A Melman Minute — December 29, 2010

As noted yesterday, we are becoming more convinced with the passage of time that rising visible price inflation will be one of the major stories which will fill headlines during 2011 and we believe one of the most vulnerable areas to inflationary pressures will be foodstuffs.

Perhaps no food commodity carries the international importance of wheat, also known as the "staff of life." Flours from that grain hold important roles in the production of breads, pastries, cereals and a host of other products consumed around the world. "Breaking bread together" has been a byword for friendly relationships for centuries. Therefore, when we note that the price of wheat has almost doubled from $4.70 per bushel to nearly $8.00 per bushel in just the past nine months, and we believe the chart appears to be ready to break above resistance at that price level, we grow increasingly concerned that grains will join coffee, cocoa and sugar in the growing list of foodstuffs that in our opinion appear headed toward significantly higher price ranges for the coming year.

Perhaps the anticipation of food price inflation is another reason for gold's stellar performance since late 2008 as the price of the yellow metal has since soared by more than $700 per ounce from a low near $670 per ounce to a present value close to $1,415 per ounce in this morning's trading. We believe that the persistence of this bullish trend has been remarkably consistent, with not one major reversal in more than two years.

We would opine that there are several other factors at work which could be reasons for the precious metals rally and we note recent news items regarding those subjects.

Quite suddenly, there has been a steep increase in news regarding Islamic terrorist groups who are planning to inflict damage in various directions. For example, the Danish security service, known by the initials PET, just arrested five people suspected of preparing a bombing attack against the Danish newspaper Jyllands-Posten in retaliation for their publishing cartoons in 2006 which many Muslims believe cast disrespect upon the Islamic Prophet Mohamed. In their information release, PET noted the suspects were, "planning to try to force their way into Jyllands-Posten and kill as many as possible of the people present there" and then added information that a machine gun was seized during the arrests.

It is also important to realize that this plot not only involved Denmark, but several of the group resided in and were citizens of Sweden and one was a Tunisian citizen. They all traveled to Denmark the night before the arrests took place, suggesting a serious level of international cooperation in this episode.

This is only the latest such scare, following hard on the heels of similar arrests in Belgium, Netherlands, Germany and the U.K.

The situation has progressed to the point where Germany is now stepping-up efforts toward enacting an outright ban on any Islamic organization which promotes "extremist Muslim teaching." Dozens of police recently raided homes, offices and religious schools in Bremen, Braunschweig and Monchengladbach with the aim of discovering places where such concepts are taught as well as identifying those who would attempt to forcibly introduce Islamic Shariah law into the general German society.

When we look to the future, serious problems appear to be developing. According to the Pew Research Center, the Islamic population in Europe has now risen to over 38 million and, given the comparatively high birth rate in the Islamic community and liberal immigration policies in most European nations, that population is expected to double by 2020 or sooner. Several European nations fear that a tide of Islamic population growth will result in the elimination of their home cultures in favor of Sharia Law and Islamic customs - and resentment against such changes is building rapidly.

We believe that due to these clashing forces, there is a high likelihood of some significant terrorist event, perhaps even similar in impact to the events of 9/11/01.

If there is one particular development which has thrown a monkey-wrench into the optimistic economic forecasts emanating from the Obama Administration and its economic "talking heads", it is the failure of the residential real estate markets to recover sharply over the past year. In fact, not only are they not recovering, residential real estate markets may be actually headed into a new era of descending prices, at least in America. Yesterday's report of the S&P/Case-Shiller Home Index which showed a decline in prices in both September and October was a stunning development and this morning we are also learning of the existence of an unexpectedly huge overhang of unsold homes, and a resurgence of new foreclosure activity by mortgage lenders as they are finally putting their foreclosure books back in order following this fall's document error disclosures.

The net result of this data is an upsurge in predictions that the American real estate market is facing a "double-dip" decline in real estate values which may have already begun. Noted economist David Blitzer, chairman of S&P's index committee, told the Wall Street Journal, "a housing double-dip is almost here." As the WSJ noted, "...the best that can probably be hoped for is that housing in 2011 manages to bounce along the bottom, rather than plumb new lows."

Since the growth of real estate equity was one of the prime factors which drove the recent era of prosperity, it is rather ominous that the outlook for that important industry has suddenly turned so sour.

One other negative the world might have to deal with in 2011, both for real estate markets in particular and all financial markets in general, is the sudden surge of expectations for higher interest rates, including higher mortgage rates, for the coming year. Ten-year and thirty-year US government interest rates have risen by over one percent since their 2008-09 lows and several government around the world are now actively raising such rates, particularly including China and Brazil, two of the world's most rapidly growing economies and suspicions regarding the repayment of European debt in a timely manner are also serving to drive rates higher.

Without question, rising mortgage rates could serious impact the entire economic structure in a negative manner, with the expectation that various governments around the world would then be forced to step up - rather than reduce - easy money, stimulative activities which rely on central bank creation of fiat currencies on an ever-expanding scale.

There are indeed serious troubles looming on the horizon for the coming year.

Tomorrow, we will attempt to put this information together in the form of a forecast for precious metal price action during the coming year.

As of 9:45 AMP PDT, price action in the precious metals continues to be positive. Gold has touched the $1,415 level and silver is soaring to near $31 per ounce. Base metals are also moving strongly higher while mining share indexes are advancing as well. Crude oil is trading quietly near $91.50 per barrel, long term interest rates are moderately lower and the US Dollar is trading quietly in currency markets.

Financial markets in the USA and Canada are both stronger today, up by about 45 and 65 points respectively for the Dow Industrials and Canada's TSX Index.

All quotes US$ unless otherwise noted.

Our next "Melman Minute" is scheduled for tomorrow, December 30 and we plan to include our 2011 forecast for precious metals prices.

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