News that corn, wheat and soybean prices have been climbing are now beginning to be seen in higher prices for bread, pizza and other food stuffs but the real story is rice. (http://www.earlywarningwire.com/rice.pdf) Rising demand from India and China and sharp price rises to over $24 per hundredweight have caused many producing nations to curtail exports. A story from Mountain View, California shows that Costco is limiting each customer to one bag of rice. More importantly we are witnessing recent riots in Haiti, Indonesia, Egypt and many African countries where the average person can not afford to purchase their main food staple. (http://nysun.com/news/food-rationing-confronts-breadbasket-world) Economics 101 tells us that price rises are always followed by increases in supply but growers wont be able to switch crops to rice until next year. This mornings UK Independent newspaper makes an important point that cutting exports does nothing except drive prices higher. (http://www.independent.co.uk/news/business/comment/stephen-king/stephen-king-food-protectionism-could-provoke-a-crisis-on-a-par-with-1970s-oil-shocks-812753.html?r=RSS). Finally good news from a speech given by Energy Secretary Bodman on Friday (4/18) on the future of biofuels. (http://www.energy.gov/news/6165.htm) The key quote that might show a change in administration policy: This means moving away gradually from ethanol produced from food stocks like corn. If the government lowers its subsidy to ethanol producers it could have a dramatic effect on the price of corn, wheat and other food stuffs. Food price inflation is painful in the short run but in the long run it will cause massive DEFLATION as consumers are spending more on food & gasoline and less on other items.
A major decline in the value of the British Pound (versus the dollar) to the $1.80 level. With oil reaching record highs ($117 today) the pound has held above its critical 1.95 level. This morning the Bank of England announced a special liquidity scheme (why did they use that word?) that will provide almost a $100 billion in funds for the now frozen British mortgage market. (http://www.bankofengland.co.uk/markets/money/marketnotice080421.pdf) Similar to the plan announced by the Fed a few weeks ago, the BOE will swap UK Treasury Bills for mortgages held by lenders and banks. Very little attention has been given to the rapidly deteriorating British economy but much like early last year when the experts told us the mortgage mess was confined to subprime we will soon be hearing that the British economy is sinking like the US.
Every Thursday the Fed releases its H.4.1 report (http://www.federalreserve.gov/releases/h41/Current/h41.pdf) which shows the amount of Treasury holdings has declined to $548 billion. Yes, that is a lot of Treasuries but this amount was over $800 billion a couple of months ago. The Fed is hoping the financial system recovers before its Treasury holdings reach zero as a worldwide panic would be created if the Fed asked the US Treasury to issue new securities for the purpose of loaning them to banks in need of liquidity and capital.
Another inflation scare?
Inflation concerns are growing as oil reaches the $120 level and rice soars to painful levels for many around the world. Long term interest rates are rising along with US stock prices as our predicted counter trend rally picks up steam. Inflation expectations have economists worried but digging inside the US Treasury 10 year note (3.83%) finds actual bond traders driving rates higher because of an expectation of economic growth NOT future inflation worries. The chart shows the yellow line (inflation expectations) in a very steady range over the past four years and at todays 2.32% level over 40 basis points away from their high of 2.72% (2005). The blue line is the actual 10 year rate and the pink line represents the expected growth rate of the economy (1.51%). If inflation were a real worry the yellow line would be rising quickly to new highs above 3%, bond players dont wait for CPI stats they sell first and ask questions later. Why have long rates risen in the past two months? Its about changing expectations of US growth. In the spring of 2007 when long rates reached 5.30% I warned that it was a fake out as inflationary expectations were not rising with nominal rates. Early this year when the 10 year reached 3.32% on January 22nd I sent an urgent e-mail to my daily subscribers that rates had seen their lows for this year as inflation expectations were NOT falling with nominal rates. We are currently in a trading range for interest rates with rallies driven by an increase in economic growth expectations and declines led by fears of an accelerating recession. The bulk of the $$$ has been made in this bond bull market but it is way too early to even consider a substantial bet on higher long term rates. This weeks Barrons polled 120 large money managers for their opinions on the performance over the next 6-12 months for different asset classes. 3.3% felt long rates would decline while 62.2% forecast higher rates. Too much money is being wagered on higher rates and as usual the majority will be wrong as rates will remain in a trading range for the remainder of the year.
Credit = oxygen for the US economy
Every Friday afternoon the Fed releases its report on the assets and liabilities of commercial US banks. When reviewing last weeks report you will see that real estate loans have clearly peaked and represent over 50% of all loans in the US. Commercial and Industrial loans continue to rise but due to a fear that credit will become unavailable soon and thus it is better to borrow today than be shut out tomorrow. Fed head Bernanke has told Congress and anyone else listening that credit is the life blood of the economy and without growth we are sure to see negative GDP numbers and a very severe recession. I have written all year that you cant lend what you dont have and the Feds biggest problem today is not the cost of money but finding a way to force the banks to lend $$$ they dont have..A positively sloped yield curve will increase profits as banks borrow short and lend long but that takes time and the Fed is painfully aware of the short fuse remaining on our credit structure. Many are asking the Fed to raise short term interest rates to defend the dollar and help cap rising inflation. Doesnt anyone remember the results in the late 20s and 1987 when Fed policy was focused on our currency to the exclusion of everything else? It is often said that history repeats itself but in this case I hope our leaders realize that following the herd is not the answer to resolving our most serious economic problem in over 70 years.
The yield curve
Rarely does a bull market give investors a 2nd chance to enter at attractive prices but the recent pullback in the 2yr-10yr. Treasury spread to the 140-150 level offers an attractive risk/reward ratio for those that did not enter earlier this year. Unless the Fed completely changes course and begins to increase short term rates the yield curve should widen to the 250+ level over the next 12 months. The best way for the Fed to assist increase capital is through a positively sloped yield curve and that continues to be my #1 best bet for the remainder of 2008.
Follow the yen
If you have only one minute per day to follow the financial markets then make sure you know the value of the Japanese yen. This has been the best predictor of almost all financial trends for every day this year. If the yen is falling in value stocks and long term interest rates are rising and if it is rising in value then stocks and long term rates are falling. Yes it really has been that simple and as they often say the trend is your friend until broken. With the yen resting comfortably at the 104.5 level and appearing to be ready for an assault over the key 105 level stocks and rates should continue to rise over the intermediate term.
Jobs and the economy
The focus has been entirely on the Fed and lack of liquidity in the financial system but Fridays (5/02) monthly jobs report will have markets attention as this lagging indicator shows more weakness. Its an election year and the rising unemployment rate will cause concern but its a sure bet that a 6-7% rate will be seen in the next 12-18 months. We do have 50 states and recent stats from Louisiana and Texas show a rising employment trend which should soften the blow from the overall US economy.
The mortgage market continues to shrink
History shows that increased regulation always follows a market that innovates faster than the economy can tolerate and I fully expect the wholesale residential mortgage market to disappear by the end of 2009. Its too easy for the government to blame the brokers and with the Fed needing to have better control over lenders the retail model for lending will be back in the forefront sooner than later.
Summer has begun
The last six months have seen extreme volatility from stocks, rates, currencies and commodities. Markets tend to go in cycles with a relative calmness following a period of hyper activity and I expect the next six months to be marked by a lessening of the fear we saw this past winter. Oil will soon slow its rate of advance (seasonally April is the 2nd strongest month of the year) as the economy begins an adjustment to a much slower rate of growth. Home prices will begin to bottom before the next leg down and everyone will look back upon this year as the last chance to exit many investments and build cash for opportunities that will be present in 2010 and beyond but NOT in the real estate arena. Remember the financial gods owe us nothing and frequently penalize those who stay too long and expect history to always repeatit does but not when we expect it.
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