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CENTRAL BANKS STRUGGLE TO MANAGE FIAT MONEY

Stocks opened higher this morning following positive earnings results from Proctor and Gamble and good news from Time-Warner. Two hours into the session the broad indexes are holding decent gains with the Dow Industrials higher by 70 points and the NASDAQ Composite moving 18 points higher. Treasury notes and bonds are flat to slightly negative and the U.S. Dollar Index is fractionally lower at 84.80 after testing support at 84.75. Many analysts are suggesting the dollar is approaching oversold territory and poised for a bounce higher, but so far today it has been energy and metals prices that are stealing the limelight. As I write, gold is $8.70 higher at $655.00 per ounce and silver is 46 cents higher at $12.20. Energy prices are higher across the board with crude oil a dollar-fifty higher at $76.45 and natural gas roughly 10% higher with the heat wave and possible developments of a hurricane in the Gulf of Mexico.

There isn’t much in the way of economic news to report today, but we have the weekly report from the Mortgage Bankers Association, the Treasury auction announcement for next week’s sales, and a few comments from foreign central banks. We know the Fed is trying to orchestrate a “soft landing” for real estate prices here in the U.S., so let’s see what the MBA data said today. The mortgage applications index fell 1.2% with the purchase index lower by 3.3%, but the re-finance index rose by 2.3% to a four-week high. Year over year the number of purchase loans is down by 22% and re-financing is down by 39%. The average 30-year rate fell from 6.69% to 6.62%, and the average one-year ARM fell from 6.25% to 6.18%. Obviously, the Fed is keeping a close eye on the housing data (and employment data) as they consider their interest rate decision for next week.

Traders will be watching the labor report on Friday to look at job creation in July as a big clue to the Fed’s interest rate action to come on Tuesday. Everyone is waiting to see what the Fed has to say, but the other big event next week is the U.S. Treasury’s quarterly debt auctions. This morning the Treasury announced the offerings for the debt sales next week per the following Bloomberg report:

U.S. 30-Year Bonds Fall as Treasury Announces Quarterly Sales

U.S. 30-year bonds fell after the Treasury Department said it will start quarterly sales of the securities in February, raising concern about additional supply. The Treasury currently sells 30-year bonds twice a year. The government began selling the so-called long bond in February after a five-year hiatus. “The markets reacted to a slight increase in long-end supply,” said Alan De Rose, a Treasury trader and strategist at CIBC World Markets Inc. in New York.

The Treasury also said today it will sell $21 billion of three-year notes on Aug. 7 and $13 billion of 10-year securities two days later in its quarterly refunding. It will sell $10 billion of 30-year bonds on Aug. 10 in a reopening of February’s sale.

From the quote above, notice the comment from the Treasury trader. He says the bond price moved lower (higher yield/interest rate) with the expectation of additional supply. Over the last five years we have witnessed the opposite of today’s initial reaction. Long-term interest rates have been kept artificially low by restricting the issuance of new 30-year debt. Less supply means higher prices, which means lower yields. The Fed knows they have been managing the yield curve. That’s why they have so much confidence to say the flat to inverted yield curve is not indicating economic weakness. In fact, the Fed’s management of the long end of the curve is what allowed them to raise interest rates even though the yield curve was already inverted.

With additional supply of 30-year bonds next year, we will have to see if the long end of the yield curve can move higher. Long-term rates don’t necessarily have to move higher, because the Fed can buy the paper off the market and support the price if they so desire. The Federal Reserve would then be monetizing the long-term Treasury debt, which I believe they have been doing all along the way.

Monetary Policy

The markets are all up-in-a-huff and prognosticating about the Fed actions and comments to come next week on interest rates, but very little is said about the Fed’s activities in buying and selling securities with the markets. From the website of the Federal Reserve:

Open Market Operations

Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. (My emphasis in bold print) The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

The Federal Reserve is trying to be as transparent as possible with their direction and outlook for interest rates, but they are trying to be as covert as possible in regard to the supply of money they are creating in the markets. Just five months ago the Fed said they will no longer disclose the M-3 money supply. They can print new money (create digitals on a computer) at will to monetize government debt. If the Fed doesn’t want to do it overtly, they may have Goldman Sachs, JPM, Citibank, etc. buy the paper on their behalf. Who knows, the Fed might even have a few of the BIG hedge funds set up to do some of their dealings in the market. If Enron had “shell companies” set up to move paper around, what is to stop the Fed from doing the same? The Fed and Treasury could even have phony hedge funds set-up in the Caribbean Islands and in the London financial markets just to make it look like foreign activities!

These markets are being heavily managed. We are getting all the information on the cost of money (interest rates), but we are not getting the straight scoop on the supply of money. I remember a comment from Jim Puplava wherein he stated that before the Fed stopped reporting M-3, money creation in U.S. dollars was in excess of 8% annually. Remember that inflation happens when the supply of money increases; the result in the economy is higher prices. The Fed is increasing the money supply by roughly 8% annually, the Commerce Department says consumer inflation hit an 11-year high in June at 3.5%, and the recent GDP report has economic growth in the U.S. higher by 2.5%. It looks to me like the Fed is pushing on a string if they plan to control inflation with higher interest rates. Higher interest rates are used to “manage” inflation expectations. If they really want to stop inflation, all they have to do is withdraw liquidity from the markets (reduce the supply of money).

To get a better idea of what is going on globally, I came across an excellent article Gary Dorsch, Editor of Global Money Trends magazine titled, “The Federal Reserve’s Next Move On Interest Rates.” In the article he details some of the coordination between central banks with regard to interest rates:

Would the Fed follow the Bank of Canada?

Would the Federal Reserve follow the footsteps of the Bank of Canada, which balked at a rate hike beyond 4.25% on July 11th, despite elevated inflation readings and a very tight labor market in Canada? The BOC had lifted its overnight loan rate by 175 basis points since last September, and defended its decision to hold rates steady on July 11th, by pointing to a strong Canadian dollar, which is hurting Canadian exports to the US, which buys 85% of Canadian sales abroad.

"The anticipated moderation of US growth, combined with the lagged effects of past interest rate and exchange rate increases, brings aggregate supply and demand back into balance," the BOC said on July 13th. Beneath the surface however, the BOC is wary of raising short-term rates further, after its last rate hike in May, briefly inverted the Canadian yield curve, hurting the profit margins of Canadian banks.

The Bank of Canada often coordinates its interest rate maneuvers with the Fed, and its decision to hold pat at 4.25% on July 11th, might be a tip-off that it expects the Fed to pause its rate hike campaign at 5.25% on August 8th. In the event the Fed surprises the market with a quarter-point rate hike to 5.50%, it wouldn't sadden the BOC to watch the Canadian Petro-dollar tumble from its 15-year highs.

But the Bank of Canada has the luxury of taking a breather on rate hikes, despite elevated core inflation numbers, because it enjoys a strong Canadian dollar, that helps keep import prices down. On the other hand, the Federal Reserve is the guardian of the chronically weak US dollar, beset by massive external deficits, and so a premature rate pause by the Fed carries much bigger risks, and can badly tarnish its anti-inflation reputation. If necessary, the BOC could hike its overnight loan rate again later this year, without a blemish on its anti-inflation record.

The following excerpt from the same article is what I believe is most functional at this point…money creation globally:

Betting on foreign central banks to contain oil prices is just a pipe-dream. The European Central Bank is inflating the Euro M3 money supply at an 8.9% annual clip, designed to insulate the European stock markets from the rising costs of energy. The ECB's monetization of crude oil is starting to backfire, with European headline inflation creeping higher, due to the rising cost of energy and its secondary knock-on effects. The widely telegraphed ECB rate hike to 3.00% on August 3rd, won't put a dent in the Euro M3 money supply, nor undermine the price of crude oil.

The Bank of England, has been conspicuously absent from the G-10's monetary tightening campaign this year, Instead, the BOE is quietly inflating the British M4 money supply at an annualized rate of 11.7%, twice the growth rate from three years ago, to insulate the British stock market from the shock of escalating oil prices. London futures traders are now betting on a quarter-point rate hike by the BOE to 4.75% this year, but still "too little, too late", to rein-in the UK's M4 money supply, or the high flying crude oil market.

China is also monetizing the price of its crude oil imports, by inflating it M2 money supply by an average of 17.5% over the past five years. The scope of the PBoC's super-easy money policy can best be measured by the level of China's 7-year bond yield, where yields fell to as low as 2.75% in the first quarter of 2006, from 5.00% in late 2004. Beijing is printing large amounts of its currency, the yuan, in exchange for foreign currency inflows acquired by an external trade surplus and foreign direct investment, in order to keep the yuan pegged at a fixed rate to the US dollar.

The People's Bank of China has started to tighten up the M2 money supply however, and drained 120 billion yuan ($15 billion) thru the sale of short-term Treasury bills. Combined with a 1% increase in bank reserve requirements to 8.5%, the PBoC has drained about 420 billion yuan over the past six weeks. Still, the central bank's latest tightening moves are actually quite gentle, when compared to the more than 7 trillion yuan ($875 billion) of liquid assets held by local banks.

Until the European central banks, the PBoC, and the Bank of Japan begin to raise interest rates in a significant way, global liquidity would remain abundant, and strong speculative demand for global stocks, gold, base metals, crude oil, and other commodities would remain intact. The PBoC might need to lift reserve requirements to 10% by early 2007 to staunch the flood of yuan liquidity, and guide the 7-year bond yield 2% higher towards 5%, to slow its economy to a sub-10% growth rate.

Mr. Dorsch also goes into detail about the Fed’s dilemma on defending the U.S. dollar or defending U.S. home prices. It really is an excellent article about the central bank's efforts to manage a very fragile global monetary system and the interplay of interest rates, currency values, commodity prices, and stock valuations…a good read!

Bringing it all back to home, I don’t think it will matter one bit if the Fed pauses or raises interest rates next week. Inflation is big in the pipeline and a 25 basis point increase in the cost of money on Tuesday won’t amount to a hill of beans if they continue to increase the supply of money globally in the area of 8% to 12% annually. The hard money of gold and silver are thumbing their noses at all the noise coming from central banks around the globe. Silver closed 52 cents higher today (4.4%) at $12.26 an ounce and gold closed $5.30 higher (0.8%) at $651.60. The HUI gold stock index gained 8.56 to close at 347.22.

Next week I expect the markets to be heavily influenced by politics with the Treasury auction on Monday, the Fed’s interest rate decision on Tuesday, and back to more Treasury auctions on Wednesday and Thursday. The announcement of a ceasefire in the Middle East would also be a significant development as it would probably exert some big downward selling in both oil and gold. It is not normal to see precious metals going through the roof just prior to and during Fed announcements and Treasury auctions. Over the coming two weeks I am expecting some big volatility in gold and silver as interest rates and currency valuations are called into question.

Don’t Get Lost in the Noise

The Fed meeting next week is now marked as a very significant event and all the armchair quarterbacks are working to figure out what the Fed is going to do. My guess is they raise rates to 5.5% but openly state they will be on pause to evaluate the lag effect of the higher interest rates. I must condition my best guess by saying only the Fed knows what assurances they have from other central banks. Will they continue to increase rates, or have they told the Fed they will hold rates if the Fed decides to pause? Today the Reserve Bank of Australia raised their rate to 6% and said inflation will exceed forecasts. They said they could increase rates again in November. The ECB meets tomorrow and it’s considered a slam-dunk for them to raise rates to 3.0%. Will they stop at 3%?

Over the last two months I have been buying gold and silver mining stocks for my clients and have deployed roughly 50% of their investment capital to the precious metals sector. Gold and silver have been declining in production while fiat funny money is growing by 10% around the globe. In this politically charged inflationary environment I believe the prudent thing to do is to buy gold and silver bullion on pullbacks and increase your leverage with some of the mining shares. I especially like companies with exposure to silver along with a few of the junior exploration companies.

If you are investing in the precious metals sector, you should take the time to read another MOST EXCELLENT article by Mr. Puru Saxena titled, “HISTORY, THE GREAT TEACHER!” It is a very short four-page editorial that calmly, coherently and objectively depicts what is happening in the big picture. Here are three brief excerpts:

THE BIG PICTURE – We are now living in an inflationary war cycle. Over the coming decade, I expect massive inflation (money-supply growth) and worsening geo-political conflicts. During such a hostile environment, commodities (especially gold and silver) are likely to outperform every other asset-class.

PRESENT SITUATION – At present, every central bank has assumed the role of an “inflation-fighter”! Interest-rates are being increased in the majority of countries under the pretence of controlling inflation. However, it is worth noting that despite rising interest-rates, our world is still awash in liquidity. Recently, the non-gold foreign exchange reserves held by the central banks rose to a record US$4.4 trillion, up nearly 10% year-on-year! Emerging nations held a record US$3.07 trillion and the developed nations held a near-record US$1.33 trillion.

In the past, I’ve stated that in a highly inflationary environment, stocks, commodities and real-estate can all rise at the same time. Basically, an over-supply of paper money causes its purchasing power to diminish. I still maintain that over the coming decade, even if all assets (with the exception of bonds) continue to rise, I expect commodities to outperform all other asset-classes on a relative basis.

On a relative basis, he was spot-on today! Energy prices are higher across the board, both precious metals and base metals moved higher in price today and the grain complex with corn, oats, soybeans and wheat all moved higher in today’s trading. Treasury bonds were initially lower with the announcement of additional supply next year, but bonds later reversed course and closed the day with marginal gains, pushing yields lower. Similarly, the U.S. dollar spent most of the morning in negative territory, but crawled back to close the US Dollar Index 0.06 higher at 84.88. Gold and silver trumped all the major currencies today! The Dow industrials erased yesterday’s loss with a gain of 74 points to close at 11,199 and the S&P 500 added seven points to close at 1,278.

It is possible we may see some wild gyrations in the markets, but over time I still expect the paper prices of stocks, bonds, and the U.S. dollar to move lower. While paper asset prices trend lower, investors will likely seek the safe haven of tangible assets in commodities and precious metals. If you are buying stocks, you may want to make sure the companies you buy are loaded with tangible assets. My preference is for large amounts of gold, silver, and energy in the ground!

Have a Great Evening!

Mike Hartman

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