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“Inflation Not a Problem”…But it’s NOT going Away!

The S&P 500 Index opened this morning at its highest level in three months at 1,303, but so far hasn’t gained enough traction to push through the 1,307 level. To capture a more bullish posture, traders are looking for an intra-day high above 1,308 with a close above 1,305. The release of second quarter GDP figures had little effect on stock futures ahead of the open on the NYSE. Bonds got an early bid on economic weakness pushing the yield of the 30-year T-bond down to 4.9%. The overall mantra on Wall Street is simple and consistent: We have a slowing economy led by housing and inflation is NOT a problem. This mantra is especially good to create added demand for bonds, and how incredibly convenient to happen while the U.S. Treasury is conducting bond sales with the auction of $22 billion 2-year notes yesterday and $14 billion 5-year notes today.

Right out of the gate Monday morning the energy complex was nailed lower with crude moving from a Friday close of $72.51 to close Monday at $70.61; yesterday we saw the follow-through to close below the psychological $70 level at $69.71. We just got more downside pressure a few minutes ago when the Energy Department said crude supplies unexpectedly increased by 2.4 million barrels when the market was expecting a decline of 1.3 million barrels. Crude is now 81 cents lower at $68.90. To add fuel to the argument that inflation is not a problem, wholesale unleaded gasoline stood at $2.35 a gallon on 8/3, but has fallen a whopping 25% in three weeks to $1.77. I believe we are headed for political elections very soon. Lower energy prices are good for the bond market, good for the stock market, good for the economy, good for the U.S. dollar, and overall very good for incumbent politicians to get re-elected in November.

Something to consider: Is it possible the government could have covertly released a few million barrels of oil from the largest inventory on the planet, the Strategic Petroleum Reserve? There is a great deal of evidence that governments around the globe have dumped gold on the markets to temporarily suppress its price. As we navigate through these incredibly political times, would they use the SPR to help support the stock and bond markets, and at the same time reduce inflation expectations and increase funds for consumer discretionary spending?….like I said, it’s something to consider. Why don’t they just mail checks to all of us for around $700 like they did a few years ago to kick-off the holiday shopping season? Lower energy prices are expedient from here right through to the elections in November and into the shopping season! Don’t tip the retail apple cart, ‘cause everyone needs to make their nut in the fourth quarter!

Yesterday, Bloomberg’s Commodity page really pounded home the mantra that inflation is not a problem with the following headlines:

“Crude Oil Falls Below $70 a Barrel as Tropical Storm Misses Gulf of Mexico”
“Copper, Nickel Decline as Waning Consumer Confidence Signals Slower Demand”
“Orange Juice Falls as Threat Eases That Storm Will Damage Crops in Florida”
“Gold Drops to One-Month Low as Falling Energy Costs Ease Inflation”
“Sugar Drops to Eight-Month Low in London on Outlook for Supply Surplus”
“Cocoa Plunges to Nine-Month Low in London as Harvest Is Forecast to Rise”

There you have it…prices tumbling across the board…we have no inflation…you are now safe to jump in and buy U.S. Treasury debt. In fact, I’m getting reports that open interest figures for bond futures contracts are at record high levels. Some of the very large players are aggressively buying bond futures contracts. With such a large gap (inversion) between the Fed-funds overnight bank lending rate at 5.25% and 30-year bond yields at 4.9%, there is little chance the Fed will raise rates in September. Fed-fund futures indicate a probability of 20% the Fed will move higher at their next meeting. Though the energy complex has remained under pressure, we saw some dramatic reversals in the market yesterday with the release of the minutes of the last Fed meeting. Bottom line: the Fed came across as dovish toward inflation (since it is not a problem) and the markets are convinced the Fed is done raising rates in the foreseeable future.

The biggest reversals I have been watching from yesterday are in gold and silver (also the bond market). After getting clobbered on Monday for no apparent reason and especially in the face of a weaker dollar, silver continued to fall yesterday to a low of $11.83; it now stands at $12.50 an ounce, up over 5% since yesterday’s low. The precious metals are THUMBING THEIR NOSES at all this nonsense the inflation problem has gone away. Higher interest rates will slow things down in the USA, but global growth is still booming from emerging nations. In fact, I believe the metals are telling the Fed they have NOT done enough to fight the real inflationary pressures that remain in the pipeline globally.

More monetary tightening will be required by other nations to rein-in the booming global expansion. The fact remains that governments around the world are inflating their supplies of money at rates in the range of 8% to 14% and some are even expanding the money supply faster. I believe the Fed minutes that were released yesterday are telling the markets the Fed is OK with the current rate of inflation, even though the statistics understate the true inflation figures. Gold and silver can smell the continuing inflation even though it appears there are some short-term games being played in the energy pits to drive prices lower.

Today’s GDP report reinforced the reality of a slowing economy, but one that is not falling off a cliff. On July 28^th the second quarter GDP was forecast to gain 2.5% and was expected to be revised to a gain of 3.0% today, but instead came in slightly weaker at 2.9%. This follows first quarter growth of 5.6%. Here’s an excerpt from a Bloomberg commentary earlier today:

While second-quarter growth was stronger than initially reported, the economy probably will continue to slow this year as consumer spending and home building weaken and factories scale back production to work off inventories, economists said. Waning demand and the end of the housing boom may persuade Federal Reserve policy makers to keep interest rates unchanged. 

"We're starting to see a slowdown here in a more meaningful way in the third quarter," Richard DeKaser, chief economist at National City Corp. in Cleveland, said before the report. "We're seeing an accelerated pace of decline in the housing sector. Growth in inventories is providing less momentum for factories than we had thought."

Home construction fell at an annual rate of 9.8 percent last quarter, the biggest drop since 1995, compared with the 6.3 percent drop originally reported and a 0.3 percent decline the first three months of the year. Consumer spending, which accounts for more than two-thirds of the economy, expanded at a 2.6 percent annual pace, compared with the 2.5 percent reported last month and a 4.8 percent gain in the first quarter.

The weak home construction data is reinforced with today’s report from the Mortgage Bankers Association which has their applications index down by 0.9% with the purchase index lower by 1.6% and the re-fi index flat from the prior week. Overall the MBA applications index is down 22% from a year ago. Thirty-year fixed rates edged one basis point higher to 6.39% and the average one-year ARM moved eight basis points higher to 5.97%.

Second Quarter Inflation Actually INCREASED!

Once again, I believe the Fed is telling us they are OK with the current rate of inflation, and will not risk a collapse of real estate prices (the 1990’s experience in Japan) to stop inflation. In fact, if we go deeper into the GDP report form this morning, we can see that inflationary pressures have actually INCREASED from the first quarter to the second quarter. From the same Bloomberg article:

While spending growth is slowing, prices paid by consumers are not, today's report showed. The government's personal consumption expenditures index, a measure of prices tied to consumer spending, rose 4.1 percent after a 2.0 percent rise in the first quarter. The index excluding food and energy, a measure favored by Fed policy makers, rose at a 2.8 percent annual rate after a 2.1 percent rise the previous quarter.

Inflation is still quite clearly in the pipeline, but the Fed can’t risk any more rate increases. Over the near-term, I’m expecting the broad stock indexes to continue chopping sideways as they build a base for a feeble late-year rally. I also expect to see continued choppiness for precious metals prices as more time will be required to consolidate the huge gains from earlier this year. Inflation has not gone away, but the Fed’s job is to manage inflation expectations. It is therefore likely we could see more heavy-handed selling of energy products and similar heavy short-selling in the metals pits.

Even though gold and silver have done well the last two days, I’m cautiously optimistic as the metals continue their consolidations. Something to watch for if you are investing in silver or silver stocks is the action between the price of the metal and the shares of the producers. Silver was nearly 3% higher today with a close of $12.49, but the primary silver producer shares are only averaging about 1% higher in today’s trading. The metals could see some pressure over the next week or so as the market managers need to keep a bid in bond prices. The 22 primary bond dealers just took down some big inventory in the debt auctions the last two days, and they will need a few good selling days (slow economy with no inflation) to get the bonds in “distribution” to move them out of their inventories. Once the distribution is complete, stocks will be cleared to move higher along with gold and silver.

By the close of today’s trading, stock prices could not punch through the overhead resistance. The Dow Industrials closed 12 points higher at 11,382, the NASDAQ Composite gained 13 points to 2,185, and the S&P 500 finished with no change at 1,304. On the energy front, natural gas was clobbered for a loss of nearly 9% to $6.29/mbtu’s, but crude made a big turn-around mid-session to close back above the $70 mark at $70.03 and is now moving higher in the aftermarket at $70.50. Wholesale unleaded gasoline has also reversed course and moved higher to $1.81 a gallon. I suspect part of the intra-day reversal is due to tomorrow’s deadline for a response from Iran to the U.N. Security Council. The U.S. is calling for trade sanctions against Iran if they do not tell the world they are going to stop enriching uranium tomorrow.

We should see all kinds of short-term gyrations in the markets as we work through geopolitical tensions and move closer to election time. We still have to deal with Iran on the nuclear issues and we still have to deal with China on currency valuations and trade imbalances. It will also be necessary to keep Israel from going after Lebanon again in the next few months. I will be interested to see how the powers that be can keep things all quiet on the western (and eastern) front. An easing of political tensions around the globe would bode well for lower energy prices and give the gold-shorts some ammo to work with over the near-term. Over the longer-term I see lower stock prices in 2007 for the U.S. with better opportunities overseas, and higher prices for precious metals and commodities in general as the booming economies of the emerging nations continue to place heavy demands on raw materials.

As my parting shot I would like to bring your attention to a fascinating article posted Monday on Financial Sense: “Monsanto buys ‘Terminator’ seeds company” by F. William Engdahl. I strongly urge you to read the article if you want to get a glimpse of how BIG BUSINESS is done in the USA and abroad. The article ties together many pieces of puzzle interlocking big money with corporate America and government. Learn who some of the money is behind the scenes and how they get things done by supporting politicians and scientists…the article exposes the real-deal that you will NOT hear through the mainstream media!!

Have a Great Evening!

Mike Hartman

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