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FEDERAL RESERVE MAINTAINS GRIP ON THE MARKETS

The dominate theme for the financial markets remains slower growth and rising inflation with the Federal Reserve maintaining a hawkish tone with continuing interest rate increases. Stocks and bonds remain under pressure along with commodities and precious metals as the U.S. dollar stabilizes in foreign exchange markets. Yesterday an analyst on CNBC commented that we are now entering a period of “stagflation” like we saw back in the Seventies. Dictionary.com defines stagflation as, “Sluggish economic growth coupled with a high rate of inflation and unemployment.” With today’s managed financial markets stagflation has replaced recession because if we take away the stated core inflation of 3% we end up with no growth in the overall economy.

The rhetoric of higher interest rates to come from the Federal Reserve is intended to contain inflation expectations as real prices continue to rise. The Fed must maintain a hawkish stance toward inflation or they risk the loss of all credibility in maintaining the global status of the Federal Reserve Note (a.k.a.: U.S. dollar). During the month of April the dollar index fell from 90 to just below 84 for a loss of 7%, but since early May the dollar has been contained in a very tight range of 1.4% by closing for 22 consecutive trading sessions between 83.8 and 85.2.

Over the last month while the dollar has stopped most of the bleeding, the price of gold hit a closing high of $728.20 and today fell below $620.00 for the first time since mid-April, a loss of 15%. The fundamentals for gold remain extremely bullish, but it is not politically expedient for the Fed (Federal Reserve Note) to see the price of gold explode through the roof. On May 11th silver closed at $15.20 an ounce and is trading right now at $11.60, a loss of 24% in less than a month. This correction for the precious metals is creating a buying opportunity for the metals and for the mining shares, but I still suspect we have more to see on the downside as the Fed talks tough to manage inflation expectations.

Some of the top headlines this morning from Bloomberg News support my comments on Fed-speak and gradually higher interest rates as the primary tools in managing the markets:

U.S. Stocks Rise as Oil Prices Drop; Google, Boeing Shares Gain

Oil Falls a 2nd Day on Iran's Positive Response to Nuclear Plan

Gold Falls to 6-Week Low on Speculation Interest Rates May Rise

Treasuries Decline as Traders Say Yields Are Too Low to Attract Buyers

Dollar Advances Against Euro as Fed Officials Signal June Rate Increase

It was interesting to see the stock market bulls fear higher interest rates to come, but now they are spinning the news as a positive force since we are now seeing commodity prices correct lower. After the market closed yesterday, Larry Kudlow (perpetual stock market bull) said it is better to give up a little growth to contain inflation because the economy will continue to flourish in an environment where inflation remains low. The Wall Street community wants you to keep all of your money fully invested in stocks and bonds, so now they are downplaying the higher rates and trumpeting the correction in precious metals and commodity prices. It appears the stock bulls would like to have their cake and eat it too!

Over the last few months my strategy has been to remain mostly in cash with a modest allocation to the Rydex short stock funds as I wait patiently for the correction in gold and silver to run its course. The mining shares are down more than 20% from 400 to 315 on the HUI Index since early May, and I’m still expecting the index to move below the 300 level before moving higher again. I still believe this is nothing more than a correction in a long-term bull market for precious metals, especially silver. Candidly, I got out of my mining shares too early back in the first quarter, so this correction is a welcome sight as I look for buying opportunities.

Energy and Home Mortgages

There is very little economic news in the headlines today except for the weekly reports that come out every Wednesday from the Energy Department and the Mortgage Bankers Association. I’ll leave it to TheStreet.com for the inventory numbers from the Energy Department:

“Also Wednesday, the Energy Department released its weekly update on U.S. fuel inventories. Crude stockpiles rose 1.15 million barrels last week, while gasoline inventories rose 1.05 million barrels and distillates rose 1.76 million barrels. Analysts had expected a decline in crude and a slightly larger build in gasoline stocks.”

The bigger issue affecting energy prices has been all the saber-rattling between the U.S. and Iran over nuclear developments. On Monday crude oil reached a high of $73.40 with Iran talking tough, but the price dipped below $71.00 in today’s trading as Iran made positive comments toward an incentives package the U.S. hopes will end the country’s nuclear ambitions. Again from TheStreet.com:

“While the contents of the package were not released publicly, the New York Times reported they include the waiving of trade sanctions and the purchase of aircraft parts from Boeing (BA:NYSE) . Iran has been unable to buy new parts for its aging civilian airline fleet since the U.S. imposed trade sanctions on the country following the 1979 revolution.”

On the housing front, the Mortgage Bankers Association said its application index fell 1.4% with the purchase index unchanged from the prior week and the re-finance index down by 3.8%. The 30-year fixed rate mortgage fell six basis points to 6.60% and the one-year ARM moved lower by four basis points to 6.05%. One year ago the 30-year rate was 5.55% and the average one-year ARM was 4.09%.

With the flattening of the yield curve over the last year, there is clearly less incentive to buy a home with a variable rate mortgage. I believe the Fed has made it a primary focus to manage the yield curve by raising rates on the short end, but not allowing longer-term rates to rise dramatically. This would serve to take out much of the speculative frenzy in the real estate markets with a 48% increase in short-term mortgage rates, but only a 19% increase on 30-year rates. With Alan Greenspan at the helm, the Fed openly stated their desire to take the “froth” out of home prices, but he also had to maintain the unstated goal of not popping the real estate bubble. Mr. Bernanke is now walking on the tight-rope while juggling the balance between economic growth and inflation.

In addition to the reports on energy inventories and mortgage applications, I also found an interesting little tidbit from Mary Ann Hurley of D.A. Davidson:

“Looking for a few good rich unhealthy relatives? The savings rate stands at a negative 1.6% and has been negative for twelve of the past thirteen months with one unchanged reading. The Center for Retirement Research according to Merrill Lynch economist David Rosenberg, noted that 43% of households are “at risk” for a large decline in their standard of living at age 65 vs. 38% in ’01 and 30% in ‘’89. According to the Wall Street Journal this lack of savings is unlikely to be replaced by inheritance. If households are “forced” to save more, any increase in savings will negatively impact spending unless wage growth soars, a negative for economic growth.”

Some Closing Numbers

I may have spoken too soon to say that the bottom isn’t in yet for gold and silver prices. When I commented earlier, gold was below the critical technical level of $620 an ounce and the dollar was moving higher. By mid-morning in New York, gold took off from a low of $617.40 and ended the trading session to settle at 627.40, a loss of only 20 cents for the day. Silver hit an overnight low of $11.35, but once it came into New York at $11.40 it never looked back and charged higher all through the session to close four cents above yesterday at $11.89 per ounce. Some of the market commentators are suggesting gold caught a sympathy bid as silver and copper moved higher. The July copper contract touched a low of $3.355, but then did a turn and burn to a high of $3.639 before settling the day at $3.584, a gain of 9.45 cents. The precious metals mining shares have been mixed today with silver producers catching a bid mid-session, but ending the day fractionally lower. The HUI gold stock index remains under some selling pressure with a close of 309.07, down 9.07 points (2.85%).

In the energy complex, crude oil closed at $70.82 for a loss of $1.68 per barrel, unleaded gasoline closed at $2.12 for a loss of nearly six cents, and natural gas was whacked for a big loss of 6.7% or 42 cents to $5.96/mbtu’s. The AMEX Oil Index dropped nearly 3% to close 31 points lower at 1,056.

The U.S. dollar index is still trying to punch through the 85.2 level, but could only make a high for the day of 85.18 before falling off to close at 84.95 for the session. The dollar was stronger versus the yen, euro, pound and Swiss franc, but flat against the Canadian dollar and slightly lower to the Australian dollar. Tomorrow the European Central Bank meets and most analysts are expecting them to raise interest rates. If they raise rates, we can expect the dollar to remain in a tight range, but if they keep rates where they are, it might be enough to break the dollar out higher.

Treasury notes and bonds were fractionally lower as the yield curve continues to flatten. The yield on the 2-year note is 5.02%, the 10-year note stands at 5.03% and the 30-year bond at 5.10%. It looks like a decent deal to buy 2-year Treasuries, but there isn’t much of a forward premium to buy 10-year or 30-year paper. Tomorrow the U.S. Treasury is set to auction $13 billion of 10-year notes to keep the federal boat afloat.

The broad stock market indexes went skidding out on their lows for the day with the Dow Industrials lower by 72 points at 10,930, the NASDAQ Composite dropped 11 points to 2,151 and the S&P500 fell seven points to close at 1,256. It wasn’t a bloodbath in the stock markets today, but it certainly didn’t look good to go out on the lows for the session. I wouldn’t expect much out of stocks tomorrow as the Treasury is scheduled to suck a cool $13 billion out of the capital markets. I intend to remain short on the broad market as I get an itchy trigger finger to buy precious metals mining stocks and energy shares on the current correction.

Happy Hunting to all of you!

Have a Great Evening!

Mike Hartman

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