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Mr. Market says Fed is Wrong!

Financial markets are absolutely consumed with the aftermath of Hurricane Katrina and the onset of Hurricane Rita. Each time I checked-in with CNBC for any breaking news, all I heard was continuing updates on the potential impact of Rita at landfall in a couple days. Economic news was light today with the regular mid-week reports on home mortgage activity and the Energy Department’s weekly inventory numbers. Probably the most noteworthy economic news for the day came from the IMF as they adjusted global growth lower.

In 2004 global growth was 5.1% and 2005 growth was adjusted from 4.4% to 4.3%, with oil prices and protectionist measures in the U.S. and Europe cited as the reasons for the lower expectations. Forecast growth in the U.S. was reduced from 3.6% to 3.5%, but what caught my eye the most was the downward revision for 2006. The IMF has reduced the forecast growth for the U.S. from 3.6% to 3.3%. Putting it all in a different perspective, global growth for 2005 was reduced by 2.3%, but forecast growth in the U.S. was adjusted 8.3% lower for 2006. With inflation on the rise, the 3.3% forecast growth is really only growth by way of inflation. If the true inflation rate is 5%, the real growth in the U.S. would actually be negative after adjusting for inflation.

The Federal Reserve raised interest rates yesterday, saying inflation is a bigger threat to the economy than the risks of an economic slowdown. The Fed statement said the negative economic effects of Katrina would not be a “persistent threat,” but where he missed the mark is simply that natural disasters CAN BE a persistent threat to the economy. Louisiana represents about 20% of our oil refining and infrastructure, whereas Texas represents roughly 25% of our oil infrastructure. There are 26 refineries in Texas, most of which are right on the Gulf Coast. You can’t miss hearing about it if you just turn on your television.

Oil inventories are all over the place as numbers are being called into question. Analysts expected a million barrel increase in crude inventory, but instead inventories declined by 322,000 barrels. Likewise, expectations called for a decline in gasoline and distillate inventories based on reduced refining capacity, but the Energy Department reported a rise in both distillate and gasoline inventories. Traders on the floor didn’t lose much heart with the build of refined products, as gasoline is currently trading 5% higher at $2.07 a gallon and crude is a dollar higher at $67.20 a barrel. Needless to say, natural gas production has been sharply curtailed and industry insiders are beginning to wonder if there will be enough natural gas to get through the winter season. December natural gas went above $14 per mbtu’s this morning and now stands at $13.65!!! This will have a huge impact on heating costs and electrical power generation…should get VERY expensive a month or two down the road.

Rising energy costs and rising interest rates are going to bring consumer discretionary spending to a screeching halt. I was also reminded in an email last week about the change in the laws for credit card companies. The way I understand it, a new law goes into effect in October that mandates the credit card companies to require a higher minimum payment. In a nutshell, the minimum payment would include the interest and a minimum portion of the principle. A consumer with a minimum card payment of $250 a month, will probably be required to pay around $400 to $500 a month….this could put a big damper on Holiday shopping. The increased payments could also force more Americans to consolidate their bills on an equity line as a second mortgage. Based on the data from the MBA, it looks like refinancing activity has picked-up with the threats of higher interest rates to come from the Federal Reserve.

The Mortgage Bankers Association said its applications index rose 1.5% with refinancing higher by 7% and new purchase applications down by 2.6%. In the last week we have seen a rush to refinance, but clearly a slowdown in purchases of new homes. The thirty-year fixed rate moved higher by nine basis points to 5.81% and the average one-year ARM moved higher by 12 basis points to 4.94%. As the ARMS rate moves higher relative to the 30-year fixed rate, borrowers have less incentive to take on the riskier-variable rate loans. I suspect borrowers are moving to lock in these historically low mortgage rates.

The Key is the Curve

Within a few hours of the Fed decision yesterday to raise borrowing costs, an ABC News/Washington Post survey showed consumer confidence fell to the LOWEST IN 13 YEARS. Sixty percent of the respondents said the economy is getting worse, but you can’t tell Mr. Greenspan. Inflation is the problem, according to the Fed!! Now we are going to get higher inflation with higher interest rates and slower growth. The big question remains if Greenspan has gone too far in raising rates as the economy begins to stare into the abyss. The key to understanding if the Fed’s policies are correct is simply to keep an eye on the yield curve. If the yield curve flattens further, they blew-it! If the yield curve becomes steeper, they done good!

According to Bill Gross, one of the Fed’s primary concerns is rampant asset inflation, mostly in the real estate arena. Higher long-term interest rates would effectively take the “froth” out of the housing market. Mr. Gross believes the Fed wants to increase the spread in the yield curve to reflect higher yields on the ten-year note and 30-year bonds. As the Fed continues to raise rates on the short end of the curve, the long end needs to rise commensurately, or we could end up with a flat or even inverted yield curve. A flat curve means we have economic trouble ahead. An inverted curve invariably means we have a recession dead ahead.

If the Fed were raising rates because the economy is booming along, it would not have much of a negative effect. In this case, the economy is slowing, but the Fed has to raise because of the inflation threat. Remember also, the Fed is desperately trying to defend their Federal Reserve Notes (a.k.a.: U.S. dollars) as the reserve currency of the world. I’m sorry, but higher interest rates will not stop the coming carnage in the dollar as the economy and stock markets begin to falter. Even as Greenspan raised rates yesterday and continued with his hawkish rhetoric, investors are selling the dollar today. When Greenspan spoke yesterday, the bond market fell in line and sold-off, reflecting the higher rates and hawkish tone. Today the bond market is singing a different song. Today, rates/yields are moving lower, especially on the long end. The yield curve is flattening, which points more toward economic weakness. The Fed wants higher rates on the long-end, but the market is still not cooperating. I believe the powers that be are actually trying to spin inflation higher in hopes they can spook the bond vigilantes into selling off the long bond. The Fed says they are concerned with inflation, but Mr. Market is saying economic weakness is a bigger threat. The stock market is singing the same song as the players in the bond pits…and Greenspan scratches his head on what to do next.

On Sunday night, August 28^th, I told my little bride that “tomorrow we should see stocks and the dollar lower with bonds moving higher”…..boy was I wrong three weeks ago. After Katrina, both stocks and the dollar rallied. I believe reality is now beginning to set in. You can try to spin the reconstruction effort as economically bullish, but many, many $billions$ in productive assets were destroyed. Rita could be the final blow to show investors that destruction of vital infrastructure is NOT the pre-cursor to an economic boom. Now the market is seeing the hundreds of billions of dollars that will need to be borrowed as a huge inflationary force. I believe the dollar will be “tested by fire” throughout most of 2006….and remember….paper tested by fire doesn’t hold-up very well!

Now Let’s Make Some Money!

From an investment standpoint, I still hold my gold and silver bullion along with precious metals mining shares, including junior explorers. If you take a look at the two-year silver chart, you can see that I have marked the top and bottom of the two massive gaps that were left in the carnage of the breakdown back in April 2004. If you were invested in silver back then, you couldn’t possibly forget the 34% decline in a month! From the red horizontal lines, you can see that the lower gap was well healed as the price spent three months on two separate occasions dwelling in the gap until the damage was repaired. Since then silver has remained in a very narrow range for over seven months this year. The narrow range was defined by the top of the lower gap and the bottom of the upper gap. In my mind, all the lower levels have been satisfied, and the next level to take out above is the $7.50 resistance. This is where the shorts should get VERY CONCERNED.

As long as $7.50 holds up as resistance, there is a chance some of the shorts will get a chance to cover at some lower levels. When $7.50 is taken out convincingly, I believe the way is cleared to move to the top of the upper gap at $7.80. Should that scenario play out, $7.50 will be the new level for support. The silver shorts have some big problems on their hands! So far the best level they have been able to buy back their short sales has been $7.35 during New York hours. I would like to see a pullback so I can buy more, but I’m taking GREAT PLEASURE in watching the shorts get THE BIG SQUEEZE!!! They deserve it for being such simpletons in taking the other side of the commercial’s trades. The commercials regularly use the “black-box” CTA trading models of the Specs to keep them short when the market is making a turn…in this case, the market turned on a dime last Friday and the shorts got trapped. All we can do for now is wait to see if the longs let them off the hook, or bludgeon them for more losses.

One article that caught my eye today came from Bloomberg on recent copper inventory draws from the COMEX warehouses. Check the opening sentence and the immediate contradiction in the next paragraph:

Copper Climbs to 5-Week High on Supply Concern as U.S. Stockpiles Decline 

Sept. 21 (Bloomberg) -- Copper prices in New York rose to a five-week high as U.S. inventories declined, renewing speculation that demand will exceed supply for the metal used in cars, homes and appliances. 

Stockpiles monitored by the Comex division of the New York Mercantile Exchange fell 2.1 percent today to 9,080 short tons, the fourth straight decline. Supplies from mines and scrap yards fell short of global demand by 219,000 metric tons in the first half, the International Copper Study Group estimates. Prices are up 27 percent in the past year, reaching a record Aug. 16.

In the first sentence the writer says there is “speculation” that demand will exceed supply. Then she says demand exceeded supply in the first six months of the year by 219,000 metric tons. There is no “speculation” about a shortfall in supply, because it is already here! Through most of 2003 copper was $0.60 to $0.70 per pound; today it closed at a new record high of $1.80 a pound…prices have tripled in two years. There is no speculation about a supply deficit…it is already very real. It is my belief we will see a similar article in the next few months on silver inventories in the COMEX warehouses. China has been the lifeline of supply for the last four years, and word now is they want their leased silver back. Many believe that is the reason AIG was the first in line to take delivery of September silver contracts. AIG used to be the big short-seller in silver, now they are back-tracking to buy back metal they previously leased and sold into the market.

Aside from the metals, I bought position in yen and Swiss francs earlier this week as the dollar rally was looking a bit tired approaching overbought levels…so far so good. Hurricanes Katrina and Rita are sure to increase our government deficits thereby putting even more downward pressure on the dollar and upward pressure on interest rates. To that point, I have a hard time understanding why so many investors think they have to be fully invested in the stock market at all times. There is a time for every season. Based on recent developments with Mother Nature, rising interest rates, low consumer confidence and a slowing economy, I don’t believe this is the season for stocks. I believe it is much more prudent to diversify a portion of your assets out of dollars and also gain exposure to the bull market in commodities. The trend is your friend, so be right and sit tight!!!

Have a Great Evening!

Mike Hartman

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