|
Financial Liquidity, Interest Rates & Commodity Prices
The broad stock indexes have struggled in the red throughout the morning with earnings season off to a bumpy start. Alcoa’s earnings came in lower than expected yesterday after the bell and this morning Monsanto disappointed with bigger losses than expected following a surprise increase in revenue for the quarter. Revenue for Monsanto grew by 9% to $1.39 billion and analysts expected a loss of 21 cents per share, but the company actually lost 27 cents per share. With the Dow Industrials hitting new highs, the big-cap stocks appear to be priced for perfection. Earnings season is off to a difficult start.
So far today there has been very little in the way of economic news to digest as the markets await the release of the Fed minutes at 2:00pm this afternoon. The energy inventories normally reported on Wednesday by the U.S. Energy Department will be released tomorrow due to the Columbus Day holiday on Monday. We did however hear from the Mortgage Bankers Association to learn that housing is still under some big pressure. The MBA’s application index fell 5.5% with the purchase applications down 5.3% and applications to refinance down 5.8% in the week ended October 6th. Overall mortgage applications are down 13.8% from a year ago with purchase applications lower by 18.4% and re-fi’s down by 7.4% from one year ago. The 30-year fixed rate increased three basis points to 6.27% and the average one-year ARM also gained three basis points to 5.88%.
Some analysts believe the worst is over for the real estate markets, while many believe this is only the beginning of bigger problems for real estate. My take on the overall situation is that the Fed will use the housing weakness, the bond market rally, the correction in commodity prices, and whatever else they need to FAKE a deflation in the first and second quarters next year. This will give them a green light to open the floodgates of liquidity with lower interest rates and a big increase in the supply of money. They know they must inflate or die! I do not believe our policy makers will allow the deflationary pressures that have persisted in Japan for the last decade. Furthermore, I believe the bond market has been deliberately ramped higher, especially on the long end of the curve to provide a soft landing for the housing markets. To get a good perspective of the EXTREMES we are facing in order to push interest rates lower, please check out this short article by Pinank Mehta,
“An ‘interesting’ Picture Of The US Bond
Market.” Statistically, it’s pretty tough to argue with what he has to say:
“THIS IS THE MOST ALARMING PICTURE I HAVE SEEN IN THE FINANCIAL MARKETS SINCE SOME TIME.”
The points to note are:
• The current Long "Open" Interest in 10-year US treasury bond is greater than SIX Standard Deviations (12 SIGMA)!!!!!!! (The odds of a 6-Sigma event are one in 500 million or 1.37 million years, so it will be exponentially higher for a 12 Sigma event.)
• This level is unprecedented.” (Check out his chart in the link above.)
On the heels of the housing commentary, I also noted a few comments from Bloomberg on the future direction of interest rates:
“Economists Forecast Slower U.S. Growth, Rate Cut”
“The U.S. housing slump will weaken the economy more than previously forecast, prompting the Federal Reserve to reduce interest rates by June, a Bloomberg News survey showed.”
“Fed officials will probably reduce the rate target to 5 percent in the April-June period and by another quarter point in the following three months, the survey showed. The rate cut would be the first since June 2003.”
Also on the global bond markets, I thought it would be noteworthy to show what typically happens to bond prices just prior to an auction. The following title and lead sentence from Bloomberg says it all:
“Japanese Bonds Drop on Concern Traders Selling Before Auction”
“Japan's five-year notes fell, pushing yields to the highest in six weeks, on speculation traders are selling to ensure stronger demand at an auction of the securities tomorrow.”
Notice how “traders” are lowering bond prices just prior to the auctions in order to increase demand for the scheduled debt sales. I have noted this pattern in the U.S. Treasury market for quite a long time. Tomorrow, Japan’s Ministry of Finance will sell $2 trillion yen ($17 billion) of five-year notes. ALSO PLEASE NOTE the same exact thing happened in U.S. Treasuries. The last few days Treasuries have sold-off thereby increasing the yields to make our debt auction more attractive tomorrow when the U.S. Treasury will sell $8 billion in ten-year TIPS. For me it’s comical to hear the U.S. financial press suggest Japanese traders are lowering bond prices to make their debt auction more attractive, but something like that could never happen here in the USA where the invisible hands of the free markets set the prices. Now go back and look at the chart of unprecedented record open interest in bond futures….Six standard deviations from the norm is statistically enormous!!! It tells me some outside entities are using some massive leverage to “influence” our supposedly free markets.
The last point that was noteworthy for me regarding bonds and interest rates came out of Europe this morning. The European Commission has revised first quarter growth lower from a prior range of 0.2%-0.8% to a revised growth range of 0.0%-0.5%. While the jury is still out as to whether or not the Fed will actually cut rates next year, the weakness out of Europe could at least stop them from raising rates further. Higher rates in Europe would continue to add competitive pressure in currency valuation between the euro and the U.S. dollar. I do not expect to see any kind of meltdown in the bond markets. If there is a BIG problem with bonds globally, governments will monetize their debt paper…covertly if necessary!
Lower Rates and Commodity Prices
Governments around the globe are under pressure to fight inflation and also keep the party going. Interest rates need to be held artificially low to provide a cushion for home prices, help the consumer to spend more, and help to prop-up the stock markets around the world. The big problem for policy makers is how to slow global growth enough to relieve the enormous demand for commodities, but do it without caving-in the financial markets. I’ve made my points on the housing market and the ramping of bond prices to lower interest rates, but let’s see if the global economic slowdown has had an impact on the supply of commodities. So far, it looks like policy makers remain between the rock and the hard spot because commodity inventories are still finding it VERY DIFFICULT to keep up with global demand.
I have read analysis suggesting the price of copper will fall from today’s level around $3.40 a pound to somewhere near $2.50 a pound by the middle of next year. Today I caught a headline that says otherwise. Here’s another short clip from Bloomberg today:
“Copper Rises on Speculation Output to Lag Behind Demand Growth”
“Copper rose in London, snapping a two- day slump, on speculation supplies from mines won't keep up with growing demand, forcing consumers to rely on limited inventories.”
“Labor strikes slowed output growth this year to a gain of 2.2 percent, compared with 3.4 percent last year, Standard Bank said in a report yesterday. Prices have surged 71 percent in 2006. Inventories monitored by the London Metal Exchange have dropped 15 percent from this year's peak in March, leaving stockpiles at 113,900 metric tons, less than three days of global consumption.”
“’We see low inventories and strong demand,'’ Jose Pablo Arellano, president of Codelco, the world's biggest copper producer, said in an interview in London today. ‘That provides the basis for strong prices.’”
I am using copper as an example to show what has been happening with commodity prices and inventories. This environment of artificially low interest rates has created an enormous GLOBAL demand for all types of commodities. Policy makers can hope to keep the financial markets alive with low interest rates, but what happens if copper inventories go to zero? Will we need ten-year Treasuries to yield 7% with 8% or 9% mortgage rates to bring commodity supply and demand into line?
It has been said that a picture is worth a thousand words. I found it fascinating to look at
Kitco’s base metals
charts.
 
This is not rocket science. The equilibrium price is where supply and demand join hands. Have a look at the five-year copper inventories that coincide with the five-year price chart. If you follow the link above, you can see the same charts for aluminum, copper, lead, nickel and zinc. My favorite chart of the bunch is the five-year zinc chart…can you say, “Zinc to zero?” How much steel and copper do you think will be required to rebuild Beirut since Israel blew-up half the city? They also need to rebuild Afghanistan and Iraq, replace the bombs and bullets, and continue building infrastructure for China to host the 2008 Olympics. How about all of the commodities that will be required to build-out the NAFTA Super Highway System (transportation corridors that will include trucks and railroads) throughout Mexico, the U.S. and Canada?
The good news is that the commodity bull market is far from over. We have been in a tough correction that is politically expedient to kite the financial markets prior to the November elections. To rally stocks and bonds while driving commodities lower looks good on paper. It is designed to keep the consumer feeling the “wealth effect” for Holiday shopping while sending the message that inflation is not a problem and justify low interest rates. I suspect the Fed could cut rates next year, but will it cause base metal inventories to fall even further?
I am banking on the fact that it takes a LONG TIME to bring new mine supply to market. The higher metals prices will inevitably bring more supply to market, but in the near-term it appears mine supply is not keeping up with the relentless demand. I have focused this Wrap-Up on base metals, but the same is very true for gold and silver. This correction is creating opportunity to buy undervalued mining shares. I have been accumulating shares of mining companies for myself and my clients on pull-backs. My favorite is a junior mining company out of Canada whose ore is VERY RICH in silver, zinc, lead and copper.
This correction could last longer than we want with the elections in November and another big quarterly debt auction coming in the middle of November, but these are only short-term political gyrations that will pass.
Commodity prices are like water…they will seek their own level. In the short-term you can dam it up or open the floodgates, but in the long-run supply and demand will dictate the price of commodities, just like water will eventually seek its appropriate level based on quantity and available space.
It’s a bit ironic that I use water as the analogy for commodity prices, because just like commodity prices, overall stock prices are more a function of overall liquidity. Many analysts expect stock prices to fall after the elections, especially in light of the slowing economy, but what happens if the Fed provides more liquidity by cutting rates to 4% and ramping the money supply by 8% or 9%...given excessive liquidity, stocks will rally and their earnings will be boosted by monetary inflation. The fundamentals of a slowing economy should usher-in lower stock prices, but I am fondly reminded by Marky Mark that in today’s financial and economic world, fundamentals are more accurately considered “funny-mentals.” In today’s world, politics are far more important. This morning watching CNBC was proof in the pudding. I tuned-in to see if there was any breaking news in the markets, and all I heard for about two hours was President Bush saying now is not the time to “cut and run” from Iraq, then he went into his rant on the nucular problem with North Korea. Mr. Bush says we must have a nucular-free Korean Penninsula, but North Korea says pressure from the U.S. would be considered a “Declaration of War.” Interesting times we live in!
After The Close
The markets just closed a few minutes ago with the Dow Industrial Index lower by 15 points to 11,582, the NASDAQ Composite fell seven points to 2,308 and the S&P 500 dropped three points to close at 1,349. Around 1:00pm in New York the broad stock indexes popped into positive territory, but it didn’t last. In fact, by 2:00pm it looked like stock prices were ready to fall off the proverbial cliff, but were rescued in quick fashion to end the session with modest losses. The Fed minutes were released at 2:00pm, so I’m betting the Fed was more hawkish toward interest rates than the market expected. I say that because bonds and the dollar both reversed direction after the minutes were released. Bonds were tracking slightly positive throughout the morning and the dollar was slightly negative. Hawkish rhetoric would have sent stock and bond prices lower and put a bid back in the dollar.
I just checked the newswires, and indeed I am correct by concluding the Fed language was more hawkish than anticipated:
“FOMC Minutes Show Concern Inflation Won't Subside (Update3)”
“Oct. 11 (Bloomberg) -- Federal Reserve officials in September saw a ``substantial risk'' that inflation may not recede as expected and noted they must ensure it slows, records of their last meeting showed.”
“’Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation,’ the Fed said in minutes of the Sept. 20 gathering, released in Washington today. ‘Members continued to see a substantial risk that inflation would not decline as anticipated by the committee.’”
(So who in their right mind would want to buy the TIPS auction tomorrow?)
“Bonds fell as investors scaled back bets on an interest- rate reduction in coming months. The minutes cap a week of speeches by Fed officials, including Vice-Chairman Donald Kohn, that highlight persistent inflation as well as reports that suggest the economy will weather the housing-industry slump.”
Thanks to the Fed, stocks and bonds were both lower today and the dollar reversed direction to close with a gain. While most commodity prices are in correction mode, wheat has been going through the roof. Less than a month ago wheat was below $4.00 a bushel and today it closed at $5.31, a gain of 37% since September 15th. Copper, gold and silver were fractionally higher today and crude oil dropped $0.82 to close at $57.70 a barrel. I expect energy prices to chop sideways for another month, but it looks like some money is already returning to the oil company shares. The energy shares will rise again; I’m just not convinced the correction has fully run its course.
We have the tools of technical analysis and the basics of “funny-mentals,” but you can be certain that in the very near-term politics will rule the financial markets. Many questions could be answered if we just knew what the Fed and key central banks around the globe intend to do…provide liquidity or dry it up. Financial markets flow like water and I believe central bankers are prepared to provide a thirsty world with a flood of monetary liquidity just as soon as they can justify it. I expect a big head-fake for deflation in the first and second quarter next year, and then the subsequent excess liquidity will be theoretically justified by the bankers and welcomed by the markets. Time will tell!
Have a Great Evening!
Mike Hartman
Mike
Hartman
|
Copyright ©
2006
All rights reserved.
Michael
Hartman
Technical Analyst & Market Commentator
Email l Commentary Archive
|
|
Back
to Top
|
