A Melman Minute — October 31, 2012

Halloween eve will make its annual appearance tonight and while the kiddies may simply focus on their fun and treats, adults around the world have some real 'ghosts and goblins' to worry about. For the short term, there is the aftermath of Hurricane Sandy and the onrushing election and in the longer term, we are beginning to receive tremors that the world's worst (my opinion) monetary monster may be making ready to emerge from his dormant cavern.

I am referring to inflation, that historic crippler of societies.

While on my recent semi-vacation in California, I read a most interesting study authored by financial columnist John Waggoner and published in "USA Today". While Waggoner concedes there is little in the way of virulent inflation today, he considers future inflation to be a real possibility and he suggests various indicators to keep in mind as early markers of rising inflation.

WAGES - Dormant wages have been a hallmark of the present minimal visible inflation era. He advises, "A sharp uptick in wages could signal impending inflation...An easy way to check this is Average Weekly Earnings via the Bureau of Labour Statistics."

COMMODITIES - "...rising commodity prices, particularly industrial metals, can be an early warning sign of inflation..."

INFLATION ADJUSTED BONDS - He advises investors to compare the rates on Treasury Inflation Protected Securities (TIPS) to the yield on 10-year Treasury Notes. He advises that the greater the difference, the greater the likelihood of rising inflationary expectations by the investment community. Therefore, a sudden rise in the rate on TIPS securities NOT accompanies by a similar rise in conventional Notes rates could be an early inflationary warning.

LONG-TERM INTEREST RATES - "Bond investors view inflation the way slugs view salt. They hate it...When bond traders think inflation will rise, they sell bonds sending rates higher."

These are simple, common-sense observations, but I believe they may become valuable tools in our analysis because, on a historic evaluation of previous golden bull markets, it has been my observation that nothing excites bullion traders as much as the prospect of sharply rising inflation.

Regarding Waggoner's last point; I am attaching a five-year chart of commodity trading in 30-year US Treasury Bonds. For once, the chart corresponds almost perfectly to fundamental analysis over the past five years.

As may be noted, when the 2008-09 crisis burst on the world's financial scene, there was a powerful burst of buying in U.S. bonds (for safety) which sent them sharply higher. As conditions began to normalize - at least to some extent - bonds fell back to their pre-crisis levels and then Federal Reserve Board actions under Chairman Bernanke became the dominant force.

Immediately following the institution of "QE1" in 2010, bonds embarked on a strong rally which drove quotes to near their 2008 highs. After some selling, "QE2" was announced and a renewed spate of buying drove bonds to their highest levels in history. Some minor selling then ensued, followed by "QE3" which has resulted in a new set of record highs, with current prices just below the highest levels in history.

From a chartist's point of view, I believe the first indication of an important reversal will be a breakdown of the "higher lows" pattern which has seen subsequent temporary lows set in at about 113, 122, 135 and 144. Any break below these markers could have true charting significance.

One proximate event which could cause an increase in inflationary numbers could be taking place at this moment. I am referring to a revival in the American housing market. If housing strengthens markedly - as some indicators are apparently showing - this would result in rising real estate prices, more lending by banks based on those increased values, stronger new home construction figures and an increase in purchases of appliances, carpeting, lumber and construction employment as well.

Given the incredible amounts of artificial money which has been created during the past few years and the fact that a significant portion of those funds have found their way onto banking balance sheets, should the banks begin to turn loose of those funds, we could see demand-driven price inflation based on the old formula of "too much money chasing too few goods."

In line with this thinking, the widely-followed "Standard & Poor's / Case-Shiller 20-city-home-price-index" rose by a full two percent in August compared to last year's price levels. This is the largest such price gain in two years and it became even more impressive when it was reported that prices increased in 17 out of the 20 cities during August, clearly indicating that the improvement was widely-based.

Going back to Waggoner's analysis noted above, if housing puts on impressive gains, please note that the net results of such expansion could easily be higher demand-driven wages, higher commodity prices for base metals and lumber; widening spreads on TIPS versus conventional notes and a general rise in long term interest rates.

Most observers still believe that the Fed can keep the inflationary genie 'in the bottle'. At The Melman Report, we have our doubts and, as noted, on a historic basis, rising inflation, should it develop strongly, should be powerful, positive medicine for our world of precious and base metals mining investments.

While many financial commentators still have their attention squarely focused on European trouble spots, we are becoming very concerned regarding the Japanese situation. Given their aging population and their declining price competitiveness compared to China or other Southeast Asian nations, concern regarding the ability of Japan to continue to finance their horrifying levels of internal government debt is growing.

The latest indication of concern has just come in the form of a new Bank of Japan 'asset purchase program' in the amount of 80 trillion Yen or $1.14 trillion. This dwarfs the recent Fed's QE3 program. The BOJ announced that the intent of the program was to increase the lending ability of the nation's banks. However, Japan faces many problems including important considerations such as declining industrial productivity combined with diminishing export figures.

As of 9:30 AM PDT, financial markets are trading once again following Hurricane Sandy and, after rising sharply near the openings, the Dow Industrials have actually turned negative and stand down about 50 points. Canada's TSX Index is benefitting from higher metals and petroleum quotes and is ahead by a similar amount. Gold is presently up by about $15 to near $1,725 while silver has gained 60 cents to $32.35. Base metals are moderately higher on balance and, not surprisingly, mining share indexes are strong gainers.

In other markets, Crude Oil is up by about 50 cents to near $86.20 per barrel; the US Dollar Index is close to unchanged and long term interest rates have moved slightly lower.

All quotes US$ unless otherwise indicated.

Next Melman Minute is scheduled for Friday, November 2 when we will examine the all-important Department of Labour figures for October which we believe may have a significant impact on next week's election.

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