Good Morning,

Yesterday's intra-day spike to record highs in the oil market dematerialized quicker than a crewmember on Star Trek and by early this morning the value of a barrel was very near $133 instead of $140. The greenback regained a little bit of lost ground overnight and rose to 73.70 on the index, mainly on news that German investor confidence had sunk to a 15-year low. The findings fueled speculation the perhaps the interest rate hike expected to come next month may be left in the ECB's torpedo tube for a little while longer. UK inflation presents problems and could top 4% by year end according to BOE Governor Mervyn King.

As was widely expected, housing starts in the US fell to a 17-year low amid ample supply conditions and the poor builders' sentiment we saw yesterday. However weak the figure may be, the statistical margin for error in these reports can be as much as 10% or more, and thus the report may have no impact on next week's Fed positioning on interest rates and their eventual rise. Gold prices spent a relatively quiet overnight period awaiting this and other US data this morning. Sure enough, the other release of the morning had US PPI figures showing a 1.4% gain last month, the largest such spike since last November. The findings quickly overshadowed the housing statistics and the focus among market participants this morning turned right back to the effects of food and energy prices (and what the Fed might do to tackle them).

New York spot prices opened with initially small losses for the day, showing a drop of about $5 to near $876 per ounce as the trade digested the morning's statistical releases and was still awaiting the arrival of information regarding US industrial production and capacity utilization later this morning. Silver declined 23 cents and was trading at $16.87 while platinum lost $13 to $2034 and palladium dropped $4 to $455 an ounce. Some support for metals was seen in news from the financial world however. Despite the noteworthy income from commodities trading to which we alluded in yesterday's reports, profits at Goldman Sachs fell about 10% to just over $2 billion for the second quarter amid difficult times of market dislocation. The firm also said US banks may need as much as $65 billion in new capital as the losses from the credit debacle could extend well into 2009. Well, at least it is not $650 billion...

We have previously attempted to point out that the Fed's track record in dealing with economic contraction was actually pretty good. The central bank has had several opportunities to add liquidity to a faltering environment in the US economy, but was also able to mop up the dollars from the scene once the idle of that engine became steady. Sobering revelations on the same topic now, from Marketwatch's chief economist Irwin Kellner, who this morning points to the fact that the skeptics who say that the Fed is full of hot air and cheap words may in fact be the ones who are full of something. Mr. Kellner sees (in the M2 figures and other indicators) a Fed that has already started the process of liposuction for much of the ample supply of dollars it has previously injected into the economy in order to keep it in reasonably attractive shape:

Don't look now, but when it comes to reining in inflation, the Federal Reserve has already progressed from talking the talk to walking the walk.

It's no secret that the rate of inflation has gotten to be uncomfortably high. Consumer prices are now 4.2% above a year ago. At the end of 2006, the 12-month change was less than 2%. Gasoline prices are leading the way, up a whopping 21 percent from May 2007 levels. Transportation is up 8%. Food is 5% higher, while medical care is up a bit over 4%.

It is also apparent that, no matter how fast these visible causes of inflation might be rising, at the end of the day inflation is first and foremost a monetary phenomenon. That being the case, the job of battling inflation has been ceded to the Federal Reserve, the creator of our supply of money and credit. Fed officials began inveighing against inflation a month or two ago. Their strategy was to convince people that the central bank would keep inflation at bay hoping that once people believed this they would act accordingly, thus creating a virtuous cycle.

However the Fed was soon perceived to be all talk and no action. As I pointed out in March, the money supply was growing at a jaw-dropping rate. (See March 25 column) After a while, this message sank in and the Fed began to take action. From a compound annual rate of more than 16% between the middle of January and the middle of March, M2's growth rate in the past two months has slowed to a little over 1%, according to the Federal Reserve Bank of St. Louis.

The growth rate of highly liquid funds, which the St. Louis Fed calls MZM (money of zero maturity) has skidded even more, from an annual rate of 34% to only 6.5% at last count. Further up the line, growth of the monetary base, reflecting the Fed's own balance sheet, has slowed from 7.4% to only 1.1%. Meanwhile, the St. Louis Fed's measure of bank reserves is actually lower today than it was in June 2007.

If the pundits haven't caught on to this change in Fed tactics, the markets have. After looking for the federal funds rate to go below 2% earlier this year, the Fed funds futures market now thinks that the Fed will raise rates as soon as August. And following an almost nonstop decline from last July through March, the 2-year swap spread has widened by a full percentage point.

Not surprisingly, Treasury yields have bounced higher all along the curve with the rise in the rate on the 10-year note outpacing that of the 3-month bill. As a result, the Treasury yield curve is now the steepest since 2005. This slowing in the rate at which the Fed is injecting dollars into the system has also shown up in world financial markets. The dollar has risen from its recent lows and will go even higher if the Fed actually takes some bucks out of the system (See May 12 column)

But the markets believe that the Fed's job of reining in money growth and thus curbing inflation is not yet finished.

How do we know? Because the 10-year inflation-indexed Treasury yield spread is up significantly from its March lows. This only happens when people fear inflation enough to want to protect themselves from it.

Meanwhile, industrial production as well as capacity utilization were both down in May and were seen as buying a bit of additional time for the Fed before it starts cranking the interest rate lever back towards positive real rates. Ergo, another opportunity for gold to try to get back to $900 or thereabouts. Thus far in June, the metal has only spent time above the round figure for a bit less time than it takes to teleport that same Star Trek crewmember.

We wish to thank Joe Martin and his top-notch crew for putting on a splendid Vancouver show over the past two days. Here is to a job well done.

Happy Trading.