A Melman Minute — January 12, 2011

Despite all the rhetoric surrounding the most recent U.S. elections and despite all the hard-nosed talk from European leaders about finally putting an end to their wild-spending ways, we at TMR find that there appears to be a sad discrepancy between the words we have been hearing and the actual deeds on the ground, so to speak.

For example, it is beginning to appear that those European nations that are buried under the greatest avalanche of debt will be rescued from their current difficulties, not by their own austere measures to limit spending to levels below genuine income, but rather by further rescue moves by the European Union. This general move was signaled by a report issued overnight from that body that they were seeking to greatly expand their bailout fund known by the name "European Financial Stability Facility" (EFSC). Many observers note that this is a 'de facto' admission that the present fund would be inadequate should a major economic nation such as Spain default on its debt.

It is also instructive to note that it is not the European Union that will provide most of the backing for the increase in their EFSC, but rather they will turn to agencies such as the International Monetary Fund (IMF) to finance the EFSC's increase from near $550 billion to about one trillion dollars. Of course, it must be noted that the American government (read 'taxpayer') is the chief contributor to the IMF, but the American government is already head-over-heels in debt, which leads us to the Federal Reserve Bank, one of the chief purchasers of American government debt.

By coincidence, virtually all Federal Reserve Board governors have suddenly decided to come on board the Fed's plans to maintain or even increase their recently-announced program of "Quantitative Easing" (QE), meaning primarily buying up of American government debt paper. One of the few Fed governors who had enjoyed a reputation of opposing further expansion of QE just capitulated yesterday by issuing a statement declaring, "...I wish we hadn't done it but that doesn't mean I want to stop it right now...Stop and go policies can be disruptive."

And so, in our opinion, we can make the following connections. Bond-holders throughout Europe, both private and government, are facing horrendous losses which they can ill afford. Since the failing governments involved have no hope of honoring their bond obligations, the European Union has felt obligated to step in to stop or at least ameliorate private and public losses - but the EU has precious few resources of its own, given the weakened state of many EU economies. Therefore, it is necessary to find outside sources to aid the EU in rescuing those bondholders and the primary source of such funds is the IMF, an agency who's borrowings are financed largely by the American government, itself buried under trillions of debt.

And so we find the "final solution." The Federal Reserve Bank will buy debt paper issued by the US government in order to save the European Union by using mountains of artificially-created fiat currency. On such towers of mush, we believe, are built the 'pillars' of international finance.

Two charts relating to important economic indicators appear to be on the verge of major moves.

In the first case, crude oil is once again pushing up against the $92 level and if it breaks through, that would imply a move to overhead resistance near $100 per barrel, which you might note formed previous resistance during the rally up to the $140s during 2008. In our opinion, should crude breech the $100 level, that could have significance once again.

Even with the current move to the low 90's, the prices for crude, along with gasoline and heating oil, are beginning to put real cost pressures on the wallets of the typical consumer as we note gasoline prices in America have risen to the range of US$3.10 per gallon on average and in Canada, C$1.10 per liter is now typical. As can be noted on the chart, these price increases, when compared to late 2008, are sizeable indeed.

Our second chart is the interest rate on long-term, 30-year US government bonds as measured by the TYX Index. It is apparent that the upturn in rates which began in mid-2010 remains intact and rates are now pressing against the 4.6% area. It is also worth observing that the chart shows two distinct bottoms, one near 2.6% at the peak of the crisis in 2008 and a later bottom near 3.5%.

According to one of the "bibles" of technical analysis, McGee and Edwards' "Technical Analysis of Stock Trends", double bottoms spread across considerable time - such as the present example - are not to be scorned. The text also provided a technique to measure the possible goal of a completed double bottom, namely the distance from the low (2.5%) to the point of breakout (4.6%) added to the breakout which in this case would provide us with figures of 4.6 + 2.1 = 6.7%.

We believe the consequences of a move in long-term rates to say, between 6.5 and 7% could be dire indeed for real estate, auto financing and other capital-intensive industries which depend on long-term financing.

One last thought looking into the future. There is no question that China has been growing at an amazing rate in economic terms over the past several years. As a result, they have gathered immense monetary wealth and it now appears they are beginning to throw their weight around in two different directions.

Monetarily, they are making moves toward enhancing the role of the Chinese Yuan (also known as the "Renminbi") in international currency transactions. The Chinese government has just initiated trading the Yuan in the U.S. for the first time and also allows their currency to be traded in Hong Kong. As the WSJ notes, "...In time, a globally traded Yuan could emerge as a store of value on par with the US Dollar, Euro and Yen." We can only wonder if this is part of the Chinese government's desire to sell off US government bond holdings and US Dollar-denominated assets - both of which could put upward pressure on US interest rates and downward pressure on the US Dollar's international value.

China also gave many countries of the world pause for serious reflection when they unveiled a new stealth jet fighter plane. The fact that China had succeeded in developing such an advanced weaponry capable of offensive operations has been interpreted by some as a statement that China would begin to exert its economic influence into newer and potentially more intrusive realms. We also wonder if it is only coincidence that China just curtailed export and provision of Rare Earth Elements, essential in many military systems.

Financial markets this morning have been buoyed up by the success of a Portuguese bond offering and, as of 8:30 AM PST, the Dow Industrials were ahead by almost 100 points to their highest levels in 28 months while Canada's TSX Index has added about 50 points. Precious metals are slightly lower with gold near $1,378 and silver at $29.40 while mining share indexes are off by about one percent and base metals are trading higher across the board. Crude oil remains near its high for the day just under $92 per barrel, the US Dollar is weaker in currency trading and, as mentioned, long-term US rates are moving higher.

NOTE: Crude oil has just traded above the $92 per barrel level and if it closes above that mark today, that will represent the highest closing price since May, 2010.

All quotes US$ unless otherwise indicated.

Next Melman Minute scheduled for Friday, January 14, 2011

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