EARLY WARNING WIRE

U.S. INTEREST RATES AND ECONOMIC INTELLIGENCE

November 30, 2007

Treasury rates fell this week but other short-term rates rose and this is causing a major problem in the credit markets. The Fed is faced with its biggest problem in over 80 years. My daily subscribers have the answers every night. Would you like this kind of up to the minute information delivered five nights a week (Sun-Thurs) at 10pm? The cost for this daily e-mail is only $251 and you will receive every update through 12/31/08. Just complete this form (http://www.earlywarningwire.com/Interest%20Rate%20Email%20Flyer.pdf) and fax or mail to my office.

The Deflation monster will be visiting the US in 2008

Interest rates fell slightly this week with the 2-year and 10-year falling six basis points. A normal week for the bond market? Not even close as beneath the surface problems are growing rapidly and they are centered around the three month Libor rate which has risen for 13 consecutive days and closed today at 5.13%. One month ago (10/30) the Fed Funds rate was 4.75%, the 2-year at 3.81% and the 10-year at 4.38%. The Funds rate was reduced on 10/31 to 4.50% and surely will be lowered by the Fed at its next FOMC meeting (12/11) by at least 25 bp. In the last 30 days the 2-year has fallen 80bp and the 10-year 44bp but the most important rate for borrowers (Libor) has risen 22bp. Corporations and individuals don't borrow at the Treasury rate as these rates are reserved for obligations issued by the US government. Everyone else borrows at rates that are tied to other indices with the vast majority ($150 trillion) linked to the Libor rate. When the Fed lowered the Funds rate on 10/31 it was done with the intention of lowering other lending rates including Libor. It does NOT control market rates so at best it can hope and pray other markets follow but if they don't.......BIG trouble follows.

The Fed is aware of the problem but...

The actual level of interest rates doesn't matter if lenders won't or can't lend and this is what the Fed has now begun to realize as we saw in three important speeches this week. Wednesday Fed Vice Chairman Kohn said, http://www.federalreserve.gov/newsevents/speech/kohn20071128a.htm "Term interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rate-like libor-and the expected path of the federal funds rate.....The spread is one development we have factored into our easing actions."

More importantly Mr. Kohn addresses the commercial finance market with: "The key question for the Fed is what is happening to credit for other uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?"

Mr. Kohn told us the Fed is aware of the Libor problems but added a significant new twist to the Fed's dilemma....commercial finance. The economy can grow with a stagnant real estate sector but credit is the oxygen that allows business to grow and when a company can't find financing for its everyday needs we are looking at a very serious economic setback.

Thursday afternoon Fed Chairman Bernanke told the world http://www.federalreserve.gov/newsevents/speech/bernanke20071129a.htm
"The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing) and increased short-term funding pressures."
He added that “the Fed is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy."

Mr. Bernanke confirms Kohn's remarks and alerts us to current Fed thinking two weeks from the next Fed meeting. The only tool they have is the Fed Funds rate which now stands at 4.50%; they don't control fiscal policy (taxes and spending) and they can't loan money to banks without sufficient collateral. Unfortunately what worked for the past 80+ years doesn't seem to working anymore as the interest rate markets are moving without the Fed.

Today the St. Louis Fed President gave a speech http://stlouisfed.org/news/speeches/2007/11_30_07.html titled "Market Bailouts and the Fed Put" which addressed many of the issues this letter has brought to your attention over the past few months. The best quote of the speech and probably the month for the Fed was: “Whether further cuts in the Fed Funds rate target will alleviate financial turmoil, or risk adding to it, is always an appropriate topic for the FOMC to discuss."
Please take a few minutes tonight to read Mr. Poole's speech and you will have a much deeper understanding of the economic storm that is in front of the Fed.

I have written extensively that the Fed often uses the stock market as a barometer for the perceived health of the economy. Mr. Poole disagreed with my theory with the following quote: "It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices." I believe this is ideally what the Fed would like to accomplish but in reality the last 20 years have shown the opposite mainly due to former Greenspan's tendency to ease before the economy's decent reached high speeds.

These three speeches clearly show the Fed is faced with a most difficult decision. If they continue to lower the Funds rate and Libor does NOT follow, the market's will panic upon realization that the most powerful central bank in the world has lost its ability to influence money markets. If the Fed keeps the Funds rate at its current level (4.50%) it risks a complete collapse in the lending market and we are already on our way...Heads they lose and tails they lose so the answer is the government must assist the efforts through loan guarantees to banks and creation of an entity that will purchase these commercial loans because the banks don't have the room on their balance sheets to retain them. The Fed needs help as it lowers the Funds rate and without it the U.S. economy will suffer the worst economic contraction since 1932.

Upcoming news

Normally the Fed would be focused on economic indicators that are released weekly by various government agencies. Friday, December 7th at 5:30am we have the very unstable and often revised jobs report. The consensus is a 75,000 gain but it is a lagging indicator and tells us what happened in the past and should almost never be used as a leading indicator. We will hear from more Fed governors and presidents next week but Bernanke and his fellow FOMC members have set the tone and alerted the world that there is a serious problem and they may not be able to help. The stock market rallied this week on the fact that past Fed easings have led to economic turnarounds but I'm not sure the past is a good indication of what we will see in 2008.

Interest rates

Early Monday morning (11/26) the 10-year reached 3.80% which is only 10bp away from my long quoted target of 3.70%. The yen continues to lead the stock market and the bond market moves almost perfectly with every move from stocks. This relationship has been solid for many weeks and should not be dismissed until it actually breaks down. The Fed will continue to ease (it has no choice) and we will have a very nice relief rally in the real estate market after January 1st as many give up all hope and sell before the end of this year. The small uptick in property prices will convince many that a bottom has been reached and the worst is over for this cycle. 2008 will prove to be a ledge not a base for those buyers who of course only see the future from their own past experiences. For those that did not sell or liquidate their holdings in the past year it will be another opportunity to turn assets into cash which will be the big winner next year.

Conclusion

Conditions have worsened in credit markets as borrowers scurry around trying desperately to find a lender that has funds it is willing to lend. Credit contractions are DEFLATIONARY and 2008 will bring a drop in prices and asset values accompanied by a strengthening dollar. This is exactly the opposite of what we read in the press but you could also say the same thing about everything I wrote early this year....lower interest rates, slowing economy and the beginning of a long, slow painful bear market for real estate owners, borrowers and lenders.

99.9% of people would rather lose in company than win alone and hopefully my readers represent the 0.1% who are brave enough to follow my forecasts and avoid the carnage in the US economy next year.

Posted by BRENT ZELT on December 5th, 2007 3:12 PMPost a Comment (0)