I am writing on April 16 so you will not think this memo is an April fools joke. Many of you may think so anyway, however I assure you that I am serious about the opinions expressed in the memo. Only time will tell whether my opinions turn out to be successful investments or a bad joke. Now that my attempts at levity have come to an end let’s get started.


At the end of March a seminar took place in Washington D.C. It was sponsored by the Center for Strategic and International Studies and it was entitled “Implications of China’s Energy Search”. The slide presentations of the expert speakers can be accessed at For those of you who are interested in the details of Chinese expansion and how energy will be affected, I suggest you review the presentations. These slides give a thorough explanation of the forces of supply and demand, which are shaping future energy prices, and are the type of information that we have relied upon for several years to develop and maintain our bullish outlook for energy prices. I am grateful to my friend Barry Sahgal of Gilford Securities for the CSIS information.

Now the question arises, if the public at large or at least the professional investing public at large knows about the increased demand, how much more opportunity is left in the stocks? I believe that plenty of opportunity still remains to make money on energy stocks. However, wider public acceptance means wider volatility, so we are employing a policy of adding to our positions on dips.


India, the Philippines, Indonesia (yes Indonesia is importing energy), Thailand, and many other Asian, eastern European and Latin American developing countries are increasing their energy consumption as they try to join the club of developed nations.


Higher interest rates in the U.S. are here and will probably be here for the next 12 months as the Federal Reserve works to decrease the existing, but not admitted inflation problem. In a way, the Fed is correct to not admit that the inflation problem has modestly resurfaced. They do no want to cause an inflation psychology to set in with corporate decision makers and consumers. If people start hording or buying today because prices maybe higher tomorrow it could set off a very unpleasant episode in American history not too different from the psychology which pervaded in the later half of the 1970’s, when inflation went to 12% and the bank prime rate went to 20%.

Clearly, this is a scenario to be avoided. So, the Fed is acting now to get interest rates above the rate of inflation in the U.S., and thus cut off the developing U.S. real estate bubble. This bubble promises to be similar to the ones, which those of you who live in London, other European cities, major Asian cities [i.e. Japan] have clearly seen. Such a bubble is clearly developing in some major U.S. cities and the Fed wants to deflate it smoothly and with as few side effects as possible to the nations economic well being.


The 1970’s scenario is instructive in that we can compare what happened at that time with the expected results of the current interest rate increase. Clearly, what happened then was a more extreme case of what is now happening.

Yet, similarly, we can confidently expect higher interest rates to diminish the demand for:

1) All speculative investments that are carried with interest rate financing.
2) Bonds, U.S. and foreign, because higher U.S. rates put pressure on foreign countries to raise their rates or lose investment capital to the higher rates elsewhere.
3) Stocks, U.S. and foreign, especially emerging market investments made by speculative players.

As yields rise in the U.S. and other parts of the developed world, investors will have less incentive to seek higher returns from risky foreign investments. Some commodities may see less speculation, especially those tied to economic expansion in the developed world. Those commodities tied to economic expansion in India and China, and located within easy shipping distance to those countries, may not see much price erosion as continued high local demand keep their prices up. In our opinion, commodities such as gold and energy are in an altogether different category. We still plan to add to our positions in energy and precious metals during the traditional spring and summer period of weakness that these commodities usually experience.


Many of you undoubtedly remember the former Chairman of the Federal Reserve, Paul A. Volcker. Mr. Volcker led the Federal Reserve from 1979 to 1987. He took over in an environment of high and rising inflation, and presided over the decrease in the rate of inflation in the 1980’s. In my opinion, Mr. Volcker did a marvelous job. I reprint here in full, an article that he wrote in the Washington Post on April 10, 2005. You will see in it many of the themes that I have been wearing out in these memos over the last few years.

An Economy On Thin Ice
By Paul A. Volcker
Sunday, April 10, 2005; Page B07

The U.S. expansion appears on track. Europe and Japan may lack exuberance, but their economies are at least on the plus side. China and India — with close to 40 percent of the world’s population — have sustained growth at rates that not so long ago would have seemed, if not impossible, highly improbable.

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks — call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.
We sit here absorbed in a debate about how to maintain Social Security — and, more important, Medicare — when the baby boomers retire. But right now, those same boomers are spending like there’s no tomorrow. If we can believe the numbers, personal savings in the United States have practically disappeared.

To be sure, businesses have begun to rebuild their financial reserves. But in the space of a few years, the federal deficit has come to offset that source of national savings.
We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6 percent more than we are producing.

What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing. There is no sense of strain. As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar.
Most of the time, it has been private capital that has freely flowed into our markets from abroad — where better to invest in an uncertain world, the refrain has gone, than the United States?

More recently, we’ve become more dependent on foreign central banks, particularly in China and Japan and elsewhere in East Asia.

It’s all quite comfortable for us. We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It’s surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth.
And it’s comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency.
The difficulty is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.

It’s not that it is so difficult intellectually to set out a scenario for a “soft landing” and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand.

But can we, with any degree of confidence today, look forward to any one of these policies being put in place any time soon, much less a combination of all?
The answer is no. So I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s — a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

The clear lesson I draw is that there is a high premium on doing what we can to minimize the risks and to ensure that there is time for orderly adjustment. I’m not suggesting anything unorthodox or arcane. What is required is a willingness to act now — and next year, and the following year, and to act even when, on the surface, everything seems so placid and favorable.

What I am talking about really boils down to the oldest lesson of economic policy: a strong sense of monetary and fiscal discipline. This is not a time for ideological intransigence and partisan posturing on the budget at the expense of the deficit rising still higher. Surely we would all be better off if other countries did their part. But their failures must not deflect us from what we can do, in our own self-interest.

A wise observer of the economic scene once commented that “what can be left to later, usually is — and then, alas, it’s too late.” I don’t want to let that stand as the epitaph of what has been an unparalleled period of success for the American economy and of enormous potential for the world at large.

The writer was chairman of the Federal Reserve from 1979 to 1987. This article is adapted from a speech in February at an economic summit sponsored by the Stanford Institute for Economic Policy Research.


Energy futures prices for years into the future, are beginning for the first time to reflect the obvious fact that demand from China and India will stay high for years to come. At this point, with current carrying costs, it pays to buy energy today and store it for resale in the future. Current demand for energy is partly for storage and holding into the future.

Gold has a different set of fundamental driving influences. Even though higher interest rates make foreign currencies more attractive in the short run and gold tends to move with currencies other than the dollar, our research over the last 30 years has shown that currency moves in the short run are closely correlated with the difference in the interest rates in competing currencies and the rate of change of those interest rates. In the intermediate term, currencies move with balance of payments and balance of trade figures. In the long term they move with economic growth and expected changes in economic growth rates in the various countries.

Of course, everyone knows that higher interest rates are very bad for bonds and not good for many interest rate sensitive stocks or stocks that need to do a lot of borrowing to grow.


As we said earlier, the big run from the dollar (the selling of dollars and buying of foreign currencies and commodities for the higher interest rates) is dying and money is flowing back into dollars. As U.S. interest rates rise, the differential to foreign interest rates is diminished, assuming that the foreigners neither raise nor lower their rates. As the speculators unwind their commitments, they sell foreign currencies and commodities and buy dollars with the proceeds. This may last for two or three more months, but we do not know exactly. Until then, we will keep buying gold shares on dips and wait patiently for what we believe will be the inevitable rise.


We are in a transition period. Energy prices are ready for their seasonal decline (except gasoline prices which are entering their season of high demand). Stocks are declining and may put on a summer rally but it is hard to see long-term demand for stocks with interest rates rising for another year or so.

Currencies and gold are out of favor due to the unwinding of interest rate spread trading that has taken place over recent years. We expect this correction to last for a few more weeks and maybe a few months.

Our strategy is to wait and buy energy, oil service and precious metals stocks on dips and wait for an opportunity to pick up common stocks in growth companies at lower prices as time passes.