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Our Well-Oiled Economy
Let oil prices be your interest-rate guide.


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Larry Kudlow

The 10-year Treasury note is known as a market bellwether. And when it jumps we often hear a familiar tune.

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In the past 30 days, the yield of the 10-year note has spiked from 4.8% to 5.4%. That’s a big increase. Numerous analysts have explained this rate jump in terms of an overly rapid economic recovery and the likelihood of rising future inflation. So, as the song goes, everyone now thinks the Fed is going to raise interest rates in order to calm down the economy and ward off inflation.

It’s a tired tune. And there’s little cause to sing it right now.

Here’s a much simpler and more direct explanation of what’s going on in the economy: oil and energy prices have been on the rise. There is a very close correlation between rising energy prices and the spiking rates we see in the 10-year note. It happens all the time. Crude oil has moved from $17 a barrel to $26 a barrel. And Treasury rates have moved up in lock-step.

This sets up an interesting investment strategy. If oil prices fall in the months ahead, then the 10-year rate is going to retrace back toward 5%. And this means stocks will have greater value, especially with today’s GDP report that shows an unexpectedly strong 17.9% (non-annualized) rise in profits.

The key is whether energy prices will fall, and ace oil analyst Fred Leuffer thinks they will.

Leuffer, the Bear Stearns expert, believes the Saudis want a price of $20 a barrel in order to avoid choking off the world economic recovery — and especially the U.S. recovery. He believes this price will include a $1 or $2 risk premium that covers the threat of a U.S. invasion of Iraq. Consider this: If the global economy declines, the Saudis and OPEC will be in a serious over-production position by spring that will cost them a further loss of market share. The Saudis simply need to get the crude price down.

Mr. Leuffer also notes that oil production in Russia and Norway was never cut, Mexican capacity and production are on the rise, and Angola production is also increasing. So non-OPEC world market share will continue to grow at the expense of the Saudi-OPEC business unless prices move back toward $20 per barrel.

Obviously, this would be a good turn for both interest rates and stock prices.

That said, U.S. economic growth could slow a bit in the spring quarter as a result of the latest increases in energy prices. Gasoline prices at the pump, for example, have increased to $1.30 from just above $1.00. The economic rule of thumb is that 10-cent a gallon increases cost motorists $13 billion annually. So the arithmetic implies that the economy will lose $40 billion in purchasing power.

This does not suggest that the economic recovery will be dashed, but it does infer that a roaring 5% to 6% growth rate in the spring and summer quarters is not likely. Given the way the Fed and the bond market often view the world, this also means the chance of rapid-fire Fed interest rate hikes is far lower than market gurus believe.

By the way, Mr. Fred Leuffer is the rare analyst who is unafraid to remove stocks from his recommended list. Because he believes in his own $20-a-barrel projection, he has lifted all but two oil companies from his buy column. Good man, Mr. Leuffer. Honesty is a virtue. And being smart about oil also helps quite a bit.



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