• The SPDR S&P Dividend ETF (NYSE: SDY) became an investor favorite in 2011. It tracks the S&P High Yield Dividend Aristocrats index, which is based on 50 of the highest-yielding dividend stocks that have increased payouts in each of the past 25 years.
  
  SDY includes companies of all sizes, and its focus on yield means plenty of small-cap companies can make the cut. Investors can go to bed at night knowing that any company that managed to raise its dividend in both 2008 and 2009 provides safety. The fund has more than $8 billion in assets, yields 3.2% and provided total returns of 9.8% in 2011.
  
  
• The Vanguard Dividend Appreciation ETF (NYSE: VIG) focuses on dividend growth, rather than yield alone, to build an index of sturdy, high-quality names. The index is limited to companies that have upped payouts for the last 10 years, regardless of yield, and then applies a proprietary formula to weight them by market value. The top-10 holdings include stalwarts like McDonalds Corp. (NYSE: MCD), The Coca-Cola Co. (NYSE: KO) and Exxon Mobil Corp. (NYSE: XOM).
  
  The fund has $7.9 billion in assets, yields 2.1% and returned a total of 10.7% in 2011.
  
  
• WisdomTree SmallCap Dividend ETF (NYSE: DES) is a fundamentally weighted index tracking the performance of the small-cap segment of the U.S. dividend-paying market. These companies typically perform well as the economy emerges from recessions. The fund is non-diversified and follows a passive investment approach.
  
  The fund has $269 million in assets, yields 3.8% and returned 2.76% in 2011.
  
  
• Finally, for investors looking for international exposure, there's the PowerShares International Dividend Achievers Portfolio (NYSE: PID). Its scope is limited to companies that trade in the United States as American Depositary Receipts (ADRs), so investors have the assurance that the companies adhere to U.S. accounting standards. The fund invests in only high-yield names that have boosted payouts in at least each of the past five years. PID has $569 million in assets, yields 3.9% and returned 4.42% in 2011.

These selections should be enough to get you started. But if you're really serious about income, and you want to know what companies are behind the juiciest dividends, then you can sign up for Martin Hutchinson's Permanent Wealth Investor by clicking here. It's the only way to ensure you're getting the highest-yielding stocks available - not just paper tigers either, but genuine "alpha-bulldogs."

News & Related Story Links:

• Wall Street Journal:
  Dividend Stocks Become the Heroes
• Money Morning:
  Investment Protection: These Dividend Stocks Yield Twice as Much as Treasuries
• Money Morning:
  The Madness of Crowds: How to Play Bonds, China, and Gold in 2012
• Money Morning:
  We're Closing In On a 70% Dividend

Where U.S. Stocks Are Heading in 2012

One of the hallmarks of a bull market is a double digits earnings yield. Remember, the 2012 earnings yield is nearing double digits at 8.6%.

The last time theS&P 500 closed at a double-digit earnings yield on a monthly closing basis was November 30, 1984. If you bought stocks in 1984, you caught a ride on the biggest bull market in history.

Let's not forget the P/E ratio. Stocks look cheap by that metric, as well.

For the record, the average P/E ratio for the S&P since the 1870s has been about 15.
At the 1,290 level, the S&P 500 is currently trading at 11.5 times 2012 earnings. That's dirt-cheap.

Even at 13-times 2012 earnings, the S&P is worth 1,452.

Better yet, at a P/E of just 14.2, the S&P 500 would hit 1,586- crushing its old highs set back in 2007.

Anyway you look at it, two of the most important indicators are saying stocks are cheap as we start 2012 - especially with bond yields hovering at historic lows.

Of course, the great unknown in all of this is Europe. And admittedly it's a big one- but there's a good chance they'll eventually find a way to clean up the mess by printing up a few trillion euros in 2012.

The bottom line: 2012 is shaping up to be a great year for equities. You should have at least some exposure to U.S. stocks or risk missing a historic bull market run.

News & Related Story Links:

• Money Morning:
  The Five Stocks You Have to Own in 2012

• Seeking Alpha:
  2012 S&P 500 Earnings Estimates, Multiples And Price Projections

• U.S. News & World Report:
  How to Value the Stock Market

• Wikipedia:
  Magic formula investing

• Minyanville:
  7 Analogs That Help Explain Current Stock Market Action

"We want to put the emphasis of our work on the quality and the benefits of economic growth," Wen said. "We want the fruits of development to benefit the people."

Wen made his comments as the country prepares for the formal release of China's next five-year economic plan at the annual meeting of its National People's Congress that begins on March 5.

Even though Wen's message was straightforward, many analysts feel the lower growth target is more of a symbolic gesture because China has blown through its stated target of 7.5% GDP growth for the last six years in a row. Growth reached 10.3% in 2010, making China the fastest-growing major economy in the world.

"No one will really have 7% as their target. Everyone's going to be higher than that. [But] the message is that they want growth to slow down," Kenneth Jarrett, head of APCO Worldwide's China consultancy, told The Telegraph.

Wen also pledged to curtail consumer price increases by reducing lending, boosting agricultural production, and punishing hoarding and price manipulation. Earlier this month, China accelerated its campaign against surging inflation by raising interest rates for the third time since mid-October.

Inflation in China rose to 4.9% in January from 4.6% in December. But those numbers exclude food prices, which are increasing at the alarming rate of 10%, according to figures released in January.

Wen acknowledged that China's official rate of inflation doesn't reflect the rising cost of food, which is making life difficult for hundreds of millions of Chinese people.

"Rapid price rises have affected the public and even social stability," Wen said in the online forum that was broadcast across all state media in China. "The Party and Government have always made a priority of keeping prices at a generally stable level."

Abundant foreign currency and grain reserves should be sufficient to curb inflation, he said.

That may mean China is considering increasing imports of grain and other foodstuffs to protect against price gains, Dariusz Kowalczyk, a Hong Kong-based economist at Credit Agricole CIB, told Bloomberg.
The announcement fueled speculation among analysts that slower growth in China may put a damper on the recent surge in commodity prices, a sector that is largely being driven by demand from the country's strong growth.

"It may cause some initial reaction that tempers some speculative demand for some commodities," Mark Kristoff, chief executive of Traxys Group, a New York-based commodities trading company, told The Journal.

But market participants are still skeptical that the Red Dragon can successfully curtail its GDP growth and consequently reduce the amount of raw materials it consumes every year.

Demand for agricultural products in China continues to remain strong despite efforts to cool its economy, which may temper the market's reaction to the announcement. And even if China manages to achieve the desired 7% growth, the country is still likely to consume the equivalent of the steel production of Germany every year, Kristoff said.

"On balance, it will still be very significant annual consumption growth for raw materials. I don't anticipate that will be a longstanding, depressing statement as relates to the markets in general," he said.

China's Premier also decried the effects China's blistering economic growth has had on the environment.

While China was chalking up big economic growth numbers over the last two decades, it also became the world's biggest energy user and the largest emitter of greenhouse gases.

"We absolutely must not any longer sacrifice the environment for the sake of rapid and reckless roll-outs," he said. "We'll never seek economic growth rate and big size at the price of environment."

Lead fumes from an illegal battery factory poisoned more than 200 children in Anhui province, hospitalizing 23 in January, according to Xinhua. And a leak of acid-laced water into the Ting River in July killed enough fish to feed 72,000 residents for a year, Bloomberg reported.

News & Related Story Links:

• Wall Street Journal:
  Beijing to Slow Growth
• Bloomberg:
  China Lowers Growth Target as Wen Calls for Sustainability
• Telegraph:
  China lowers growth targets
• Money Morning:
  China Rate Increase a Responsible Move to Tame Inflation
• Wall Street Journal:
  Bid to Cool Expansion Is Expected to Take a Toll on Surging Commodities
• Xinhua:
  Poisoning more than 200 Chinese children by lead

"The life cycle cost, I think, was decisive," Dicks said. "It's a great victory."

The contract provides Boeing with fresh momentum after the giant aircraft maker had stumbled badly in the past few years.

Earlier this month, the Chicago-based company announced yet another delay in the delivery schedule for its first 787 Dreamliner. Boeing pushed the initial delivery of the bellwether plane to the third quarter of 2011-marking the seventh time the aircraft has been delayed and putting it behind schedule by at least three years.

The contract announcement could be the final chapter of a decade-long battle that has featured intense back-and-forth lobbying, advertising slurs and scandal, as Washington lawmakers pushed to bring the project - and thousands of jobs - into their districts.

Two earlier awards were rescinded, with one forcing the resignations of several Air Force officials and landing a Boeing executive in jail. Another award to EADS and Northrop Grumman Corp. (NYSE: NOC) in 2008 was overturned after Boeing protested.

EADS can appeal the Pentagon's decision, but Pentagon officials said they were sure any protest would fail. Still, with jobs on the line, there is bound to be political pressure to overturn the decision.

The Pentagon is expected to provide both companies with detailed briefings soon. And members of Congress are expected to receive the full explanation next week, congressional and industry sources told Politico.

The chief executive of EADS, Louis Gallois, told Bloomberg News Friday that he was "disappointed" and "perplexed" by the Pentagon's decision.

The supertanker program will support more than 50,000 jobs and 800 suppliers spread across more than 40 states, Dennis Muilenburg, CEO of Boeing Defense, Space & Security said in a conference call with reporters.

That's good news for a country plagued by high unemployment. EADS had planned to assemble its tankers in Mobile, Alabama with non-union labor. Boeing plans to build its tanker in Everett, Washington, where it has assembled aircraft for decades with a strong union labor force.

"This decision is a major victory for the American workers, the American aerospace industry and America's military," said U.S. Sen. Patty Murray, D-WA. "At a time when our economy is hurting and good-paying aerospace jobs are critical to our recovery, this decision is great news for the skilled workers of Everett and the thousands of suppliers across the country."

The other side was clearly disappointed and promised to take a close look at the decision.

"I am deeply disappointed that the EADS team was not selected to build the next air refueling tanker for the Air Force," Sen. Jeff Sessions, D-AL, said in a statement. "In light of today's result, I intend to examine the process carefully to ensure it was fairly conducted."

Both Boeing and the North American unit of EADS submitted bids based on popular civilian aircraft. EADS's tanker was modeled on its A330 wide-body aircraft, while Boeing's successful bid used the older and smaller 767 jet.

Aerial refueling tankers allow the military to refuel aircraft in mid flight, greatly extending the range of smaller aircraft.

The contract calls for Boeing to build a total of 179 of the tankers to replace the aging Boeing KC-135 "Stratotanker," which first entered service in 1957. Approximately 100 of the old models have been grounded since 2006 due to age.

Originally designed and built to lengthen the missions of B-52 nuclear bombers, the Stratotanker morphed into a workhorse in Vietnam, where its use allowed small fighter bombers to strike targets that were previously unreachable. The tankers continue to play a large role in Iraq and Afghanistan.

News and Related Story Links:

• CNNMoney:
  Air Force awards Boeing $35 billion contract
• Politico:
  Boeing gets $35 billion Air Force tanker contract
• Bloomberg:
  EADS Loss of U.S. Tanker Deal Threatens Plan to Reduce Airbus Jet Exposure
• Daily Finance:
  Boeing's Dreamliner Delays: Outsourcing Goes Too Far
• Money Morning:
  Déjà vu All Over Again: Boeing Delays Dreamliner for Sixth Time

The results marked the end of a $90 billion losing streak that started in 2005, stretched through 2008, and then climaxed with the American automobile icon tumbling into bankruptcy in 2009.

Net income for the fourth quarter was 31 cents a share, Detroit-based GM said. Profits were 52 cents a share, excluding a charge for purchases of preferred shares from the U.S. Treasury Department.

The results topped the 44 cents average estimate of analysts surveyed by Bloomberg News. Revenue rose to $36.9 billion, also exceeding the $34.6 billion average estimate. The company reported $135.6 billion in sales for the entire year.

The turnaround comes after the bankruptcy and a massive bailout by the federal government, which loaned the company $50 billion in exchange for a 61% ownership stake.

In the restructuring that followed, GM slashed debt, cut payrolls, closed outdated factories, shed product lines and reduced health benefits and other expenses by renegotiating union contracts. The changes allowed GM to trim the cost of building a vehicle by several thousand dollars.

But U.S. taxpayers are still the automaker's largest shareholder, holding roughly 500 million shares for a 27% stake of the company. It remains to be seen whether they will ever recoup their investment.

Shares of GM, which went public at a price of $33, closed Wednesday at $34.59. The government will have to sell its remaining shares at an average of price $53 to make taxpayers whole.

GM's global sales jumped 12.2% to 8.39 million vehicles in 2010, within shouting distance of retaking the world's largest automaker title from Toyota (NYSE ADR: TM), which sold 8.42 million.

For the first time in its 102-year history, GM sold more cars and trucks in a foreign market than in the United States. Sales in China jumped 28.8% from 2009 to 2.4 million, while U.S sales came in at 2.2 million, up only 6.3%.

"Their recovery has been fueled by significant cost-cutting, arrival of new products that consumers were seeking along with better management of incentives and supply," Jesse Toprak, vice president of industry trends and insight at TrueCar.com, which tracks the auto industry, told The New York Times. "The sky is the limit for GM after becoming profitable at this low of a sales pace."

The company's turnaround is also the result of revamping its product line in 2010.

As part of its restructuring, GM closed or sold the Saturn, Pontiac, Hummer and Saab brands. Meanwhile, it unveiled a string of hot-selling new models, including the Chevrolet Cruze, the Buick LaCrosse and the Cadillac SRX SUV.

"While GM still has some work to do in terms of improving their product lineup, the current offer of GM vehicles is the most balanced and highest quality they have ever had," Toprak told the Los Angeles Times.

GM also benefited from finding ways to rein in spending on sales incentives and making price increases for its vehicles stick.

Spending on incentives fell more than 5% to an average of $3,397 per vehicle, while the average transaction price in 2010 was $34,149, a 7% increase from 2009. Both of those figures outperformed the industry average, according to TrueCar.com.

GM ended the year with $27.6 billion in cash and $4.6 billion in debt. The company reduced its under-funded pension obligations in the United States to $11.5 billion, down from $16 billion a year earlier.

GM employees stand to reap a big payout. Approximately 45,000 union workers will receive $4,300 in bonuses. About 26,000 salaried workers in the United States will receive from 4% to 16% of their pay as bonuses, and several hundred white-collar employees will get more than 50% of their pay.

GM also resolved a significant accounting concern, announcing that its board and management team have concluded that the company had fixed material weaknesses in its financial reporting process.

If the automotive market continues to improve as expected, 2011 "should be a better year" than 2010, Christopher P. Liddell, GM's chief financial officer, told the NYT.

"Our focus for 2011 is to build on our progress and continue to generate momentum in the marketplace," Liddell said. "We expect our first quarter will be a strong start."

News & Related Story Links:

• General Motors Press Release:
  GM Announces First Full-Year Results as New Company
• Bloomberg:
  GM Reports Smallest Profit in a Year on New-Vehicle Costs
• New York Times:
  GM Reports an Annual Profit, Its First Since 2004
• Los Angeles Times:
  GM reports first annual profit since 2004
• Money Morning:
  Stock Market Analysts and Insiders Wave Caution Flags After $20 Billion GM IPO
• Money Morning:
  Buy, Sell or Hold Special Report: How Retail Investors Should Play the GM IPO
• Money Morning Archives:
  General Motors

The exchange has been looking at teaming up with Chicago Mercantile Exchange owner CME Group Inc. (Nasdaq: CME) and commodities trader IntercontinentalExchange Inc. (ICE) in a joint bid to acquire NYSE, people familiar with the matter told The Journal. Of the two, ICE appears to be the more likely partner, although talks are only preliminary at this point, they added.

The bulk of Nasdaq's business comes from intensely competitive, low-margin equities trading, with derivatives and clearing sales of only $265 million, or 17% of overall net revenue. Nasdaq's derivatives revenue comes mainly from stock options, as opposed to the higher-margin futures business.

By comparison, derivatives trading accounted for 33% of NYSE/Euronext revenues and 40% of Deutsche Boerse's.

Derivatives are a contract between two parties used to hedge risks or speculate. They can be based on an underlying asset such as stocks, bonds, currencies or commodities. They can also be linked to specific events like changes in interest rates.

Derivatives have become so valuable to trading venues because they can yield operating margins of as much as 55%. If completed, the NYSE/Deutsche Boerse merger will create the world's largest futures exchange accounting for 40% of the U.S. options market.

Despite trailing badly in the growing derivatives market, however, Nasdaq has been a leader in technology and expense controls, allowing it to remain competitive, analysts say.

Nasdaq, valued at $5.7 billion, has "been doing just fine, judging by the stock price," Richard Repetto, an analyst with Sandler O'Neill & Partners told The Journal. "But in the long run, they need to be bigger."

But any effort to put together a competing offer for NYSE will face significant obstacles.

Deutche Boerse is guaranteed the chance to match any offer for NYSE and a breakup fee of $337 million, The Journal reported. And before any offer can even be made, the two must agree on the terms and structure of an offer for NYSE.

If Nasdaq decides against mounting a competing bid for NYSE, it might look to expand by buying Chicago Board Options Exchange owner CBOE Holdings Inc. (Nasdaq: CBOE), which is reportedly open to an offer. Conversely, it could consider selling itself to ICE, sources told The Journal.

The latest wave of consolidation in the exchange industry was launched by a $7.9 billion bid by Singapore Exchange for the Australia stock exchange operator ASX Ltd. late in 2010.

That was followed by the London Stock Exchange's agreement to purchase Toronto's TMX Group Inc. in a deal that would create a transatlantic operator worth $7 billion in market value and the world's fifth-largest exchange by trading volume.

But both of those deals have run into strong opposition from lawmakers who see the local exchanges as a source of national pride as well as new capital and business.

TMX yesterday (Wednesday) pressed the case for its deal, warning lawmakers that opposing the merger would damage Canada's reputation as a bastion of open and fair markets.

Canada is putting its reputation for free trade and competition on the line, TMX Chief Executive Thomas Kloet told Reuters.

"One of the things Canada has to make sure to consider as it goes through this is what if it says no," Kloet said, adding he was taking political opposition to a deal "very seriously."

Meanwhile, fearful of being left behind, exchanges in Malaysia, the Philippines, Vietnam, Indonesia and Thailand are building electronic trading links between their markets, Reuters reported. The links are intended to eventually allow cross-border dealing in all their listed shares.

The trading bourses of Asia face considerable hurdles to stock exchange consolidation because of cumbersome regulatory environments and complicated ownership structures.

It will be at least several years before South East Asia's stock exchanges join the global trend towards consolidation, Thailand's market regulator predicted.

"Right now the only linkage is through the electronic means of this project, and that is the only likely option for now," Thirachai Phuvanatnaranubala, Secretary General of Thailand's Securities and Exchange Commission, told Reuters.

News & Related Story Links:

• The Wall Street Journal:
  Nasdaq Weighs Own NYSE Bid
• Money Morning:
  Deutsche Boerse/NYSE Mega-Merger More About Derivatives Than Stocks
• Reuters:
  NASDAQ Buying NYSE? Stock Market Merger Mania Heats Up

Libya produces only about 1.6 million barrels of crude per day (bpd), compared to worldwide production of 87 million barrels, Peter Beutel, an oil analyst with energy risk management firm Cameron Hanover told CNN.Money.com.

Instead, the biggest danger is that the political unrest could spread to Saudi Arabia, the world's largest exporter of crude at 8.4 million bpd.

"Tunisia and Egypt were disconcerting. But the unrest in Bahrain and Libya is far more dangerous," said Dr. Moors. "Bahrain is located strategically in the worst place for such an uprising...because Bahrain connects directly to the eastern province in Saudi Arabia that contains its principal oil production."

If political unrest in Libya spreads to other oil-rich countries and the ensuing chaos disrupts crude oil production in Saudi Arabia, the implications could be huge.

One obvious result would be that U.S. motorists could be paying a lot more at the pump. Prices for gasoline could hit $5 a gallon by peak summer driving season, industry analysts say.

"If this thing escalates and there's a good chance that there'd be a shift in supplies, $5 gas isn't out of the question," Darin Newsom, senior analyst at energy tracker DTN told USA Today.

The average price of regular gasoline is expected to rise to $3.25 within a few days, 2.5% above Tuesday's $3.17 national average, according to Tom Kloza, chief analyst at the Oil Price Information Service. Gas prices are up 20% from a year ago but remain 23% below the record $4.11 average set in July 2008.

But while riots in the Middle East are one factor driving fuel prices higher, there are also other reasons for the surge.

A rebound in the U.S. economy, rising demand from emerging countries the approach of the summer driving season are likely to push gas to $3.75 to $4 a gallon by July.

"We have all the wrong things working together at the right time: an economic recovery, stocks making new highs, a lower dollar, strong seasonal demand and unrest in the heart of oil production," said Beutel.

Gas prices of $5 a gallon or more would have a significant impact on the broader U.S. economy.

"The money that you spend filling up your car is money you don't have to spend at the shopping mall," David Wyss, chief economist at Standard & Poor's told The Wall Street Journal.While $100 oil "is a number we've seen before, it's still going to squeeze consumers' budgets."

If oil prices hit $100 a barrel and stay there it could also put a dent in the wider global economic recovery.

Each $10 move higher in oil prices can knock a few tenths of a percentage point off gross domestic product (GDP), or the total value of all goods and services produced. The world currently spends roughly 5% of GDP on petroleum products, a level last seen in 2008, when oil briefly hit $150 a barrel, The Journal reported.

Worldwide stock markets would tumble on any surge in oil prices.

"If oil continues to rise and the dots get connected beyond Libya, then you can set yourself up for a setback in stocks," David Sowerby, a money manager at Loomis Sayles & Co. in Michigan, told Bloomberg. "People are going to wait and see what type of unrest there is in the largest producing oil countries."

News & Related Story Links:

• Bloomberg:
  Oil Rises to Two-Year High on Libya; Goldman Sees $110 Brent
• CNNMoney.com:
  Oil prices surge 5% on Libya unrest
• Oil & Energy Investor:
  The Crisis Unfolding in the Middle East (and What I Won't Be Telling FOX Tomorrow...)
• USA Today:
  If Libyan unrest spreads, gas could reach $5
• Wall Street Journal:
  The Stealth Return of $100 Oil
• Money Morning:
  Energy Forecast: Oil Prices Poised to Again Test Record Levels in 2011

India was still the biggest market for gold during 2010, with total demand rising by 66% to 963 tons, the WGC said. Buying may slacken this year, however, because the government is likely to increase import duties on gold in the forthcoming budget.

Gold imports by India, the largest buyer of gold in the world, climbed to a record of 918 metric tons in 2010, driven by a surge in jewelry demand with Indians continuing to buy jewelry as a store of value.

"Last year was a great year for gold globally, and especially for India and China. India emerged as the strongest market with total demand rising...amid strong economic growth," Ajay Mitra, the WGC's Managing Director for the Middle East and India, told reporters.

Inflation Drives Demand Higher

Investment demand for gold in China was especially hot in the fourth quarter of 2010, rising 84%, said Wang Lixin, the WGC's China managing director, attributing the surge mainly to concerns about inflation.

"The main motivation behind this demand has been concern over domestic inflation pressure and poor performance of alternative investments, combined with expectations of further gold price gains," the WGC's report said.

The significant increase in demand seen in China, India and around the planet is reflective of the uncertainty facing consumers as people buy gold to protect themselves from macroeconomic risk and rising inflation.

After an extended period of tame inflation, relentless increases in commodity costs are beginning to filter through the global economy.

"Inflation is beginning to cross-pollinate as ultra-loose monetary policy in the United States is exported to places like China, pushing up wages and commodity prices..." analyst Anthony Mirhaydari wrote last week in a column for MSNMoney.

Core consumer prices in China increased 2.6% year-over-year in January, after posting a 2.1% rise in December. The producer price index (PPI) jumped 6.6% -- well above December's 5.9% and significantly more than the 6.1% increase forecast by analysts.

China's broader consumer price index (CPI) increased 4.9% year-over-year in January, exceeding the official government inflation ceiling of 4% for the fourth month in a row.

"We are seeing explosive demand for gold," Zhou Ming, deputy head of the Industrial and Commercial Bank of China Ltd. (ICBC) precious metals department told Reuters. "As Chinese get wealthy, they look to diversify their investments and gold stands out as a good hedge against inflation."

The WGC report also said the surging investment demand in China is a reflection of the ongoing internationalization of the Chinese yuan.

But Money Morning Chief Investment Strategist Keith Fitz-Gerald sees the Chinese government's desire to move away from dollar-based currency reserves as a more important reason for the gold fever sweeping China.

"Appreciating gold demand will have very little to do with yuan appreciation. I have not seen any evidence the two are linked...yet," Fitz-Gerald said in an interview. "What is really happening is that Chinese are buying gold on an institutional level to hedge away from the dollar and build in diversification. This is a conscious part of the yuan decision...the government definitely wants at least a partially hard asset backed global currency."

Demand for Gold a "Global Phenomenon"

The price of gold soared nearly 30% last year, reaching a record high $1,431.25 an ounce in December as the dollar dropped and investors sought a store of value against the loose monetary policies of Western governments.

Global demand for gold last year rose 19% year-over-year to a 10-year high of 3,812 tons. Demand in India and China accounted for about 41% of that total.

The WGC said that the increase in investment demand for gold is a "global phenomenon," and is set to remain strong in 2011 though growth will likely slow from last year's pace.

China's appetite for the yellow metal is expected to remain robust in 2011, making it a significant force in global gold prices.

Demand for gold investments in China could grow 40% - 50% this year, with gold jewelry expected to rise a more moderate 8%-10%, said the WGC's Wang.

Meanwhile, the country continues to cement its role as the world's largest bullion miner after it toppled South Africa from the perch in 2007.

China produced a record 340.9 tons of gold in 2010, up 8.6% over last year, the China Gold Association said last month. But that was not nearly enough to meet demand as gold imports into China soared in 2010, turning the country into a major overseas buyer for the first time.

China imported 209 tons through October 2010, up almost 500% from the total brought in the previous year, according to the Shanghai Gold Exchange. Mine output reached a record 340 tons last year, the China Gold Association said.

Government Pushing Gold in China

Although it's rarely mentioned in the Western media, the Chinese government is encouraging their citizens to buy physical gold bullion as part of an effort to cool further investment in the red-hot real estate and housing sectors.

"Unlike the property market, investment in the gold sector is something the government is encouraging," ICBC's Zhou told Reuters.

China actually banned its citizens from owning gold from 1950-2003.

ICBC, the world's largest bank by market value, sold about seven tons of physical gold in January this year, nearly half the 15 tons of bullion sold in all of 2010, Zhou said.

ICBC is also coming up with other creative ways for Chinese citizens to invest in the shiny metal.

In an initiative with the WGC, ICBC started offering physical-gold linked savings accounts in December. Over one million such accounts have already been opened, and the bank is now storing over 12 tons of gold on behalf of investors.

"There is frantic demand for non-physical gold investments. We issued 1 billion yuan ($151 million) worth of gold-price-linked term deposits in 2010, but we managed to sell the same amount over just a few days in January this year," Zhou said, adding that investors will deposit more than 5 billion yuan ($759 million) in gold-linked accounts this year.

Last week, the bank launched its second physical gold investment product, which sells gold bars to investors. They can then be resold for cash through ICBC based on real-time gold prices.

Zhou said that the huge increase in Chinese demand would continue in 2011 due to a "choppy stock market" and concerns about how rising interest rates will affect property markets.

Fitz-Gerald says insatiable Chinese demand can do nothing but continue to drive gold prices higher.

"For global gold buyers [this will have] a huge impact because Chinese buying programs are going to drive prices a lot higher before this is done...especially if the dollar gets worse," he said.

Fitz-Gerald believes gold prices will hit $2,500 in the near future.

News & Related Story Links:

• Wall Street Journal:
  China Gold Demand Skyrockets
• Indian Express:
  Gold demand in India rises 66 pct in 2010: WGC
• MSN Money:
  Inflation contagion pushes gold stocks higher
• Reuters:
  China gold demand growing at "explosive" pace: ICBC
• Money Morning:
  Gold Price Forecast: Four Reasons the "Yellow Metal" Will Hit $1,900 an Ounce in 2011
• Money Morning:
  Chinese Investors Drive Gold Imports Five Times Higher on Inflation Fears
• Money Morning:
  U.S. Stock Market Forecast: Tech, Energy, Commodities and Gold Are Top Plays For 2011
• Money Morning Archives:
  Gold

Cropland prices rose for the fifth consecutive quarter since dropping in the third quarter of 2009, when the recession depressed wholesale prices for livestock, the Kansas City Fed's survey showed. The bank's region covers the 10th District, including western Missouri, Nebraska, Kansas, Oklahoma, Wyoming, eastern Colorado and northern New Mexico.

An auction last month in Jefferson, Iowa for a plot of 120 acres of prime cropland in Greene County drew a winning bid of $8,200 an acre - almost $1 million total. That was 44% higher than the $5,701 per-acre estimate for average values in the county as of Nov. 1, according to Iowa State University data.

"Prices continue to increase due in part to the limited supply," Randall Pope, chief executive officer of Champaign, Illinois-based Westchester Group Inc., which manages farm tracts, told Bloomberg News. "There are a number of people who would like to buy these days but there isn't a lot of product on the market."

The surge in farmland prices is directly related to soaring prices for crops.

Corn futures rose 52% last year on the Chicago Board of Trade as inventories fell when warm, dry weather stifled output in Brazil and Argentina, the biggest corn exporters after the United States.

Spot prices of wheat are roughly double what they were a year ago as global demand surged and crop failures in Russia and China threatened supplies. Other agricultural commodities on the upswing include cotton, where prices are up 155% from last year, and soybeans, which are up 50% in that same period.

High commodity prices provide farmers more money to spend on land as well as heavy equipment and seeds.

The U.S. Agriculture Department said Monday that it expects net farm income, a widely accepted gauge of the U.S. agriculture sector's profitability, to climb 19.8% this year to $94.7 billion, Bloomberg reported. The 2011 estimate is the second- highest in 35 years when adjusted for inflation, the agency said.

The latest surge in prices for farmland led Federal Deposit Insurance Corp. (FDIC) Chairman Sheila Bair to issue warnings in October that a bubble could be forming.

The current situation is eerily reminiscent of 2008, when grain prices hit historic highs. Prices for irrigated farmland jumped 23.4% that year, while prices of non-irrigated farmland rose 21.2%.

Prices for grains and farmland both took a tumbled when the financial crisis and recession hit full swing. However, they resumed their upward climb in June 2010, as demand recovered.

Of course, doubts about the sustainability of the current surge in prices for farmland are starting to surface.

One troublesome bit of news came in Tuesday's report, when the Fed reported that cash rental rates for cropland across the 10th District rose only about 6% in the fourth quarter, far too little to justify such a big increase in land prices, according to The Wall Street Journal.

In reaction, some farm bankers across the region are beginning to pull in the reins on real estate loans.

"Bankers in the survey were starting to raise questions about the sustainability of farmland values" and "paying closer attention to their loan-to-value ratios," Brian Briggeman, an economist at the Omaha branch of the Kansas City Fed told The Journal.

But farmers and outside investors continue to benefit from the Fed's low interest rate policies, buying up more land and effectively putting a floor under prices.

Real estate interest rates on farms were just 5.81% in the third quarter in Iowa and parts of four other states in the third quarter -- the lowest since the Federal Reserve Bank of Chicago began keeping data in 1974, The Journal reported.

Lenders usually require a 35% down payment for land purchases in the farm belt, Troy Louwagie, a land consultant with Hertz Real Estate Services Inc. in Mount Vernon, Iowa told The Journal.

"A large percentage of this land is being bought with cash," Louwagie said, as profits are re-invested in more acres.

As long as agricultural commodities don't go into a major swoon, values in Iowa -- the largest corn- and soybean-growing state -- may climb another 10% this year, Mike Duffy, an Iowa State University economist in Ames, told Bloomberg in a telephone interview.

"In the next year to two years, I don't see a lot right now to indicate that it's going to take a nosedive," said Duffy, who conducts the annual Iowa land survey. "What people have to remember is farmland is primarily bought by farmers and they buy it for the long term."

News & Related Story Links:

• Bloomberg:
  Farmland Boom Provides Bright Spot for U.S. Midwest Real Estate
• Wall Street Journal:
  Crop Surge Lifts Farmland Prices
• Money Morning:
  Three Ways to Profit as Growing Demand and Tight Supplies Send Corn Prices Higher
• Money Morning:
  Surging Corn Prices Making Hay for Commodities Producers
• Money Morning:
  Drought Forces Russia to Ban Grain Exports
• Money Morning:
  How to Profit From the Russian Wheat Shortage

Obama's Reform Proposal

The White House on Friday took a tentative first step towards reforming Fannie Mae and Freddie Mac when it put forth a proposal to wind down theagencies, which are now controlled by the federal government.

The administration's "white paper" proposal for replacing the mortgage giants broadly outlines alternative possibilities to reduce the government's role in the mortgage market, including:

• Gradual increases that will eventually raise to 10% the minimum down payment for any loan Fannie and Freddie could buy. Currently, borrowers can make smaller down payments if they purchase mortgage insurance.
• Shrinking the size of the portfolio of mortgages held by government housing finance agencies by at least 10% a year.
• Removing all government loan guarantees beyond those already in place with the Federal Housing Administration, turning most of the market over to the private sector.

The paper also recommends gradually raising fees that Fannie and Freddie charge to lenders in order to make mortgages that aren't government-backed more competitive.

Any of the actions are likely to raise borrowing costs and limit access to affordable home loans for consumers. Administration officials said the transition to a new system could take five years or longer.

It's taken this long for Washington to take on the problems surrounding Fannie and Freddie because there are no simple solutions. Fannie and Freddie buy mortgages from banks and other originators, repackage them for sale as securities and make investors whole when borrowers default.

Shutting them down likely would just add to the $150 billion Fannie and Freddie have already taken from taxpayers' pockets to cover bad loans.

"Someone has to pay it," John Taylor, president and chief executive officer of theNational Community Reinvestment Coalition told msnbc.com. "It doesn't miraculously disappear. We sponsored these loans and now, with the companies going under, we have to make good on the loans."

A shutdown also would leave homebuyers with reduced access to affordable loans. So many private lenders shut down or stopped lending when the housing bubble burst that the two agencies guaranteed more than 90% of home loans written last year, The Wall Street Journal reported.

"We are going to start the process of reform now, but we are going to do it responsibly and carefully so that we support the recovery and the process of repair of the housing market," U.S. Treasury Secretary Timothy Geithner said in a statement.

The proposal outlines a series of steps to shrink the government's participation in the mortgage market that could be taken without seeking congressional approval, although the administration would prefer legislative action.

Politicians in Washington have been fighting over how to reform the housing-finance system, with both parties reluctant to propose detailed legislation.

Most Republicans believe Fannie and Freddie were key players in the financial crisis and oppose any solution that would keep them in the business of backstopping most home loans. Democrats have said the government must play a prominent role in ensuring public access to homeownership.

By advancing multiple proposals, the administration could be trying to build consensus around one option, according to The Journal. Some analysts say it may help build the case for a continued government backstop that many administration officials are said to privately favor.

"Most people in Congress understand that this is a very political, contentious issue," said David Berson, a former Fannie Mae chief economist. "It's going to be a very volatile ride as we move toward what ultimately will be the future of Fannie and Freddie. It's hard to know what that's going to be."

More Homes Underwater

As the politicians continue the debate over how to stabilize the loan market, the number of U.S. homes worth less than their outstanding mortgage jumped to 27% in the fourth quarter of 2010, according to Zillow.

Roughly 15.7 million homeowners were saddled with negative equity in their homes at the end of the year, also known as being underwater. The figure was up from 13.9 million in the third quarter, the Seattle-based real estate information company said in a report last week.

Home prices will fall as much as 5% this year, putting even more homeowners underwater, as foreclosed properties sell at discounts and 9% unemployment curtails buyer demand, Stan Humphries, Zillow's chief economist told Bloomberg News.

"These seem like fairly grim numbers," Humphries told Bloomberg in a telephone interview. "We're still expecting a bottom in home values later this year. And this, if anything, makes me a bit more confident because I'm seeing very large corrections now, which means the market can start to repair itself."

Home seizures fell in the fourth quarter as Bank of America Corp. (NYSE: BAC) and other lenders imposed a moratorium after accusations they failed to process documents correctly and hurried the review of paperwork. All 50 states are investigating the banks and may sue to recover unpaid fees.

The sheer number of defaults is also slowing the time it takes for the banks to repossess properties after buyers stop payments. It took an average of 507 days for lenders to reclaim homes in foreclosure in December, 25% longer than in 2009, Lender Processing Services reported this week.

Las Vegas had more than 81% of its mortgages underwater, the highest percentage in the United States, Zillow said. Phoenix was second at 69.9%, followed by Reno, Nevada with 67.9%, and Orlando, Florida at 61.7%.

The median value for a U.S. single-family home was $175,200 in the fourth quarter, down 5.9% from a year earlier, according to Zillow. Values have fallen 27% from the June 2006 peak.

The company's figures exclude homes that are resold after foreclosure, which usually fetch at least 20% less than similar properties, Humphries said.

Mortgage Interest Rates Spike

Yet another challenge to the housing market recovery surfaced last week when 30-year mortgage rates pierced the psychologically-important 5% level for the first time since last spring.

The average rate on 30-year fixed-rate mortgages jumped to 5.05% in the week ended last Thursday, according to a closely-watched survey by Freddie Mac, up from 4.81% a week ago. It was the highest rate in the survey since April.

The spike in rates has been unusually swift. In just three months, the national average mortgage rate has jumped to more than 5% from a record low of 4.17%, according to Freddie Mac data.

The increase in borrowing costs is a direct reflection of a large jump in the yields of U.S. Treasury bonds in recent weeks. The yield on the 10-year Treasury note closed Thursday at 3.712%, up almost 140 basis points over its October low of 2.318%. The increase comes despite buying by the Federal Reserve, which has employed a second round of quantitative easing to keep rates down and sustain the economic recovery.

The higher cost of buying already is discouraging some buyers from entering the market. Mortgage applications have fallen 12% in two months as rates have surged, according to an index compiled by the Mortgage Bankers Association.

But some analysts say the increase may be healthy because it will motivate buyers to take the plunge before rates go even higher.

"The latest rate rise has kicked a few people off the fence; also, it's given a little bit of a wake-up call for real-estate agents to connect with clients who may have been sitting on the fence or arguing over small differences between the bid and ask" home prices, Stephen Calk, chairman and chief executive of Chicago Bancorp, which does mortgage business in 35 states, told The Journal.

But other analysts say another critical element of the market -- refinancing activity -- has already been hard-hit.

"Once mortgage rates reached the 4¾ level in December, refinance activity stopped altogether," said Lou Barnes, a mortgage banker at Premier Mortgage Group in Boulder, Colo. Mortgage applications for refinancing are down 59% from their peak in August, according to research firm Zelman & Associates.

Barnes told The Journal that many buyers think prices have farther to fall, keeping them from stepping up.

News & Related Story Links:

• Wall Street Journal:
  Views of Life After Fannie, Freddie
• Msnbc.com:
  White House wants Fannie, Freddie to go
• Bloomberg:
  Home-Price Drop Leaves 27% of U.S. Owners Underwater on Loans, Zillow Says
• Money Morning:
  What You Don't Know about "Mortgagegate" Could Crush the U.S. Banking System
• Wall Street Journal:
  Rise in Rates Is Headwind for Housing

In a political nod to New York City's status as the world's most important financial hub, the company will have duel headquarters in Frankfurt and New York. NYSE Euronext Chief Executive Duncan Niederauer will be CEO of the new company, while Deutsche Boerse CEO Reto Francioni will be the chairman.

When the deal is completed, Deutsche Boerse will own a company that may generate more than 50% of its earnings from options and futures by 2013, Ed Ditmire, an analyst at Macquarie Group Ltd. in New York, told Bloomberg News.

Earnings from those instruments will top $462 million by 2013, based on analyst estimates compiled by Bloomberg.

The derivatives business of both firms would then be worth $24.7 billion by itself, 5.7% more than the market capitalizations of both companies combined before the two trading giants announced they were talking this week.

"The main reason that this deal occurred is that the market is moving towards the derivatives," Matt McCormick, a money manager at Cincinnati-based Bahl & Gaynor Inc., which oversees about $3.2 billion, told Bloomberg. "It's not because they want real estate on Wall Street."

Derivatives are a contract between two parties used to hedge risks or speculate. They can be based on an underlying asset such as stocks, bonds, currencies or commodities. They can also be linked to specific events like changes in interest rates.

Derivatives have become so valuable to trading venues because they can yield operating margins of as much as 55%. The merger will create the world's largest futures exchange accounting for 40% of the U.S. options market.

By bolstering their profile in the derivatives market, the companies are moving to offset revenue declines in stock trading. Derivatives revenue climbed 14% last year at NYSE Euronext, while cash equities fell 10%, as smaller trading platforms geared toward high-speed automated trading cut into volumes.

NYSE Euronext countered by investing heavily in technology and building data centers in Mahwah, New Jersey, and outside London where customers can house trading systems closer to the physical exchanges to speed transactions.

But fourth-quarter earnings still declined by 20% from 2009, NYSE Euronext reported last week. The company said slumping trading volumes in the United States and Europe and gains by the dollar against the euro hurt its bottom line.

The deal creates an unprecedented exchange powerhouse with more than $20 trillion in annual trading volume and operations in Germany, France, Britain, Amsterdam, Portugal, Belgium, and the United States, according to Reuters.

The companies said the takeover would yield cost reductions of $400 million (300 million euros) a year.

The deal follows a revival of merger activity in global financial exchanges after a period of quiet in the wake of the financial crisis.

International mergers between exchanges often raise hackles among politicians who see them as symbols of national pride and important means of raising capital and other business.

The London Stock Exchange's bid to take over Toronto Stock Exchange operator TMX Group Inc. (PINK: TMXGF) has fanned concerns about foreign ownership in Canada and regulators are sure to closely scrutinize the Deutsche Boerse - NYSE Euronext deal.

Just last week, the Singapore Exchange revised its $7.9 billion bid for Australia's ASX by increasing the number of Australians on the board of directors in an effort to win support from reluctant politicians.

After the deal closes, Deutsche Boerse's Eurex unit and NYSE Euronext's London-based Liffe unit would control more than 90% of European exchange-based futures trading, Reuters reported, raising antitrust questions among regulators.

In the United States, the Department of Justice and Securities and Exchange Commission will have final say on the merger.

Traders who use the exchanges have also expressed concern over the proposed deals, raising fears about a lack of competition.

"Euronext and Deutsche Boerse are still screwing us on fees for clearing, the closing auctions and small and mid-cap trading -- the areas where they still have virtual monopolies," the head of markets at a large European bank - who declined to be named - told Reuters. "A merger is concerning because together they will be more powerful and better placed to protect these monopolies."

News & Related Story Links:

• Wall Street Journal:
  Deal Profile: Deutsche Börse to Buy NYSE
• Bloomberg:
  NYSE-Deutsche Boerse Merger Is Free With Derivatives: Real M&A
• Reuters:
  Deutsche Boerse unveils NYSE mega-exchange deal
• Money Morning:
  What Really Caused the Stock Market 'Flash Crash

The interest hike came on the final day of China's weeklong Lunar New Year holiday and before a report next week that may show consumer prices rose 5.3% in January.

Commodity markets fell after the central bank announcement on concerns the hike might slacken demand in the country that helped guide the world out of the recent financial crisis.

Three-month copper fell below $10,000 a ton, U.S. crude oil futures prices dropped and emerging-market stocks posted losses as China joined India, Indonesia, Thailand and South Korea in boosting rates this year.

These losses could be followed by even more disquietude as investors worry about the effect higher rates will have on global economic growth.

"If inflation stays high in February, the central bank will be forced to increase interest rates on a continuous basis," said Money Morning Chief Investment Strategist Keith Fitz-Gerald. "Investor confidence will be seriously hurt by expectations of aggressive policy tightening."

Of course, while tighter policy may have tapped the brakes on the Chinese economy and taken a toll on the domestic stock market - which has dropped 12% since hitting a 2010 high in November - Fitz-Gerald thinks the long-term effects will be moderate.

"Ultimately the raising of interest rates will be viewed as a sign of adult supervision and strength," said Fitz-Gerald. "Real interest rates remain negative, which means that Chinese monetary policy actually has a stimulative effect."

As China struggles with a property market bubble and surging food prices on the heels of a drought that's crimping supplies, Beijing's goal is to hold inflation at 4% this year. But the economy is flush with cash after money supplies jumped more than 50% in two years and China's world's-biggest foreign exchange reserves climbed by a record $199 billion in the fourth quarter to $2.85 trillion.

Banks extended $1.2 trillion (7.95 trillion yuan) in new loans last year, exceeding the government's targeted maximum of $1.13 trillion (7.5 trillion yuan). And new lending may have surged to $181 billion (1.2 trillion yuan) in January alone, according to the median estimate in a Bloomberg survey of analysts.
In response, Beijing has raised reserve requirements on banks seven times over the past year and ordered them to lend less.

Beijing also has imposed a series of controls targeting property prices that have stayed stubbornly high. Acutely aware of polls that say the public is angry about unaffordable housing, the country's leaders have said they will not tolerate property inflation and speculation.

"The rate hikes, while ostensibly about controlling inflation, are actually part of a much broader program designed to crack down on speculation and hoarding, while giving the Chinese people reason to keep money in banks rather than shifting into property and equities," said Fitz-Gerald.

In yesterday's move, the central bank raised long-term rates for savings deposits by 45 basis points for five-year terms, 20 basis points higher than for lending. China's one-year deposit rate will climb to 3.25% by June, economists forecast in December.

Isaac Meng, a Beijing-based economist for BNP Paribas SA (PINK ADR: BNQPY), told Bloomberg he expected "accelerated tightening" that would see rates rise by as much as another 1.5 percentage points.

But while more interest rate hikes this year are likely to slow China's economy some, it still is expected to keep humming along at a rate more developed economies can only view with envy. China's gross domestic product (GDP) will grow by 9.3% in 2011, according to a Reuters poll, down from a red-hot 10.3% last year.

Still, that Beijing is tightening the reins on its economy at a time when U.S. and Eurozone interest rates are at record lows is a mark of confidence that the world's second-largest economy is on solid ground, according to Fitz-Gerald.

"In the end, the move will be seen as a sign of strength, with solid growth momentum allowing policymakers to raise rates. Global markets should respond positively to such moves aimed at controlling inflation," he said. "Isn't the action China's now taking exactly what everybody wishes Team Bernanke would do here to counter the more than $14.1 trillion in inflationary kindling now stacked up outside the door?"

News & Related Story Links:

• Bloomberg:
  China Raises Rates to Counter Accelerating Inflation
• Reuters:
  China raises rates to battle stubbornly high inflation
• Money Morning:
  New China Yuan Policy Holds Promise As the "Trade of the Century"
• Money Morning:
  China Monetary Policy: Inflation Won't Last - Growth Will

Under the terms of the deal, Pride holders will receive 0.4778 share of Ensco plus $15.60 in cash for each share of Pride common stock. Once the deal closes, Pride holders will own about 38% of Ensco's outstanding shares.

Pride has been pursuing a sale of the company since last year, and has been holding discussions with a number of possible buyers including Seadrill Ltd. (NYSE: SDRL), a big Norwegian drilling contractor. Seadrill already owns a 9.9% stake in Pride after a failed attempt to buy the whole company in 2008, Forbes reported.

Analysts say the offshore oil drilling sector is ripe for consolidation due to uncertainty following the Gulf spill. Tighter regulations in the United States will make it harder for small drillers to compete and benefit large companies with modern fleets of deepwater rigs, like Transocean and Ensco.

For Ensco, which recently moved its headquarters to the United Kingdom from the United States, the deal would significantly boost the number of deepwater rigs in its fleet, which command much higher rates than shallow-water rigs.

The acquisition will expand Ensco's fleet of offshore drilling vessels to 74, including 21 rigs capable of operating in seas of 4,500 feet (1,372 meters) or deeper.

The combination will cut at least $50 million in pretax operating costs, immediately add to earnings and will boost Ensco's backlog of unfilled orders to $10 billion, Ensco said in a press release.

"The combination is an ideal strategic fit, as our rig types, markets, customers and expertise complement each other with minimal overlap," Dan Rabun, Ensco's chief executive, said in a press release.

The offshore drilling industry in the United States has been in limbo after the Deepwater Horizon, a drilling rig leased by BP PLC (NYSE ADR: BP), exploded and sank off the Louisiana coast on April 20, 2010.

In response to the disaster, U.S. President Barack Obama's administration in May halted offshore exploration in waters deeper than 500 feet, leading many companies to relocate their rigs out of the Gulf to other offshore fields in regions like West Africa, The Wall Street Journal reported.

Even though the government lifted the drilling moratorium in late 2010, officials have been slow to issue any new deepwater drilling permits. And even after new permits are issued, many analysts believe it will take many more months for production to return to normal.

Last week, U.S. District Judge Martin Feldman of New Orleans ruled the Obama administration acted in contempt by continuing its deepwater-drilling moratorium after he struck the policy down last June, Bloomberg reported.

Interior Secretary Ken Salazar instituted a second drilling moratorium in July that was contested in a lawsuit by the industry claiming the ban was harming the Gulf Coast economy, which is heavily dependent on deepwater drilling activities. That ban was rescinded in October, before Feldman could rule on its validity.

Feldman later ruled that the enhanced drilling safety rules Salazar imposed to permit companies to resume offshore exploration violated federal law. Opponents of those rules insisted that regulators were continuing to block the resumption of drilling after Feldman's rulings.

Interior Department regulators acted with "determined disregard" by lifting and reinstituting a series of policy changes that restricted offshore drilling following the explosion, Feldman ruled on Feb 2.

"Each step the government took following the court's imposition of a preliminary injunction showcases its defiance," Feldman said in the ruling. "Such dismissive conduct, viewed in tandem with the re-imposition of a second blanket and substantively identical moratorium...provide this court with clear and convincing evidence of the government's contempt."

The Offshore Marine Service Association, a group representing offshore service vessels and shipyards, urged the president to end what it called an informal moratorium on offshore drilling.

"President Obama claims to have lifted the Gulf moratorium, yet not a single deepwater permit has been issued in nine months," Jim Adams, the association's president, said in a release last week. "As a result, thousands of workers are out of jobs, Americans are paying more for gasoline and heating oil, and our nation is becoming even more dependent on unstable nations for our energy needs."

Wyn Hornbuckle, a Justice Department spokesman, told Bloomberg News the government is reviewing Feldman's ruling but declined further comment.

News & Related Story Links:

• Bloomberg:
  Ensco to Acquire Rival Driller Pride for $7.3 Billion
• Wall Street Journal:
  Oil Drillers Plan to Merge
• Forbes:
  Seadrill buys 9.9 percent stake in US drilling company Pride International
• Ensco plc:
  Ensco plc to Acquire Pride International, Inc.
• Bloomberg:
  U.S. in Contempt Over Gulf Drill Ban, Judge Rules
• Money Morning Archives:
  Gulf Oil Spill

The number of cotton contracts outstanding has grown by 21% in the last year, boosted by an influx of hedge funds and small speculators.

The squeeze could come in the next few weeks as cotton mills are holding contracts to buy cotton under the March contract, which expires on March 9.

Under normal circumstances, they would have already locked in a price for that cotton. But as prices kept soaring, many held off, hoping for lower prices that never came, according to a report in The Wall Street Journal.

The fear is that speculators could put the squeeze on the mills by buying up cotton, driving prices even higher. In response, ICE on Thursday said it would start to require buyers taking big positions in the cotton markets to justify a need.

Between now and March 9, market participants wanting to hold more than 300 contracts, the equivalent of 30,000 bales, must request approval and prove they have an economic need for the cotton, The Journal reported.

"Cotton is a mess. It's moving so quickly, predominantly up. Every day you pass thinking you are going to see something better, you risk missing out on cotton all together. If you don't take cotton today, your costs are escalating and you are under water pretty quickly." Tracy Linton, vice president of Galey & Lord, a textile mill based in Society Hill, S.C. told The Journal.

While this rule is new to the cotton market, it is has been regularly enforced across other agricultural products.

Regulators take a dim view of excessive speculation in commodities markets, arguing that it can distort prices and make it harder for producers and users of commodities to manage their risk. They say it also may negate fundamental investment factors like supply and demand.

Traders point out that there is no data to prove such activity can artificially inflate prices in the commodity markets.

But new limits on speculators have been gaining favor around the globe as prices for everything from soybeans to copper set records.

Among the notable gainers last year were gold, which gained 30% in 2010, and silver, which gained 83%. Agricultural commodities also jumped in 2010, with wheat climbing 47% last year, while corn rose 52% and cotton advanced nearly 92% in 2010.

Civil unrest in North Africa and the Middle East has governments on edge as they fear a repeat of the food crisis of 2008, which saw violent protests in developing countries around the world.

Last Wednesday, the European Commission, which writes laws for the region's 27 countries, published an outline of plans to clamp down on speculators.

"Between 2002 and 2008, the number of financial contracts for derivatives in commodities has tripled," Michel Barnier, the commissioner in charge of EU financial reform told Reuters. "We are no longer talking about foodstuffs. Agricultural products are turning into financial assets."

Barnier wants to increase the powers of regulators to intervene in the markets when speculative positions in derivatives - the value of which is tied to a commodity - send grain or energy prices soaring.

Europe's concern followed actions by the U.S. Commodity Futures Commission (CFTC), which proposed a rule on Jan. 13 establishing limits on positions in physical commodity futures contracts designed to combat excessive speculation and manipulation in commodity markets.

The proposed rule, which also covers swaps that are economically equivalent to those contracts, could govern trading in 28 commodities - 19 agricultural contracts, four energy, four precious metals and one base metal contract.

"Position limits help to protect the markets both in times of clear skies and when there is a storm on the horizon," said Gary Gensler, chairman of the CFTC. "Today's proposal would implement important new authorities in the Dodd-Frank Act to prevent excessive speculation and manipulation in the derivatives markets."

The proposal was formally introduced by a 4-to-1 vote. Interested companies and traders will have at least 60 days to comment on the proposal before Gensler can bring it before the commission for a final vote.

Although the limits were written into the Dodd-Frank financial overhaul mandated by Congress last summer, a majority of the CFTC's five commissioners must still vote to finalize the rule sometime after the comment period ends.

News & Related Story Links:

• Wall Street Journal:
  A Cotton Market Targets Speculators
• Reuters:
  EU executive pledges curbs on commodity speculators
• MarketWatch:
  CFTC proposes stricter commodity limits
• Money Morning:
  U.S. & Euro Regulators Move to Curb Commodity Speculators
• Money Morning:
  Commodities, "BEE" Markets and Multinational Stocks Are Best Investments For 2011

Spiking Oil Prices Threaten Profits

Indeed, if oil prices simply hold at current levels, they will increase airline costs by more than this year's projected earnings, threatening the industry's return to profitability, according to the International Air Transport Association (IATA).

Based on oil prices of $84 a barrel, airlines would rake in $9.1 billion in net income in 2011, IATA said in a Dec. 14 forecast.

But every one-dollar increase for a barrel of oil translates to higher jet fuel costs of $1.6 billion. And with crude now trading at about $91 a barrel, costs could increase by $11 billion this year, wiping any profits from the books, according to data compiled by Bloomberg News.

"The story this month is the sharp rise in oil prices," IATA Chief Executive Officer Giovanni Bisignani said in a statement. A sustained increase in oil prices "could spoil the party" even as people start to travel again after the recession. That could further erode the carriers' 2.7% profit margin, which he described as "pathetic."

Since fuel prices account for at least one-third of airline operating expenses, even comparatively small price shifts can have a major impact on profits.

With the protests in Egypt threatening to halt shipments through the Suez Canal, airline officials are worried about a repeat of the fuel price hikes of 2008. In July of that year crude oil prices topped out at over $147 a barrel and sent airlines' earnings into a tailspin.

Wall Street analysts recently lowered their 2011 earnings estimates for a number of carriers, with fuel prices at the forefront of their thinking.

In a recent memo to employees, Delta Airlines Inc. (NYSE: DAL) Chief Financial Officer Hank Halter pointed to the recent run-up in fuel prices as the biggest challenge facing the airline.

And in a recent conference call with investors, American Airlines CEO Gerard Arpey characterized the trend as "the most worrisome trend we see."

While Delta and American Airlines reported increased revenue for the fourth quarter, sales didn't rise quickly enough to offset an average 13% increase in fuel prices.

Delta reported in-line revenue of $7.8 billion but its operating profit missed Wall Street estimates. AMR, meanwhile, beat earnings estimates but its revenue merely met Wall Street forecasts.

In the face of dramatic fuel price increases, Arpey said the most "logical" first step would be to "raise your ticket prices."

In response to crude oil prices nearing the $100-range, most major U.S. airlines have rolled out three waves of fare increases since Thanksgiving.

And just this week, domestic airlines attempted a "significant" fare and fuel surcharge hike, MarketWatch reported, citing an anonymous source.

American was first in line to attempt the latest round of fare increases, raising its airfare by $4 to $10 a roundtrip on the bulk of its domestic route system. United Continental Holdings Inc. (Nasdaq: UAL), US Airways Group Inc. (NYSE: LCC) and Delta later matched the increase with fuel surcharge increases.

Additionally, JetBlue Airways Corp. (Nasdaq: JBLU) added a whopping $70 to $90 per roundtrip fuel surcharge for flights to Puerto Rico and the Caribbean.

That's more bad news for deal-seeking air travelers. Fees for things like checked baggage and blankets already have induced sticker shock on the traveling public.

Stormy Weather Hammers Revenues

Meanwhile, this week's winter storm is halting air travel throughout the United States, slashing the revenues of several U.S. airlines already weighed down by a massive wave of cancellations over the vital holiday season.

More than 5,000 flights, or roughly 20% of those scheduled nationwide, were canceled for a second day in a row Wednesday as a storm battered much of the country, The Wall Street Journal reported. More than 1,000 flights were canceled in New York and hundreds more were nixed in Dallas. Most importantly, Chicago, United Continental's biggest hub, was a no-fly zone.

A whopping 52,742 flights have been canceled at U.S. airports since Dec. 1, 2010, or 4.98% of those scheduled, according to FlightStats, a flight-tracking service. That's the most in five years for the same period and more than double last winter's rate.

"Other than September 11, I haven't seen it shut down to this degree at all. This has really been a major shutdown." Terry Trippler, owner of travel website Airlinerulestoknow.com told Reuters. Trippler said it would take several days for airlines to accommodate the thousands of displaced travelers.

Airlines usually build winter weather delays and cancellations into their annual budgets. But the kind of massive disruptions experienced this year can hit quarterly earnings hard as carriers lose business and struggle with higher operational costs.

"Given that the first quarter is always a tough one even in good years, a major storm that lasts several days and hits several hubs could make or break the quarter," John Heimlich, chief economist at the Air Transport Association (ATA), an umbrella group for U.S. carriers, told The Journal.

Delta, the second-largest U.S. carrier by traffic, recently reported that weather events in the first half of January alone would knock $30 million off its first-quarter profits. It also disclosed that December storms slashed its fourth-quarter profit by $45 million.

United Continental, the largest U.S. airline, said bad weather cut its fourth-quarter net income by $10 million. But that number could grow worse in the first quarter after Chicago was snowed in this week.

A Lost Decade for U.S. Airlines

Rising oil prices and the fierce winter storms are just the latest setbacks for an industry that has been struggling just to survive for the last 10 years.

Although U.S. airlines finished 2010 with nice profits, they have been threatened with extinction in nearly every year of the first decade of the 21st century.

Although 2010 "[was] a very satisfying year. It was an upbeat end to what I think most would agree has been a lost decade for the airline industry," Southwest Airlines Co. (NYSE: LUV) chairman and chief executive Gary Kelly said in a teleconference with analysts Jan. 20.

Only six of the 10 largest U.S. passenger carriers in 2000 are still in business. Trans World Airlines Inc., Northwest Airlines Inc., Continental Airlines Inc. (NYSE: CAL) and America West Airlines Inc. all have merged with other carriers.

UAL Corp., parent of United Airlines Inc., TWA, Northwest, US Airways, and Delta all filed for bankruptcy during the decade.

AMR avoided bankruptcy by radically restructuring in 2003, but has failed to turn a profit for most of the time since.

Only Southwest showed a profit for each year from 2000-2010. AirTran Holdings Inc. (NYSE: AAI), which cracked the top 10 early in the decade, came in second best, losing money in only two of those years. Southwest is scheduled to close a merger with AirTran in the second quarter.

Discount Carriers Shine

Stormy weather will come and go. But while the airlines focus on increasing efficiency and lowering operating costs, fuel price swings - up or down - will have the most influence on where fares, and profits, go from here.

Airlines might be able to cope with fuel prices in the $75-$100 a barrel range by making capacity adjustments, Ray Neidl, a senior aerospace specialist at Maxim Group, told InvestorPlace in a recent interview. But if prices exceed $100 a barrel, it will be much harder to pass increased costs on to customers.

On the other hand, if oil prices dip below $75, airlines could be motivated to increase capacity by bringing big, fuel-guzzling planes back into service, he said.

But even if oil prices surge, some analysts think the major airlines will benefit from the lessons they learned during the crises of the last decade.

Transportation economist George Hoffer, who teaches at the University of Richmond, said he is bullish on the prospects for U.S. airlines, particularly those with strong networks and international routes. That would include what he calls the big three - Delta, United and American.

The mergers of the past decade and the capacity shrinkage of the past two years have the airlines in good position for a strong decade ahead, Hoffer said.

"They may look like they've got problems with respect to fuel, but I think they end the decade on a real high. They have much more economic power. They have much more pricing power." Hoffer said.

Even so, the record for the big airlines throughout the last decade was dismal.

Those carriers, including AMR, Continental, Delta, Northwest, UAL, US Airways and America West, lost $66.7 billion during the 2001-2009 period.

By comparison, the low-cost carriers, including Southwest, Frontier Airlines Inc., AirTran and JetBlue, earned $3.3 billion as a group during the same period, with most of that - nearly $3.2 billion - coming from Southwest.

Investors who want to make a wager on the industry might want to spread their bets with the Claymore NYSE ARCA Airline ETF (NYSE: FAA). Keep in mind, however, the fund is not limited to U.S. airlines, but invests in carriers around the globe.

News & Related Story Links:

• Money Morning:
  Egypt Protests Could Lead to $150 Oil
• Bloomberg:
  Rising Oil Prices Threaten to Wipe Out Airline Industry Profit, IATA Says
• InvestorPlace:
  Airlines Face Turbulence as Fuel Costs Rise
• MarketWatch:
  Airlines hike fares, fuel surcharges
• Wall Street Journal:
  Weather Whacks Airlines' Revenue
• Reuters:
  U.S. airlines grapple with storm
• Dallas Morning News:
  U.S. airlines end a mostly down decade with a profit

The sales, "will make BP the smallest refiner among its international competitors," and reduce its total capacity by around a fifth, a BP spokesman said.

The Texas City refinery is BP's largest in the United States. In 2005, it was the site of an industrial explosion that killed 15 people while saddling the company with millions of dollars in fines from the U.S. government.

BP has already received inquiries from "competent operators" regarding Texas City, Chief Executive Officer Robert Dudley told reporters. The two refineries up for sale can produce a combined 741,000 barrels a day.  BP expects to get at least $4.4 billion from the sales, Iain Conn, head of refining, told Bloomberg News.

"The shrewd strategic move would have been to divest the refining completely as this would have provided a substantial cash injection, as well as remove a problematic and not very profitable business unit," Dougie Youngson, an analyst at Arbuthnot Securities Ltd. in London told Bloomberg.

"The re-introduction of the dividend is good news for investors, but it is likely to prove inflammatory to Gulf Coast Senators whose communities are still being impacted by the spill," said Youngson, who has a "sell" recommendation on BP.

BP's Dudley is repositioning the company into a "smaller" and "more agile" entity after his predecessor Tony Hayward lost his job following the worst spill in U.S. history.

BP expects production to be about 3.4 million barrels of oil equivalent a day in 2011, compared with 3.8 million barrels in 2010. Output fell 9% in the fourth quarter from a year earlier.

The lower production forecast comes as BP struggles to drill any wells in the Gulf of Mexico this year due to the stringent demands of regulators, a London-based analyst who did not wish to be named told The Wall Street Journal. BP could lose 80,000 barrels a day of oil production in the Gulf this year simply by not being able to drill wells on existing fields, the analyst said.

"2011 will be a year of recovery and consolidation as we implement the changes we have identified," Dudley said in a statement. "It will also be a year in which we have the opportunity to reset the company, adjusting the shape of our business," he said.

So far, the company said it has sold $22 billion of assets. BP will work harder to grow production from a lower base by increasing investment in exploration in strategic oil and gas properties by 10%.   Last month. BP agreed to an $8 billion share swap with OAO Rosneft to join a Russian Arctic exploration venture in the Kara Sea.

"The U.S. Gulf of Mexico has presented an opportunity to downsize and refocus on higher upstream returns and improved growth," Jason Kenney, an analyst at ING Wholesale Banking in Edinburgh told Bloomberg.

BP announced the restoration of the dividend even after its billionaire partners who own 50% of BP's other Russian venture, TNK-BP Ltd., filed an injunction to block the Rosneft venture.

BP said it would actively oppose the court action, which may delay the deal. TNK-BP accounts for 25% of BP's output and one-fifth of its reserves.

BP, Europe's second-biggest oil company, last year pledged to sell as much as $30 billion of assets to help cover costs from the spill. Dudley said yesterday that he would no longer be bound by that target.

Under pressure from President Barack Obama, the company also established a $20 billion fund to compensate victims. Kenneth Feinberg, the government appointee who is administering the fund, said in a Dec. 31 Bloomberg Television interview that it appeared that $10 billion may be "more than enough to pay all the claims."

BP was mostly responsible for decisions that led to the disaster, according to a report last month by The National Commission on the BP Deepwater Horizon Oil Spill.  But the report also cast blame on contractors Halliburton Co. (NYSE: HAL) and Transocean Ltd. (NYSE: RIG). Attorney General Eric Holder is heading up a civil suit and an investigation that may lead to criminal charges against BP and company officials.

BP reported net profit for the fourth quarter of $5.57 billion, compared with $4.30 billion a year earlier. Total revenue for the quarter was $83.99 billion, up 14% from $73.64 billion in the same period in 2009, the London-based company said in a statement.

BP's earnings were bolstered by higher oil prices and improved refining margins. Brent futures have gained more than 25% since the start of last year. BP's Global Indicator Margin, a broad measure of refining profitability, averaged $4.64 a barrel in the fourth quarter, up from $1.49 in the year- earlier period.

For the full year, BP recorded a net loss of $3.59 billion, the first losing year the since 1992. The losses were entirely attributable to the huge write off of costs for the Gulf of Mexico spill.  Total costs for the oil spill rose by $1 billion in the fourth quarter to total $40.9 billion, The Journal reported.

Despite the fall in adjusted profit, "BP remains significantly oversold," ING analyst Jason Kenney told The Journal. The new dividend payment is generous, but will give BP the financial flexibility to invest and grow, he said.

News & Related Story Links:

• Wall Street Journal:
  BP Resumes Dividend as Profit Rises 30%
• Bloomberg:
  BP Reinstates Dividend, Will Sell Two U.S. Refineries
• Money Morning:
  Is BP Dealing Away Its Future?
• Money Morning:
  Money Morning Mailbag: BP Stuck in Oil Spill Spotlight While Others Downplay Disasters
• Money Morning:
  Special Report: New CEO Dudley Isn't the Long-Term Answer at BP, Expert Says
• Money Morning Archives:
  Gulf Oil Spill

BP, the largest foreign investor in Egypt, began relocating workers, as did Russia's OAO Novatek and OAO Lukoi. Italy's Eni SpA (NYSE ADR: E) is repatriating 250 employees from Cairo.

Statoil stopped drilling yesterday (Monday) due to the growing political unrest, Baard Glad Pedersen, a company spokesman told Bloomberg News. Statoil has "a few dozen" employees in Egypt, he said.

Statoil in October started drilling with Transocean Ltd.'s (NYSE: RIG) Discoverer Americas rig in the El Dabaa area, west of the Nile Delta.

"Due to the uncertainty tied to the current situation and how long it will last, we've chosen to reduce activity offshore to a minimum," said Glad Pedersen. "We're in the process of halting drilling operations."

Meanwhile, Shell has evacuated "non-essential" staff and their dependents from Egypt, company spokesman Kim Blomley said Monday in an e-mailed statement.

"Given the development of events over the weekend, it was decided to temporarily relocate expatriate staff, dependents and some non-essential expatriate staff," said Blomley. "A number of senior and key personnel, including the Shell Egypt country chair, remain in the country."

Egypt has Africa's third-largest gas and sixth-biggest oil reserves. The country pumped 742,000 barrels of crude a day and 62.7 billion cubic meters of gas in 2009, according to BP data.

Egypt's oil and gas production based in the Western Desert, Nile Delta, and Gulf of Suez, has not yet been affected by the protests, according to western oil companies Bloomberg surveyed.

An estimated 1 million barrels a day of crude and refined products moved north through the Suez Canal to the Mediterranean in 2009, while 800,000 moved daily southbound into the Red Sea, according to the U.S. Energy Information Administration.

"The real concern from an oil and gas perspective is the risk of political unrest extending to other parts of North Africa," Bank of America Corp.'s (NYSE: BAC) Merrill Lynch unit said in a report.

The shares of oil and gas producers with operations in Egypt and North Africa dropped. BG Group PLC (PINK: BRGXF), fell as much as 1.4% in London. Eni, Italy's largest oil producer, fell by as much 1.7% in Milan.
Circle Oil PLC, an exploration company with fields in Egypt, Morocco and Tunisia, dropped for a third day, declining as much as 4.7% in London.

Investors continued to be concerned that the turmoil may spread to other countries in the Persian Gulf, which controls more than 50% of the world's proven oil reserves. Egypt's benchmark EGX 30 Index plummeted 16% in its last two trading sessions. The stock exchange was closed Monday.

Other big international companies outside the energy business also began to halt operations in Egypt yesterday but appear ready to resume production as soon as law and order is restored. Shipping in the Suez Canal remained unaffected.

Chemicals company Akzo Nobel NV, Dutch brewer Heineken NV (PINK ADR: HINKI), consumer-products giant Unilever NV (NYSE ADR: UL), Japanese automaker Nissan Motor Co. (PINK ADR: NSANY), French building materials company Lafarge SA (PINK: LFRGY) and General Motors Co. (NYSE: GM) were among companies suspending operations, according to The Wall Street Journal.

Lafarge's production in Egypt had been "temporarily stopped because of the situation," a spokeswoman for the company told The Journal. The company, which has six quarries and 62 ready-mix plants on top of six cement-production sites in Egypt, will resume production as soon as conditions in the country allows, she said.

Lafarge evacuated about 30 Cairo-based expatriates and their families on Sunday. It employs 8,172 workers in Egypt. Its Egypt operations account for about 4% of its annual revenue, The Journal reported.

Heineken suspended production, evacuated its 25 expatriate employees on private planes and instructed its local employees to stay at home. It wasn't clear when operations will be resumed or what the cost will be to restart them, a spokesman said.

SNS Securities analyst Richard Withagen told The Journal the country is Heineken's most important market in North Africa with estimated sales of more than $220 million (160 million euros). The brewer employs 2,040 people in Egypt.

News & Related Story Links:

• Bloomberg:
  Statoil Halts Egypt Well as Unrest Starts to Hurt Oil Industry
• Platts:
  Oil companies evacuate Egypt staff on safety concerns
• Wall Street Journal:
  Businesses Halt Operations in Egypt
• Money Morning:
  Unrest in Egypt Rattles Markets as Fed Keeps Pedal to the Metal

"Although no rating action is contemplated at this time, the time frame for possible future actions appears to be shortening, and the probability of assigning a negative outlook in the coming two years is rising," wrote Steven Hess, a senior credit officer in New York and the author of the report. The rating remains "stable," according to the report.

The warning from Moody's came on the same day that Standard & Poor's lowered Japan to AA- from AA, signaling that the ratings firms are stepping up pressure on the world's biggest economies to curb their spending.

U.S. debt has increased from about $4.34 trillion in mid-2007 to roughly $14.3 trillion currently, as the government supported a massive bailout of the financial system and spent trillions in stimulus money in order to bring the economy out of recession. The budget deficit has increased to 8.8% of gross domestic product (GDP) from 1% in 2007.

"Because of the financial crisis and events following the financial crisis, the trajectory is worse than it was before," Hess told Bloomberg News in a telephone interview.

A downgrade would significantly tarnish the world's faith in U.S. Treasury bonds. That would reduce the country's ability to borrow money on extremely favorable terms.

A credit rating tells lenders and investors how likely it is that a borrower will default on a loan. A "AAA" rating means there is little for lenders to worry about. That leads to lower borrowing costs, whereas a lower rating typically results in bond investors demanding higher interest rates to take on riskier debt.

Higher rates also can expand a country's overall debt burden, forcing the government to cut spending programs and raise taxes. That conundrum was recently demonstrated by the social unrest in Greece and Portugal, as citizens marched in the streets to protest tough austerity measures that directly reduced state welfare programs and entitlements.

Even the threat of a lower rating could lead international investors to avoid U.S. assets. About 50% of the almost $9 trillion of U.S. marketable debt is owned by investors outside of the nation, according to Bloomberg's analysis of Treasury Department data.

Moody's said it expects there will be "constructive efforts" to reduce the U.S. deficit and control entitlement spending. It predicted 10-year Treasury yields would rise toward 5% but not exceed that level.
"Other large AAA countries have plans to reduce deficits substantially over the coming few years, indicating that this trend may continue," Hess said.

Congress is currently bickering over whether to raise the debt limit above $14.29 trillion, which the Treasury estimates will be reached between March 31 and May 16.

The debate over the debt ceiling, which was increased a year ago, has grown more rancorous since the November elections, when Republicans won control of the House of Representatives.

Republican lawmakers have pledged to challenge the Obama administration on spending, and have told the president and Democratic legislators that they will insist on budget cuts as a condition of raising the U.S. debt limit.

Moody's warning comes only a few days after President Barack Obama's State of the Union address, in which he called America's current situation a "Sputnik" moment.

The speech caused consternation among analysts, including Money Morning Contributing Editor Martin Hutchinson, who analyzed President Obama's speech in a column last week.

"President Obama's fascination with the ‘Sputnik moment' goes way beyond rhetoric," Hutchinson wrote. "Just as the nation saw after Sputnik, President Obama wants to ‘invest' more taxpayer money in research, hoping to find a new industry or two."

During the hysteria surrounding the Sputnik scare, "Congress...embarked upon an orgy of public spending," Hutchinson wrote. "At a time of zero inflation, the federal spending total for the fiscal year that ended in June 1959 was a staggering 11.7% above that of 1958, the highest peacetime increase between 1949 and the inflationary year of 1976."

And in a two-part interview last week, Money Morning Chief Investment Strategist Keith Fitz-Gerald stressed debt reduction as a fundamental piece of an eight-part plan to fix the U.S. economy.

"There's a longtime axiom among professional traders: Big Government = Small Wallets. Pure and simple," Fitz-Gerald wrote. "There is no such thing as a multiplier effect and every government dollar spent actually replaces a dollar from the private sector. The very notion that the government can spend money more efficiently than private enterprise is badly flawed and robs this country of wealth at all levels."

News & Related Story Links:

• Bloomberg:
  Moody's Says Time Running Out for U.S. as S&P Cuts Japan
• Money Morning:
  S&P Slashes Japan's Credit Rating
• Money Morning:
  State of the Union: Why You Should Fear America's "Sputnik Moment"
• Money Morning:
  The Real State of the Union: A Rescue Plan for the U.S. Economy

"Although no rating action is contemplated at this time, the time frame for possible future actions appears to be shortening, and the probability of assigning a negative outlook in the coming two years is rising," wrote Steven Hess, a senior credit officer in New York and the author of the report. The rating remains "stable," according to the report.

The warning from Moody's came on the same day that Standard & Poor's lowered Japan to AA- from AA, signaling that the ratings firms are stepping up pressure on the world's biggest economies to curb their spending.

U.S. debt has increased from about $4.34 trillion in mid-2007 to roughly $14.3 trillion currently, as the government supported a massive bailout of the financial system and spent trillions in stimulus money in order to bring the economy out of recession. The budget deficit has increased to 8.8% of gross domestic product (GDP) from 1% in 2007.

"Because of the financial crisis and events following the financial crisis, the trajectory is worse than it was before," Hess told Bloomberg News in a telephone interview.

A downgrade would significantly tarnish the world's faith in U.S. Treasury bonds. That would reduce the country's ability to borrow money on extremely favorable terms.

A credit rating tells lenders and investors how likely it is that a borrower will default on a loan. A "AAA" rating means there is little for lenders to worry about. That leads to lower borrowing costs, whereas a lower rating typically results in bond investors demanding higher interest rates to take on riskier debt.

Higher rates also can expand a country's overall debt burden, forcing the government to cut spending programs and raise taxes. That conundrum was recently demonstrated by the social unrest in Greece and Portugal, as citizens marched in the streets to protest tough austerity measures that directly reduced state welfare programs and entitlements.

Even the threat of a lower rating could lead international investors to avoid U.S. assets. About 50% of the almost $9 trillion of U.S. marketable debt is owned by investors outside of the nation, according to Bloomberg's analysis of Treasury Department data.

Moody's said it expects there will be "constructive efforts" to reduce the U.S. deficit and control entitlement spending. It predicted 10-year Treasury yields would rise toward 5% but not exceed that level.

"Other large AAA countries have plans to reduce deficits substantially over the coming few years, indicating that this trend may continue," Hess said.

Congress is currently bickering over whether to raise the debt limit above $14.29 trillion, which the Treasury estimates will be reached between March 31 and May 16.

The debate over the debt ceiling, which was increased a year ago, has grown more rancorous since the November elections, when Republicans won control of the House of Representatives.

Republican lawmakers have pledged to challenge the Obama administration on spending, and have told the president and Democratic legislators that they will insist on budget cuts as a condition of raising the U.S. debt limit.

Moody's warning comes only a few days after President Barack Obama's State of the Union address, in which he called America's current situation a "Sputnik" moment.

The speech caused consternation among analysts, including Money Morning Contributing Editor Martin Hutchinson, who analyzed President Obama's speech in a column last week.

"President Obama's fascination with the 'Sputnik moment' goes way beyond rhetoric," Hutchinson wrote. "Just as the nation saw after Sputnik, President Obama wants to 'invest' more taxpayer money in research, hoping to find a new industry or two."

During the hysteria surrounding the Sputnik scare, "Congress…embarked upon an orgy of public spending," Hutchinson wrote. "At a time of zero inflation, the federal spending total for the fiscal year that ended in June 1959 was a staggering 11.7% above that of 1958, the highest peacetime increase between 1949 and the inflationary year of 1976."

And in a two-part interview last week, Money Morning Chief Investment Strategist Keith Fitz-Gerald stressed debt reduction as a fundamental piece of an eight-part plan to fix the U.S. economy.

"There's a longtime axiom among professional traders: Big Government = Small Wallets. Pure and simple," Fitz-Gerald wrote. "There is no such thing as a multiplier effect and every government dollar spent actually replaces a dollar from the private sector. The very notion that the government can spend money more efficiently than private enterprise is badly flawed and robs this country of wealth at all levels."

News & Related Story Links:

• Bloomberg:
  Moody's Says Time Running Out for U.S. as S&P Cuts Japan 
• Money Morning:
  S&P Slashes Japan's Credit Rating
• Money Morning:
  State of the Union: Why You Should Fear America's "Sputnik Moment"
• Money Morning:
  The Real State of the Union: A Rescue Plan for the U.S. Economy

At the same time, S&P said Japan's outlook is stable, citing the country's strong external balance sheet and the "flexibility" that comes from the yen's international role. Japan has the world's second largest foreign reserves at more than $1 trillion.

The S&P downgrade puts the world's most indebted nation's credit rating one notch below both Fitch Ratings and Moody's Corp. (NYSE: MCO) and on a par with China and Saudi Arabia. The new level is one notch below Spain.

The ratings cut may serve as a warning for heavily indebted developed nations that have increased their spending following the global credit crisis, leaving some in a fragile financial state.

Debt problems in Europe have already prompted financial bailouts of Greece and Ireland, and the U.S. budget deficit is expected to hit a record $1.5 trillion this year.

Japan has piled up government debt that now totals nearly 200% of annual gross domestic product (GDP). Politicians and credit ratings agencies have been calling for it to lower its public debt for years but the government's efforts have yet to yield meaningful results.

While Japanese Prime Minister Naoto Kan has made tax and social security reform top priorities, the S&P downgrade took a swipe at his party's inability to unify a divided parliament.

"In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country's debt dynamics," S&P said in the release.

Opposition parties seized on the news to again press the attack on the government.

Yoshimasa Hayashi, who serves as the shadow finance minister for the Liberal Democratic Party, told The Journal that S&P's action is "proof of what the LDP has been warning to government," adding that "we all need to take the S&P decision to heart."

Fitch Ratings said that it was maintaining its stable outlook on the basis that the current low interest rates would allow it to fund itself, although it noted that the longer-term pressures from an aging population could threaten funding stability.

The yen and bond futures fell on concern the downgrade would push up the cost of borrowing for Japan.

Markets in the past have not worried too much about the country's high debt because it is well serviced by ample domestic savings and few foreign investors hold Japanese government bonds.

However, Japan's population is aging quickly, so entitlement programs will soak up an increasing proportion of the budget unless the government implements painful reforms, which will further constrain Japan's already weak fiscal flexibility, S&P said.

Japan's government must fix its finances to avoid a debt crisis that could trigger a "global depression," Vice Finance Minister Fumihiko Igarashi said earlier this week.

"I hope this serves as a warning for the government, they have absolutely no sense of crisis," Azusa Kato, an economist at BNP Paribas in Tokyo told Bloomberg News. "Once bond yields spike and the fire is lit, the amount needed to finance Japan's borrowing needs is going to jump and it's going to be too late."

Economy Minister Yosano warned the same day that a reliance on such sales could lead to a jump in borrowing costs.

"If we continue relying on bond sales to make up for spending that exceeds revenue, we could see long-term interest rates increase or a deterioration in our debt ratio, causing Japan to lose credibility globally," Yosano told Parliament.

Japan's borrowing costs are among the lowest in the industrialized world, helping it fund its debt load. The yield on the benchmark 10-year bond touched 1.26% on Jan. 19, the highest since Dec. 16.

News & Related Story Links:

• Wall Street Journal:
  S&P Cuts Japan Rating As Budget Woes Linger
• Reuters:
  S&P cuts Japan sovereign rating
• Money Morning:
  Federal Budget Deficit Climbing Dangerously Higher on Continued 2011 Government Spending
• Bloomberg:
  Japan's Credit Rating Cut to AA- by S&P on Debt Load