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HIGHER INTEREST RATES & INFLATION

Just over two hours into the trading session the broad stock indexes stand slightly in positive territory after noteworthy declines on Friday and yesterday. Stock prices have stabilized with a good earnings report from Circuit City on strong sales of flat panel TV’s during the Holiday Season. Boeing also reported a large order from China for 80 aircraft. The big concern for stocks is the slowing economy and rising interest rates. Interest rates are creeping higher again this morning and the dollar is slightly higher after a better than expected trade deficit was reported by the Commerce Department.

According to a Bloomberg survey analysts expectations called for a February trade gap of $67.5 billion follow the record $68.6 billion in January. The deficit reported this morning was $65.7 billion, still the third highest on record. Most analysts suggest this is only a temporary reprieve from what is expected to be another record year for trade deficits. Higher oil prices and continued strong demand from China are expected to drive the deficit moving forward. As it stands, the gap with China narrowed significantly from $17.9 billion in January to $13.8 billion in February. Time will tell how much the higher interest rates will take their toll on consumer spending.

President Bush meets with the Chinese President next week while congressional pressure mounts for China to speed up its efforts to allow the yuan to appreciate against the dollar. In negotiations yesterday, China agreed to open up it’s mobile phone and medical devices market, lift it’s ban on beef imported from the U.S. and begin to police the piracy of music and software. The large order for 80 Boeing 737 jets was good news, but we will have to watch the situation to see how many aircraft they actually take for delivery. Look for a nice surprise to the upside in the next report for durable goods orders.

Interest Rates Rising

Two weeks ago right after the Fed meeting I noted a comment by Bill Gross of PIMCO who rightly stated that the employment figures would indicate the near-term direction for interest rates. He said strong employment data would signal a further sell-off in bonds ushering in more increases by the Federal Reserve. Bond traders are pricing-in at least two more increases from the Fed to 5.25%. The curve is still flat with the two-year yield currently standing at 4.90%, five-year at 4.89% and the ten-year at 4.96%. Treasury yields should be around 5.4% to 5.5% by the end of June if all goes as expected.

As I continue writing, overall market volatility remains low with the S&P 500 index higher by three points or 0.27% at 1,290, the dollar index higher by 0.13% at 89.27, and the ten-year note lower by 0.19% at 105 27/32. Gold is $1.50 higher (0.25%) at $600.90 an ounce and crude oil is lower by $0.33 (0.48%) at $68.65 a barrel. I list all of the percentages so you can see stocks, bonds, gold and the dollar are all very quiet. This is absolutely NORMAL for a day when the U.S. Treasury is busy borrowing more money. The government is auctioning $8 billion of ten-year TIPS this afternoon and Freddie Mac already sold $10 billion of their debt this morning.

Bill Gross says to watch employment data to see what the Fed is going to do, but I would like to add that we should be watching the dollar very closely. If the dollar begins to sink notably lower, the Fed will be forced to continue raising interest rates. Overall commodity prices have been going through the roof! Global consumption of commodities is still sky high and looks to continue increasing. The Fed says they are inflation watch which should be considered synonymous to defending the strength of the dollar. The U.S. dollar is the “tool of control” on the global scene…they can’t afford to let it go into freefall. If foreign governments continue with announcements of divesting dollars for euros, gold and other currencies, bonds will sell-off, but stocks should get worse. If necessary, stock prices will be sacrificed to save a cratering bond market. I expect interest rates to continue rising as much as is required to keep the dollar showing some semblance of stability.

A final note on interest rates has the Mortgage Bankers Association reporting 30-year fixed rate mortgages higher by one basis point to 6.50% and the average one-year ARM also higher by one basis point at 5.97%. From one year ago, the one-year ARM is higher by 1.69%. The MBA also reported their application index fell 5.5% (down 15.2% from a year ago) with the purchase index lower by 4.7% and the refinance index lower by 6.6% from the prior week. The purchase index is 12.0% lower from a year ago and the re-fi index is down 19.3% year over year. You can see why the Fed is between a rock and a hard spot. They need to defend the dollar, but risk caving-in the economy (home prices, consumer spending and the stock markets) if they go too far! The price of gold suggests they will still err on the side of inflation to keep the current fiat money system in place.

Global Inflation Watch

It’s fascinating to hear all the Fed-speak about inflation being “well contained.” The only thing they really care about is inflation EXPECTATIONS being well contained. They don’t want everyone to freak-out with higher prices because it means they are not doing their job. Rising prices are the consequence of inflating the supply of money! Inflation is here loud and clear. Gasoline prices moved higher again today by nearly 2% at 2.09 a gallon as crude presses against the $70 mark again. We should be expecting $3.00 gasoline at the pumps for the summer driving season. The oil companies are in hog-heaven! Look at the five-year increases in oil, silver, copper and the commodity index. A picture is worth a thousand words. From just a few years ago, prices are three to five times higher, but you wouldn’t know it based on the inflation data with the core rate rising at roughly 2%.

When the first hurricane hits this season at least the government and the oil companies will have an excuse for higher prices, not to mention the growing turmoil in Iraq and Nigeria, and the growing tensions with Iran. The real issue is a big increase in the supply of money…that is the core of the inflation issue. Remember, real inflation is very different from the Fed managing inflation expectations with contrived data and a mish-mash of Fed-speak. Based on the above charts, me-thinks they will continue raising interest rates to slow consumption. Keep an eye on the dollar to see just how fast interest rates will rise.

Have a great evening!

Mike Hartman

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