyone was distracted with the Presidential elections, but notice the spike low below $420 just before the auctions. Gold was definitely at a low for the last auctions back in February, and if I’m correct, we could touch the 200-day moving average at $424 during the auctions next week, and then be ready to move up. I have read at least three articles in the last week about the XAU/GOLD ratio and the HUI/GOLD ratio. Precious metals stock investors have been bailing out and running for the hills with the ratios at extremely low levels. Mining stocks have been killed relative to the metals. This is a clear indication that capitulation selling is showing us the bottom. This is where it is not easy to be a contrarian. Buffett says to be brave when all others are scared and to be afraid when others are over confident. This is NOT the time to throw in the towel on your gold and silver shares.

Going back to the Treasury announcement on reinstating the 30-year bond, this development should help Alan Greenspan with his “conundrum” about long-term interest rates. He scratches his head wondering why long-term rates have not been moving higher since the Fed has raised the Fed Funds rate from 1% to 3%. I think that was just a show on his part. He obviously knows that when the supply of an item is reduced with demand remaining basically constant, the price will move higher, or at least not fall as much as it would given more supply. During our economic soft patch since the dot-com meltdown, they did this deliberately because they knew they would have to keep long-term interest rates artificially low by keeping the price of long-bonds artificially high. The Fed supposedly only has control over short-term rates, but I believe they discontinued issuing new bonds so it would be easier to influence the long end of the curve.

Things are definitely changing, especially with higher debt levels than our Treasury estimated a few years ago along with threats of higher inflation. By releasing the long end of the curve, they are probably hoping to take some of the speculative excesses out of the real estate market and slow down the inflationary forces of higher commodity prices. The direct impact of today’s announcement and the Fed’s comments from yesterday are working to steepen the yield curve. Short-term rates are moving lower with the expectation the Fed will stop the rate increases sooner rather than going too far. On the long end, bond prices are going lower with the threat of new supply, pushing long-term rates higher. It will be interesting to see the impact this will have on mortgage rates in the next few weeks.

Today the Mortgage Bankers Association said its application index rose 0.2% with the purchase index higher by 0.1% and the re-finance index higher by 0.4%. The 30-year fixed rate fell one basis point to 5.74% and the average one-year ARM also dropped one basis point to 4.14%. We have clearly lost the economic stimulus from refinancing activity. I’m waiting for the big spin on the threats posed by deflationary forces (crashing stock prices) that will give the Fed a green light to start pumping the money supply even harder and lowering interest rates due to a faltering economy. A really big deflation scare would push enough money into bonds forcing interest rates lower to kick-in a round of mortgage refinancing. This would re-liquefy the consumer and free-up the credit cards for fourth quarter Holiday Shopping Season. If that scenario doesn’t play out, I sure hope you have a fixed-rate mortgage, because it means we have seen the bottom for mortgage rates in this cycle.

Stock prices were kited higher today with the “rescue” announcement for GM coming from a corporate raider, Kirk Kerkorian. This is looking like a really bad joke in the market. GM shares closed higher by $4.97 to 32.74…a HUGE one-day gain of 17.9%! The shorts were brutally squeezed out of their positions today. My first thought was, “Nice save for the stock market today…who put him up to it? Rather cynical, but I’ve been watching these markets a long time. Then I thought to myself, “I wonder if he can sell any of his 22 million shares into this spike?” You know, create an atmosphere for “distribution” and sell into it. One of the other writers on FSO sent this email to me early this morning: “Yo Mike. How about this. Kerkorian could have easily purchased his shares of GM on the open market for much less than $31/share. The stock trades an average of 11 million a day, so over the course of say 40 trading days he could have accumulated that many GM shares I'm guessing considerably less than 30. So why the highly publicized tender offer at this time. This smells!!!”

Who knows, he might want to buy Fannie Mae and AIG next if he likes these companies that use creative accounting. I look at it and ask who would want to buy this junk?!! GM isn’t even close to competitive with the Asian auto makers…they better stick to finance and leave car manufacturing for a company that can actually profit from making and selling cars. GM’s problems are so enormous, why would he want it? Here are a few clips from an article by Nick Barisheff on howestreet.com:

While most people think of GM as a car company 80% of its 2004 earnings came from GMAC, its financial division. While the auto divisions posted losses the finance division provided all of the profits. GMAC doesn't just do auto financing; in fact the majority comes from consumer credit, insurance and mortgage financing. This division provided GM with most of its profitability. Just as with GM, the financial industry was responsible for 50% of corporate profitability in the US. With rising interest rates and the prospect of increasing defaults by overleveraged consumers this is likely to change dramatically in the near future.

This financing activity is clearly masking the problems plaguing its automotive operations. Apart from competitive market factors for car sales, foreign competition, rising commodity and labour costs, and rising oil prices, the areas of greatest concern are GM's underfunded pension liabilities and corporate debt. In 2003, GM faced the largest pension fund shortfall of any US corporation - $25 billion, requiring it to float an extraordinary $17.6 billion bond issue, bringing its long term debt to over $300 billion. This still left GM with a deficit of over $50 billion in its health care fund. The magnitude of this becomes more apparent when you consider that GM's market capitalization is now just $16.6 billion.

Pension underfunding is a global problem that is particularly pronounced in the US due to the underfunding of Social Security. In 2004, the US Federal government posted the highest budget deficit in history- $412 billion. However, its total indebtedness rose by $11 trillion to $46 trillion largely due to underfunded social security and Medicaid obligations. The magnitude of this liability comes into focus when one considers that the 2004 annual increase is equal to the entire GDP of the whole country. It translates into $350,000 per worker and since both couples work in most families, this represents a $700,000 liability per family.

In 2003, 70% of US corporate pension plans were underfunded by $278 billion with estimates for 2004 exceeding $400 billion. The Pension Benefits Guarantee Corporation, that insures the pensions of over 44 million American workers, incurred a record net loss of $12 billion in 2004 increasing its liabilities to $62 billion on $39 billion in assets, resulting in a deficit of $23.3 billion. The CATO Institute, a policy research group estimates that the agency's shortfall may top $50 billion in the next ten years. If the economy experiences a decline due to rising interest rates or rising oil prices the number of corporate bankruptcies could increase dramatically. Given the precarious financial position of GM, it could be one of them.

In addition to the pension and health care liabilities GM's debt is also of concern and is symptomatic of the high consumer, corporate and government debt levels. US corporate debt grew to new highs of over $9 trillion, representing 84 percent of GDP. These high debt levels are significant when you consider that the Federal Reserve has stated it intends to continue to raise interest rates, and that equity markets are overvalued by all traditional measures. The combination of decreasing consumer spending and increased debt service costs will ultimately translate into slower growth, a contraction in earnings and reduced profit margins. This will all translate into declines in stock prices.

GM's total consolidated debt was $301 billion on December 31, 2004. To put this into perspective this is almost as large as Canada's entire Federal Debt of about $363 billion. It is larger than the value of the US gold reserves of 512 million ounces, worth about $217 billion at $425/ounce gold.

As far as I’m concerned, GM shares don’t justify the amount of ink I included in the above quote, but I included the portion about long-term pension liabilities because it is also a topic that is being bantered about with regard to the new issuance of 30-year Treasury paper. I don’t understand all the issues with the need for longer-dated Treasury paper in relation to under-funded pensions, but some analysts are tying the two items together in the same arguments. I will report as I learn more, but for now just look at the mountain of problems at GM and ask yourself why this billionaire says he wants to buy more shares of GM. Does this really justify a one-day gain of 17%???? I don’t think so!

Overall the GM news lit a fire under the stock market today, along with lower short-term interest rates (the day after the Fed raised short rates). The Dow Industrials charged higher all day by adding 127 points to close at 10,384, the NASDAQ Composite launched 29 points higher to close at 1,962, and the S&P 500 gained 14 points to 1,175. I believe stocks as a whole are overvalued, except for companies engaged in harvesting natural resources.

Crude oil prices remained firm today in light of a continuing build of crude inventory. The Energy Department said crude stocks rose by 2.6 million barrels and gasoline stocks rose by 2.2 million barrels. By the end of trading, the crude price was higher by $0.65 to $50.15 a barrel and unleaded gas moved nearly a penny higher to $1.468 a gallon. The firm oil price today probably had more to do with the dollar falling in value rather than the barrels of crude added to inventory. Ask yourself the question if oil went up in price today, or if oil stayed the same and it costs more today because the dollar fell in purchasing power.

We use the dollar to determine or “measure” the cost of everything we buy, just as a seamstress would use a yardstick to measure a bolt of fabric. Think how confused our seamstress would be if one day they said the yard was 36 inches, another day a yard is 33 inches and the next day it’s 37 inches. As the measurements change on a daily basis, it becomes increasingly difficult to determine a true yard. The unit of measure must be DEFINED. We use the dollar to measure PRICE, but it is impossible to find a definition for the dollar. In the Bible, the law of just weights and measures is mentioned at least six different times to indicate the significance of this law for mankind. “A false balance is abomination to the Lord; but a just weight is His delight.” I wonder what He thinks about the dollar? If you want biblical money, trade your paper fiat Federal Reserve Notes for gold and silver!

Have a Great Evening!

Mike Hartman

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