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WE WANT YOU TO SUCCEED!

Early this morning the US dollar caught a bid when the ADP employment report said the private sector created 158,000 jobs last month following expectations for a gain of 125,000 new jobs. The better than expected employment figures follow yesterday’s stronger than expected report from the ISM non-manufacturing sector. The combined reports are causing some analysts to think the US economy is perhaps stronger than many believe. The unexpected good news on the employment front also caused bond prices to fall, pushing rates higher, but wait just a minute. The big employment report traders are anticipating will be released on Friday to show the government statistics for job creation in November. Right along with the volatility in currency values, we are also seeing a short-term correction in gold and silver along with the mining shares.

Candidly, I have some rather large positions in a few junior mining companies, so I have spent a disproportionate amount of time tracking the precious metals sector this morning. Any investors out there that have been long the PM shares during a “waterfall” correction know exactly what I am saying. When the share prices turn red across the board in the PM sector, one can become a bit “puckered-up” with large long positions. As it stands, we are seeing a normal correction following recent gains. Now that it appears we are not going to get massive liquidation in the mining shares, I will add a few more observations and then shift to the broader markets.

Yesterday the euro closed at 1.3337 and this morning it opened lower at 1.3269. So far it has fought its way back to 1.3308. In similar fashion, gold and silver came into NY trading lower following a further sell-off in the overseas markets. The March silver contract closed yesterday at $14.04 and gapped-down to open at $13.83 today. February gold closed at $647.90 yesterday and gapped-down $7.50 to open at $640.40 today. In pre-market trading, the mining shares were down about 2% on average.

As the dollar came off its highs, gold and silver crawled higher throughout the morning hours. In the second hour of trading, GG, CDE and HL turned positive and SSRI flashed green in the third hour of trading. Since that time the metals rolled over to get hit at the close with gold down $12.10 to $635.80 and silver down $0.28 to $13.74. The shares are under some pressure, but still around 2% lower from yesterday…no big deal. With silver nearly two percent lower for the day, it would not be unusual to see the mining shares down by five or six percent. The shares are waiting for the metals to regroup for the next move higher. For now let’s wait to see the impact the employment report has on the dollar in two days.

Weekly Reports

The Mortgage Bankers Association said their applications index rose 8.1%, with the purchase index higher by 4.9% and the re-fi index higher by 13.7%. This is the highest level of mortgage activity since mid-January and it’s all tied to lower rates. The 30-year fixed rate fell 15 basis points to 5.98% (year ago at 6.32%), the 15-year fixed fell 20 basis points to 5.66% and the average one-year ARM dropped eight basis points to 5.79%. Woops, hold the phone…. Please notice the inversion in the mortgage rate curve! Fifteen-year fixed rates are lower than one-year adjustable rates! We have all been watching the flat to slightly inverted yield curve in Treasuries, but this is highly unusual for mortgage rates. Who needs the Fed to cut interest rates when we see money pouring into the long end of the curve! Bond prices are correcting lower today, but are still above the break-out point at 113 for the long-bond. A weak jobs report on Friday could easily send bond prices higher again, thereby lowering long-term yields and interest rates. An inverted rate curve in the mortgage universe is highly unusual, but also highly constructive if the Fed is to succeed in their “soft-landing” scenario.

Here’s a quick look at the 30-year bond chart to show you what I mean:

The second weekly report that comes out on Wednesday has the Energy Department telling us there was a surprise drawdown in crude oil and gasoline inventories. Analysts expected to see higher inventory levels, but crude and gasoline both fell by 1.1 million barrels. This would normally be bullish, but I just checked back to see January crude closed 33 cents lower at $62.10 and unleaded gasoline closed slightly lower at $1.635 a gallon. My take on this one has energy prices staying down to get further along the holiday shopping season.

I don’t expect energy prices to move significantly higher until later in the first quarter unless OPEC has their way. One analyst attributed today’s surprise of lower inventories to OPEC’s most recent production cuts. Last time they met they agreed to cut production by 1.2 million barrels a day, but so far they have only realized an actual cut of 600,000 barrels per day. OPEC is meeting again next week on 12/14 to discuss further production cuts and probably to get compliance on the lower production the have already agreed to maintain. Frankly, it’s a wonder to see crude remain near its lows as the dollar loses value. In dollar terms we have seen the fall from $84 a barrel back in July to a low of $58 in November, but as the euro strengthens, they are seeing an even greater decline in the price of oil.

Oil producing nations are not satisfied with receiving dollars for energy. Here’s the latest from Iran and OPEC:

Dec. 6 (Bloomberg) -- Iran, the world's fourth-largest oil exporter, plans to reduce its use of the U.S. dollar in world trade and increase use of the euro, two Tehran-based newspapers reported.

Organization of Petroleum Exporting Countries members including Qatar earlier this week expressed concern about the falling dollar, saying output should be cut to drive prices higher.

Stock Markets Struggle for Direction

Generally speaking, stocks are not happy with rising interest rates and a stronger dollar, as we are seeing today. Stock bulls are saying price to earnings multiples can expand with the anticipation the Fed will cut rates sometime early next year…but will they cut? The European Central Bank is expected to raise interest rates tomorrow and maintain hawkish rhetoric toward inflation moving forward. We are also hearing more rumblings out of Japan for higher interest rates (from Reuters):

BOJ SOUNDS HAWKISH NOTE

BOJ Policy Board member Kiyohiko Nishimura said on Wednesday the central bank could raise interest rates even if its views on monetary policy do not completely match those of financial markets.

Nishimura's remarks followed a speech on Tuesday by fellow board member Atsushi Mizuno, who said strength in all economic indicators was not necessarily a prerequisite for raising rates.

Don’t count your chickens before they hatch if you think stocks are going to move higher just because the Fed is going to cut rates next year. Bond prices have been moving higher because economic growth is expected to slow. P/E multiples should be contracting due to the economic slowdown, NOT expanding because the Fed just might cut interest rates. Earnings growth has been declining sequentially, and if multiples do indeed contract, it will not be pretty on Wall Street. Here are two brief Bloomberg excerpts that tell of a few story stocks from today’s headlines:

Dec. 6 (Bloomberg) -- A two-day rally in U.S. stocks faltered after Merck & Co., the nation's fourth-biggest drugmaker, gave a disappointing revenue forecast and Lehman Brothers Holdings Inc. recommended selling shares of Oracle Corp.

"Earnings have peaked for some of these companies," said Dave Stepherson, who manages $640 million at Hardesty Capital Management in Baltimore. For stocks to move higher, "it's going to take more evidence that the economy is in for a soft landing and a consensus builds that the Fed will cut rates."

A drop in Yahoo! Inc. shares amid a management shuffle at the most-visited U.S. Web site helped drag the Nasdaq Composite Index lower.

In my mind, this is by far the bigger story on insider selling:

Dec. 6 (Bloomberg) -- Stock sales by America's corporate chieftains exceeded purchases last month by the widest margin since 1987, suggesting they don't share the confidence of investors who sent the Standard & Poor's 500 Index to a six-year high.

Executives including Microsoft Corp.'s Bill Gates, Google Inc.'s Eric Schmidt and Kohl's Corp.'s William Kellogg in aggregate sold $63.18 of shares for every $1 they bought in November, an analysis by Bloomberg of data from the Washington Service showed. That's the highest since at least January 1987.

Bernanke and Paulson Off to Beijing

Mr. Ben Bernanke has a very busy schedule next week. On Tuesday the Federal Reserve will meet to tell us they are not changing the Fed-funds rate and to possibly make some minor changes in their policy statement. I doubt much else will happen with the Fed meeting. Right after the statement is released, Mr. Bernanke will join Treasury Secretary Henry Paulson to jump on a plane headed to Beijing for meetings on Thursday and Friday.

Last time Mr. Paulson went to China he took with him the mantra, “We want you to succeed!” To make a long story short, Mr. Paulson was telling China that we want them to succeed in modernizing their financial system. I’ll say right here, you better be careful boys, because if they take lessons on financial market management like they have in manufacturing, we could lose a great deal more than manufacturing jobs to China. I found it almost comical to read Mr. Paulson’s comments on modernizing China’s financial system as an effective way to create more jobs in China…like creating jobs in China should be one of our big concerns! What about getting a few jobs back from them?

To give you an idea of what Mr. Bernanke and Mr. Paulson will be working to accomplish next week, I’ve included an excerpt of Mr. Paulson’s comments from three months ago. It’s a bit long, but will give you the general flavor of the discussions.

September 13, 2006
HP-95

Remarks by Treasury Secretary
Henry M. Paulson
on the International Economy
Treasury Department Cash Room
Washington, D.C.

One week from today, I will be in China to discuss the economic relationship between our two nations.  Today I will speak about China, and more broadly about the international economic system.

CUT TO THE LAST PAGE:

Without question, the nation must modernize its financial sector, open up its capital account, and move to a more consumption-based model of growth.  A competitive, well-regulated financial system and the free flow of capital will help reduce the extraordinarily high levels of precautionary savings and allocate capital to its most efficient use, which will help raise productivity and living standards.  China must also pursue fiscal and regulatory polices that address the investment/savings imbalance.

These changes will help create the millions of jobs that China needs to generate annually, and will help create markets for U.S. exports of goods and services to China.

China faces several critical, immediate challenges.  The first is the pressing need to put in place widely-accepted, market-based tools to keep its economy from veering out of control.  A much more flexible, market-driven exchange rate along with a more nimble, self-determined monetary policy are key ingredients to stable and sustainable, non-inflationary growth.

Accordingly, maintaining and relying on an overly rigid exchange rate and outdated administrative controls increases the risk of boom and bust cycles.  Also, to be under estimated only at China's own peril, is the fact that their currency exchange rate is increasingly being viewed by their critics as a symbol of unfair competition.

Another pressing issue is greater protection for intellectual property rights.  China cannot achieve its goal of being a modern economy if it fails to adhere to the rule of law and fair trade and encourage the innovation that is the engine of growth for developed – and developing – economies.

Moreover, U.S. businesses lost billions of dollars in sales last year due to the illegal acquisition and use of their copy-righted ideas and products in China.

When I visit China in the coming days I will discuss these issues with the Chinese leadership, and I will use a Chinese saying indicating that it is for the good of both of our economies that they undertake these changes, for our economic fortunes are interconnected.  I will say: We want you to succeed.

Bigger domestic markets and more success for you mean expanded markets, a higher standard of living and more jobs in the U.S.  It also means lower prices for U.S. consumers and higher returns for U.S. investors.

The United States has a huge stake in a prosperous, stable China – a China able and willing to play its part as a global economic leader.   We are not afraid of Chinese competition.  We welcome it.

We want China to assume its rightful place as a responsible member of the international community.  The choices you make will affect many things from the air we breathe to price of our farm products.  And, of course, of vital importance to you is a United States of America with a healthy, growing economy which believes you are committed to being a responsible global economic leader dedicated to moving forward with your economic reform agenda and fair trade.

These reforms will not be easy, and they will take time.  This is why we must take a strategic view of our relationship with China.  Both in China and in the United States, we must not allow ourselves to be captured by harmful political rhetoric or those who engage in demagoguery.  Instead, we must realize that the U.S./Chinese relationship is truly generational and demands a long-term strategic economic engagement on our common issues of interest.

Mr. Paulson insists that, “Without question, the nation must (do certain things).” I can only wonder if the Chinese officials are thinking the same way. Based on the following headline, it looks like China is doing fairly well:

BEIJING, Dec 6 (Reuters) - China posted a trade surplus of $23.37 billion in November, just shy of the record $23.8 billion in October, the official Xinhua news agency said on Wednesday.

The surplus was more than double the November 2005 figure of $10.5 billion and beat the $20.1 billion median forecast of economists polled by Reuters.

I also consider the drubbing of the US dollar over the last couple weeks. I have to wonder out loud if China had anything to do with the heavy selling of US dollars as a precursor to the visit from the Chairman of the Federal Reserve and the US Treasury Secretary. I wonder if China wanted to send a message through the financial markets. Could they be saying, “Humble yourselves, and don’t try to come to our country heavy-handed and dictatorial…it won’t work.” I suggest it won’t work because we need to attract more than $2 billion PER DAY from foreign investors to support our debts and ongoing deficits.

We want to mandate they modernize their financial markets and make other significant changes within their nation, but remember what the Good Book says, “The borrower is slave to the lender.” I wonder which side will actually have more leverage in the negotiations next Thursday and Friday in Beijing.

Looking Ahead

Tomorrow we will get the Monster Employment Index and jobless claims to possibly shed more light on what to expect in the employment report due out on Friday. Tomorrow we will also get the policy announcements from the European Central Bank and from the Bank of England as they are expected to move interest rates higher.

Next week it gets even more interesting. On Tuesday we will get fresh data on international trade along with the policy statement from the Federal Reserve. Wednesday morning we will see the latest on retail sales and in the afternoon a 10-year Treasury auction. Thursday OPEC will meet to discuss another production cut while Mr. Bernanke and Mr. Paulson negotiate with China. Finally on Friday next week we will get data on Industrial Production, the Consumer Price Index, Treasury International Capital (TIC Report), Empire State Mfg. Index, and a Quadruple Witching day with futures and options expiration. It should be a wild ride!

Please don’t get me wrong in painting the picture of what our officials need to accomplish with their counterparts in China. I believe much of our future success and even survival as a nation depends on the level of success we have in the ongoing negotiations. As Americans, we are the beneficiaries of the dollar standing as the primary global reserve currency. Will it stay that way?

In parting, I would like to suggest you listen to Jim Puplava’s interview with Mr. Marc Faber at the San Francisco Hard Asset Show if you haven’t already heard it. It was a fascinating interview that is only about 20 minutes long and covers a multitude of topics. During the dialogue, Mr. Faber listed what he believes to be the top-five global currencies: US dollar, yen, euro, yuan and gold! The relationship of those five currencies will have a huge impact on your investments as we turn the corner to 2007!

Have a Great Evening!

Mike Hartman

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