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.
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.
The information below indicates trends and is not a predictor of what rates are going to do in the future. You might tend to agree or disagree with the information below. This is not Cypress Mortgage's opinion nor my opinion. Many of us look at trends and have established opinions of our own, supplying data to back up your opinion is important and here is some data that supports these observations.
The biggest cruise liner in the world has a gaping hole that Captain Bernanke and his Fed crew are desperately attempting to cover and keep the ship from sinking in the stormiest seas we have seen in last 70 years. The events of the past week remind us that hope is not an answer when events cause us to believe recent history will repeat thus giving us certainty for the future. The experts continue to predict the future of our economy from their own experiences in the late 70s through the 90s but you almost never hear anyone offer a view from the 30s or earlier.Non ow us are old enough to remember the last depression or the big depression of 1837. Yes it is easier to forecast the future from our life experiences but often it doesnt allow us to see similarities to a previous era. The Fed is clearly in uncharted waters and Captain Ben is trying hard to steer a path to calmer waters but sometimes listening to the views of a crew that has far less experience that leads to direction changes and moves that are always a step too late.
The buzz word for 2008 has become moral hazard, preventing a party from suffering the risk from a poorly timed investment. Whether it is a child that needs to learn one of lifes important lessons or investors that took too much leverage seeking high returns if the risk of loss disappears the decision making process is irreparably harmed. The Fed is always leery of coming to the rescue of its member banks unless the consequences of no action are too great to the economic system. Sunday we saw the end of Bear Stearns as the Fed injected $30 billion of guarantees into JP Morgan so they could survive with all of Bears liabilities. Is this a historic event? Yes, but probably not the end of the extraordinary actions by the Fed and/or the US government. Although memories are short, history has shown our government has always prevented the biggest from failing (Continental Illinois Bank) and thus contained further damage to other banks. Former Fed Chairmen Volcker and Greenspan were quick to take action and built reputations on their gut instincts that were translated into mostly positive results. Our current chairman is a brilliant historian but is picking up his hard experiences early in his term and desperately needs to jump out ahead of the crowd instead of reacting to fires that are coming close to burning the building to the ground. Fridays Fed move that was to allow Bear a financing outlet (JP Morgan) for its mortgage collateral never got off the ground as Bear had an old fashioned run on the bank and by nightfall was ready for bankruptcy or bail out. Obviously Captain Ben was a step behind in realizing the severity of the liquidity crises as Bear couldnt obtain overnight financing for its mortgage collateral. It appears that Ben is focused on the high seas around his ship instead of the storm that is creating the daily waves. Liquidity is the ability to create cash from the borrowing against or sale of assets. The Fed has created lending facilities for banks and now primary dealers to borrow against mortgage securities. BUT the Fed is not fighting the bigger storm which has long term DEFLATIONARY implicationslower asset values. The prices of homes and commercial properties (soon) are declining and that is creating a spreading fear among lenders and borrowers. A bank will loan money against an asset that is rising or stable in price but falling prices create a domino effect on the value of the underlying loan. The Fed is chasing its tail by focusing on the debt side of the balance sheet and must step up in a major way and inject capital on a permanent basis to the twins (Fannie and Freddie) and through the purchase of mortgages that will be held until maturity or default. If the price of a security is determined by demand and supply, a Fed purchase of mortgages will dramatically reduce the supply thus driving up debt prices and lowering yields. Reducing the overnight Funds rate to 0.00% (Japan) may not translate into lower long-term rates as they are influenced by inflationary expectations and an expected real rate of return. A Fed move before the markets make it a requirement would see a massive stock market rally followed by dramatic increase in the dollar (big short covering). Moral hazard is an important issue in a normal healthy economy but if the Fed continues to worry who caused the accident before deciding whom to help we will soon find us in the third great US depression.
Much has been written about the dollars slide over the past few months but today is a good example of the media overstating the facts as a worldwide panic out of stocks into US Treasuries yesterday morning appeared to also include dollar selling. But a look under the hood shows us the only currency rising against the dollar was the Japanese yen as the carry trade continues to be unwound by those who borrowed yen at low interest rates to buy higher yielding currencies. Trends tend to stay in motion longer than anyone expects and causes major financial problems for those that try and predict a change in the major trend. The yen has been the #1 best predictor of US stock and bond movements for the past 1+ years and a strong yen has led to lower US stock prices and interest rates. With the yen trading tonight at 97.43 you would expect intervention from the Bank of Japan if the yen reaches the 90 level and would not expect a significant stock market rally unless we see yen weakness back above the 100 level. Why fight a perfect correlation? Until worldwide hedge funds liquidate all of their carry positions the yen trend is a traders best friend. For those that believe the US is suffering from a withdrawl of foreign funds note stats that were released yesterday morning showing net foreign purchases of $37.6 billion of US Treasuries in January with over $36 billion coming from central banks. Brazil was the largest buyer ($10.3) followed by China ($9.6), Norway ($8.4) and Japan ($6.4). Each one of these countries has seen its currency rise sharply against the dollar in the last few months. Dollars that are being sold to these countries are being re-circulated through purchases of Treasuries neutralizing the effect of a weak US dollar.
In your first issue of the year on January 8th of this Interest Rate Update the forecast was a widening yield curve to be the best bet of the year. With the spread between the 2 year and 10 year Treasury notes now trading at 196 basis points we should see more Fed easing push the spread to the 250bp level. With $140 billion in rebate checks coming in the next 60 days you can expect a bounce in economic activity and consumer spending. It will appear to most that we have bottomed and real estate agents will be breathing a sigh of relief that they have weathered the worst storm in history but bear markets dont end that quickly and another leg down will visit in 2009. The inability to be objective because one cant short real estate will be the most painful lesson learned this decade for those that sell homes.
The good news is that the Fed appears to be waking up to the fact the US economy has entered a recession but the bad news is that if they dont change course we will be entering the deep waters of a great depression similar to 1837 and 1932. The level of interest rates is irrelevant if the banks dont have the $$$ to lend due to shrunken balance sheets and massive losses from the mortgage mess. Recent temporary solutions of increased lending facilities and lower short term interest rates are band-aids that are keeping the patient alive but its time for a permanent (capital) blood transfusion to put the country back on the right course.
The information below indicates trends and is not a predictor of what rates are going to do in the future. You might tend to agree or disagree with the information below. This is not Cypress Mortgage's opinion nor my opinion. Many of us look at trends and have established opinions of our own, supplying data to back up your opinion is important and here Is some data that supports these observations.
The Fed, Wall Street and Sesame Street The Fed does NOT control the level of long-term interest rates. The Fed does NOT control the level of long-term interest rates. The Fed does NOT control the level of long-term interest rates. The Fed IS able to change the rate of the overnight Fed Funds rate and today lowered the rate by 50 basis points to 3.00%. The overnight Funds rate is very important to banks as it represents the price of money borrowed from other US banks for one night. In the past 8 days the Fed has lowered this rate by 125 basis points from 4.25% to todays level of 3.00%. Unfortunately for corporate and individual borrowers the 10-year US Treasury rate has risen in the same 8 day period with a move of 20 basis points from 3.44% to todays level of 3.64%. The Fed would rather have long-term rates following the Funds rate lower but long rates are influenced by inflationary expectations NOT the overnight Fed Funds rate. This is frustrating and confusing for the typical mortgage borrower as press reports of Fed action always lead to expectations of lower long-term rates. The long end of the US government bond market was judge and jury for the Fed in the early 80s when the Fed was lead by inflation slayer Paul Volcker. At todays rate of 3.64% the 10-year is composed of an inflation expectation component of 2.31% and a real expected growth rate of 1.33%. On the surface these rates seem normal but when we review the last few weeks of market activity it becomes obvious there is a growing problem that the Fed will soon face when deciding upon future changes in the Funds rate. On December 26th with the stock market at much higher levels the 10-year was trading at 4.28% with the inflation component at 2.35%. Today we are 64 basis points lower but the inflation component has fallen only 4 basis points. The stock market is lower, the Fed has cut the Funds rate by 125bp but inflation expectations are unchanged. Would former Chairman Greenspan have eased this much in such a short period of time? With the Funds rate at 3.00% the Fed doesn’t have much more room to maneuver and the closer we get to 0.00% the more the markets will begin to worry that the Feds ammunition no longer has the effect on the economy it had in the past 25 years.
Three weeks ago you read here in the Interest Rater Update about the best bet for 2008 with the spread between the interest rate on the 2-year versus the 10-year widening to much higher levels. On January 7th this spread was 108 basis points. Today that spread is at a new high of 151 bp for the year with the 2-year at 2.13% and the 10-year at 3.64%. This spread will widen dramatically if inflationary expectations continue to rise while the Fed continues its easy money policy. The Fed has a dual mandate of economic stability and low inflation but they seem to be focused entirely on an impending economic contraction. You must be very concerned that the Fed has lost its leadership role and is now playing a game of follow the leader as it changes the Funds rate based on declines in the stock market. Can you picture the popular PBS children’s show Sesame Street where Big Bird leads the neighborhood children on a merry march to visit his pals. Of course everyone is happy and singing and that seems to be where Big Ben sits tonight as the stock market leads the Fed to the destination (lower Funds rates) it desires. While Wall Street leads the Fed, the bond market has begun to bristle because lending money to the government is only a good investment if the interest rate is higher than inflation until final maturity. The Fed is totally focused on improving banks profitability so balance sheets can grow enabling banks to lend money again to its best borrowers.
Fridays jobs number is important because last months weak number sent the stock market tumbling and bond prices soaring and forced the Fed into panic mode. Expectations (based on todays ADP report) are for an increase of 150,000 which would send those predicting an imminent recession back into the hole they were hiding in before last months report. The government is notorious for huge revisions to these reports but Fridays report is for January and that has been the one month of the year where the seasonal adjustment number (birth/death model) has been negative. The markets are not set up for a disappointment in the number and any decline in the 10-year towards the 3.50% is the signal to lock.. The weather in January was unusually warm in most parts of the country but this shouldn’t have too much positive effect on the jobs number.
The Pound continues to act weak considering the Fed is easing and thus widening the spread between British and US short-term rates. A few minutes before yesterday's FOMC announcement the Pound was at 1.9854 and now is trading at 1.9850 after bouncing to 1.9950 after the Feds announcement. A great rule that has stood the test of time is when a market doesn’t rally on good news (Fed cut) it is going to fall fast on any other news and continue to expect a dramatic fall for the Pound this year to the 1.80 level.
Yesterday the House passed a bill that would raise the conforming limit from $417,000 to as high as $729,750 in expensive home areas. This increase would expire on December 31, 2008. The Senate has yet to pass anything that there will be a conference committee that will ultimately decide the fate of this provision or initiate a completely different limit level. Be careful because long-term rates may be higher and the value of many houses have fallen to levels that make it impossible to refinance. The key to a housing bottom is NOT interest rates; rather the availability of credit and a perception that prices have stopped falling.
The yellow flag is flying as a cautionary sign to everyone that 2008 will not be an easy one for those who need long-term interest rates to hit new lows. The Fed is done for now but unless Big Ben stops following Big Bird long rates will rise thus increasing the spread between long and short-term interest rates. This is great news for banks (big profits) but bad news for an economy that needs the oxygen of credit to have any chance of avoiding the worst economic contraction since 1932.
U.S. Treasury notes gained, pushing two-year yields to the lowest since April
2004, on speculation the Federal Reserve will keep cutting interest rates to avert
a recession in the world's largest economy. Benchmark 10-year yields dropped to
the lowest since June 2003 as European stocks and futures on U.S. stock
indexes declined, prompting investors to seek safety in government debt. The
Fed's decision yesterday to slash the target for overnight loans between banks to
3.5 percent pushed notes to the biggest rally since the aftermath of the Sept. 11,
2001, terrorist attacks. The two-year Treasury yield fell 13 basis points to 1.85
percent as of 9:15 a.m. in New York. The price of the 3 1/4 percent security due
December 2009 rose about 1/4 to 102 21/32. Benchmark 30-year yields touched
4.101 percent. Ten-year note yields dropped 11 basis points to 3.3 percent. Twoyear
notes yielded 1.45 percentage points less than 10-year securities. The
steeper yield curve indicates investors favor shorter-maturity debt in anticipation
of lower interest rates.
The Dow dropped 366 points last Friday and the 10 year Treasury note fell to 4.39%. Fed Chairman Bernanke gave a speech titled "Monetary Policy under Uncertainty." Everyone is confused except us as rates continue to decline as predicted earlier this year. Investors would rather lose in company than win alone and the majority were caught this week on the wrong side (again). Have rates reached their lows for the year? Will the Fed lower short term rates again? The only way to find the answers to these questions is to read it in this Interest Rate Update (Economic Intelligence) .
The most frequent topic of financial commentators the past few weeks is whether the US is going to enter a recession. The question is: Does it matter? If you knew we were entering a recession what would you do differently? What is a recession? Does the President of the United States come on television and address the nation? Read further to address all of these questions but the answers really don't have anything to do with your finances. All year in this newlettter the favorite phrase for 2007: "We only see life through our own experiences". Markets are supposed to anticipate economic events and yet this year it has done just the opposite and been the caboose for the economic train that is crashing and will soon resemble a scene from the early 1930's. The term recession is used to designate an economic slowdown and is generally, but not always, accompanied by two consecutive quarters of negative real (inflation adjusted) GDP (Gross Domestic Product). The NBER (National Bureau of Economic Research) ( http://www.nber.org/cycles/recessions.html ) is the "official" arbiter of this overused description of the economy. Due to massive revisions of government data it is often a couple of years before the term recession is attached to a past economic cycle and is of no use to anyone except historians or those seeking a term to describe their own personal financial pain. If you are in the residential real estate market you realize recession is too soft a term and the word depression is more appropriate. If you are in an export business recession is not in your business model as you dream of finding more workers. The next time you hear a financial commentator ask his or her guest whether the US is entering a recession feel free to scream at the TV: "Why does it matter and what would you do about it?" You won't get an answer but it will help you realize that the answer is irrelevant to you and the future course of the US economy.
Last Friday morning Fed Chairman spoke (via teleconference) to a St. Louis Fed financial conference. ( http://www.federalreserve.gov/newsevents/speech/bernanke20071019a.htm ) The title of his speech tells us everything we need to know about current Fed thinking, "Monetary Policy and Uncertainty." His remarks were generally about Fed history but he chose the title knowing world financial markets would easily see his current state of mind. Friday's stock market decline of 366 Dow points was caused in part by the realization that the Fed doesn't know what it will do on October 31st (next FOMC meeting) and is having difficulty forecasting where we are going.....total confusion just like the 1970s Temptations hit song titled "ball of confusion". Monday evening (10/15) Mr. Bernanke told the Economic Club of New York ( http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm ) that the Fed was concerned about an unusually high Libor borrowing rate (today at 5.15% for 3 month Libor). The Fed lowered the Funds rate by 50 basis points on September 18th but that only assisted banks as most corporate and real estate variable rate loans are tied to Libor which is normally 10 bp above the funds rate. The Fed was hoping to reduce the market based Libor rate but so far that has not occurred and was noted by Mr. Bernanke with the following quote: "Interbank term funding markets have improved modestly, though spreads there remain unusually wide." The US economy also has Mr. Bernanke confused as we heard with this comment: "It remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions." It is no coincidence that as world financial markets began to realize the most powerful central bank in the world was seeking direction bond prices rose and stocks fell. Markets always rise when the information flow is clear and understood even if the news is bad but confusion creates fearful sellers and that is why Friday's action was so violent. (Dow down 366 and 10-year interest rate down 10bp to 4.39%.
One of the main reasons Fed monetary policy has been behind the curve for most of 2007 comes from the enormous data their staff analyzes on a daily basis. Early in the year they told us the mortgage mess was temporary and would not spill over to the general economy. The stock market's decline in February was short lived and buyers stepped in with both hands driving the market to new highs. Always have faith in the Fed was a mantra we learned from the Greenspan era (1987-2006) and it always paid off well at the cashiers window. Since we only see life as we experience it stock investors are only too happy to be rewarded from buying on weakness and seeing immediate profits. In the summer we again saw a nasty stock decline that was again met with buyers with hopes that the Fed was always right and if needed would lower short-term rates that would support the economy and stock prices. This again turned out to be prescient as stocks recovered quickly and rose to new highs a couple of weeks ago. Two for two is 100% and this week's stock decline should again bring out the buyers whose memories are high on success and low on fear. Is it really that easy? Maybe not as the Fed is confused and faced with a dilemma that has no easy solution. Normally when interest rates fall we see the economy slowing and inflation falling but this month we have a fight with no clear winner (yet) to drive the Fed in the correct direction. Last Thursday we saw the price of oil reach $90 per barrel in Asian trading as demand from hedge funds, speculators betting on turmoil in the Middle East and those caught on the wrong side of the market propelling this most precious commodity to new daily highs. We have not seen a similar rise in the price of gasoline but if oil holds at these levels for a few weeks it is a certainty that a gallon will surpass $3 and then rapidly ascend to $4. Consumers don't buy oil they purchase gas for their cars and that is why there has not been an outcry from Congress which always reacts too late to fix the problem. Could Congress create a realistic solution but with next year's election it is certain every candidate will try and fix the problem with an impossible solution. Gasoline is a non-discretionary purchase for most consumers and price increases generally don't move buyers to cut back unless the price levels remain for many months/years. We have virtually the same situation with grain prices as a drought in Australia and strong demand from China and India have sent wheat prices to record highs. These commodities are also non-discretionary and these price rises have many fearful of a rise in inflation. A falling dollar that has our exports rising and trade deficit narrowing has others worried about import price inflation. But, and its a big but, we now have asset prices declining (stocks, mortgages, etc.) and this is deflationary leading to credit contraction as the mortgage mess has investors worried about the value of securities that were market to model instead of market to market. As a side note the Financial Accounting Standards Board announced this week they will not delay the implementation of FAS 157 which will require companies to value their investments based on market value even if they are going to hold until maturity. ( http://www.cfo.com/article.cfm/9985407?f=most_read ) The Fed is caught between two strong forces and is trying to straddle between them but that is causing confusion in world markets. They must make a bold move and acknowledge that the economy is weakening fast and with a declining stock market and an upcoming rise in gasoline prices they will have the cover they need to show the world they are back in the drivers seat of their Humvee and will make sure passengers will arrive safely at their destination.
Capital One announced a loss for the third quarter of $81.6 million due to closing Greenpoint Mortgage. These results are not surprising but inside the report was a disturbing report that gives us a clue about future consumer spending. ( http://www.washingtonpost.com/wp-dyn/content/article/2007/10/18/AR2007101802454.html?nav=rss_business ) They reported an increasing number of delinquencies and defaults in both the credit card and auto finance sectors.
From Phoenix, Arizona comes the report that third quarter apartment occupancy rates fell to 91.2% from 95.4% a year ago due to a glut of single family homes that aren't finding buyers so the sellers are attempting to rent at any price. ( http://www.azcentral.com/business/articles/1018biz-renters1018.html ) In Shasta, California we see RE developers taking homes off the market and turning them into rentals. ( http://www.redding.com/news/2007/oct/15/its-not-a-good-sign-when-the-home-builders-start/) It's called deflation and will soon show up in lower owners equivalent rent in the monthly CPI.
From Sacramento and San Francisco we see stories about pending lower property tax bills for homeowners. ( http://www.sacbee.com/101/story/434423.html )( http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/10/14/BUDGSP2P3.DTL). From Maryland we have the Governor proposing a legalization of slot machines to cover a $1.7 billion shortfall in the budget. ( http://www.washingtonpost.com/wp-dyn/content/article/2007/10/12/AR2007101201609.html ) Looking for a solid bet in the next couple of years? Watch gambling companies as states try to out do each other in a race to the casino.
The big story will be on Monday as the world watches the US stock market to see if last Friday was a one day drop in prices. For those that are interested in short-term trading (we are NOT an investment newsletter) the last ten years the day after the October option expiration (last Friday) the stock market has risen all ten times. Economic news will be sparse but Treasury Secretary Paulson will be speaking about US-China trade relations and which will include rhetoric about the dollar-Yuan relationship. Wednesday at 1:15pm Fed Governor Mishkin will speak on Financial Instability a very timely topic. Thursday at 6am the Fed's Consumer Advisory Council will discuss mortgage loans and this should receive a lot of attention from Congress and the press. Unfortunately this will again be too little too late as the lenders have already reacted to this year's meltdown with much tighter underwriting guidelines.
Early in the year you read here that interest rates would fall after July 1st and the economy would not be able to withstand the fall from the mortgage market. The US 10-year closed last Friday at 4.39% and is headed lower with a final destination around the 3.70% level. The Fed will be forced to ease again as the Libor rate must decline and the Fed's only weapon is a lower Fed Funds rate. There is not much else they can do and we will really see panic when the world realizes that lower rates are not going to prevent the most serious economic setback since the early 1930's. No one believed it early this year and no one believes it now because we only see life from our own experiences and 99% of the world wasn't around during that time period. Fasten your seat belt, the ride is going to be very bumpy over the next couple of years and when you've never lived through that experience it can be frightening.
When analyzing and forecasting interest rate trends alway review the relationship between different points on the yield curve. Bond market rallies are always more impressive when they are led by the long end as that is where the inflation bets are made while the short end is often about expectations about Fed policy and that is NOT a good reason to make a bet on the long end. On Thursday September 20th (two days after the Fed lowered the funds rate by 50 basis points) the yield curve stood at these levels: 2 yr. = 4.11%, 5 yr. = 4.36%, 10 yr. = 4.70%, 30 yr. = 4.97%. The 10-year rose 13 basis points in the two days after the Fed eased as the market was 100% convinced that a Fed easing would easily ignite the US economy (as it has every time before) and that of course would create more inflation. As usual market expectations have changed in the past three weeks and today the yield curve closed at levels that were far different than after the Fed easing with the 2yr. = 4.23%, 5 yr. = 4.41%, 10 yr. = 4.68%, 30 yr. = 4.90%. It's a lot of numbers but please review because as Rod Stewart told us "every picture tells a story" and the yield curve storybook has many chapters.
Since the Fed's abrupt change in monetary policy the long end (30 yr.) has actually fallen in the past three weeks by 7bp while the 2 yr. has risen by 12bp. What is the one thing that would surprise the market the most? What event is the market not prepared for? That event would clearly be for the economy to be much weaker than expected accompanied by more easing by the Fed. The 2nd biggest surprise would be a fall in the inflation rate which would allow long-term rates to reach new cycle lows. Since September 18th the inflationary expectation component of the 10 yr. has risen only two basis points from 2.31% to 2.33%. The biggest reason rates are higher over the last three weeks is that the stock market has been on a rocket ship ride to daily new highs as foreign investors see the US market as a bargain due to the depreciation of the dollar. Within the next 12 months expect major central banks to jump on board the "let's depreciate our currency to strengthen our economy" train as they see their own economies soften. A weak currency narrows a country's trade deficit but is almost always a result of weak domestic demand. Would you rather have a weak economy with a narrow trade deficit or a strong economy with a big trade deficit? Hopefully everyone comes to the same answer, low US consumer demand (2008) is not something that can be offset by strong exports. The stock market is about corporate profits and the bond market moves to inflationary expectations, they can and often coexist together.
Last Friday mornings report showed a 0.6% rise (0.4% without auto sales) but most of the gain was from food and gasoline which are both inelastic items(demand does NOT go down when prices rise). When the consumer buys food and gas and their income and assets don't rise (not everyone owns stocks) the loser is other non-discretionary items. Building materials, clothing and furniture sales were weak which should be expected for the remainder of this year.
Amity Shlaes from Bloomberg wrote a good article ( http://www.bloomberg.com/apps/news?pid=20601039&sid=aKdxPLBCVXDc&refer=home ) today with a couple of interesting ideas. First she brings up the possibility that short-term rates might decline which would allow adjustable rate mortgage holders to pay less than their new reset rates. The problem is that underwriting guidelines are much tighter than when the original loans were made so many of these borrowers probably can't qualify at any interest rate. There is also the problem of declining home prices so the loan to value ratio might be too high. She also invites Washington to consider limiting the deductibility of adjustable interest while increasing the deductible fixed rate interest. Changing public policy to deal with this problem is a sure bet but changing the tax code doesn't stand a great chance of being the preferred choice of most legislators. The easiest solution is always throwing government money at the problem but that might not help unless they want to embrace an idea of having lenders take over the houses and rent back to current owners.
We are witnessing a record amount of home auctions by builders overwhelmed with costly inventory and lenders who have foreclosed on delinquent borrowers. Normally auctions are a great way to reduce supply and allow the market to find its true price levels. An article in last Friday Sacramento Bee ( http://www.sacbee.com/103/story/428371.html ) shows us why current auctions may not be the answer to the housing market supply problem. In an auction last week the seller rejected all bids because they were below the minimum price set by the lender. The lenders have not caught up with reality and are unwilling to lower selling prices to the point at which it will attract buyers. Many builders and lenders are cancelling "once in a lifetime" sales and auctions due to a lack of buyer interest at listed prices. Home prices are a very inefficient market and prices will take much longer to adjust than other markets that trade daily (stocks, bonds, commodities, etc.). Best quotes of the week come from last Friday morning's Boston Globe in an article about the housing problems. ( http://www.boston.com/business/globe/articles/2007/10/12/how_bad_is_the_housing_bust_it_depends_a_lot_on_where_you_are/ ) "The housing bust is like a leaking ship. You may still be able to stay afloat, depending upon where and how bad the holes are. Markets glutted with housing may sink further. Like too much water in a ship, excess inventory doesn't contribute to buoyancy."
Markets may be very volatile next week as we have CPI and housing starts on Wednesday (10/17) and Fed Chairman Bernanke will speak to the Economic Club of New York on Monday at 4pm. Usually the speaker at this event accepts questions from the audience so watch the markets on Monday evening for any reaction. Friday at 7am the Fed head gives a speech at the St. Louis Fed Economic Conference. This has a better chance of being a non-event as the host St. Louis Fed President Poole may want the headlines. Pay close attention the how the long end of the bond market reacts to these events and that should give us an indication for the direction of rates until the next FOMC meeting on October 30-31.
Palm Beach County, Florida now has 33,708 houses and condos for sale which represents a 40 month supply. ( http://www.palmbeachpost.com/business/content/business/epaper/2007/10/10/a1d_reslowdown1010.html ) Unless they find oil or gold in Palm Beach the only way to reduce the supply is for prices to decline and that is going to happen in 2008. I'm sure most of these owners have mortgages and not fully paid for so the pressure to sell will increase each month and it also tells us foreclosures are coming sooner than later to this Florida county. The problem is that these new owners will not want to hold this new inventory. Home prices are going to accelerate their decline and the next 75 days are going to be the worst for sellers since the 1930's. From San Pablo, California comes the story ( http://www.cbsnews.com/stories/2007/10/10/eveningnews/main3355299.shtml ) of an angry homeowner (probably with a mortgage) that paid $585,000 from a developer that is now stuck with unsold homes and accepting $295,000 bids for the same house at an upcoming auction. It is unfortunate but the markets believe the worst is over for the housing market and that these problems will not spread to other parts of the economy. The dollar could go to zero and it wouldn't create enough demand for our exports to offset the coming depression in consumer spending.
Nothing has changed and the markets are focused on future inflation so long rates have risen for the past few weeks. There is almost a zero probability of the housing mess ending anytime soon. Interest rates are headed lower as the consumer does the unexpected and cuts back on spending. Those that have been predicting the demise of the consumer for the past 20 years will finally be right but sadly timing is everything and most of these experts have moved on to other ventures.
Early friday morning the BLS (Bureau of Labor Statistics) announced that the US had created 110,000 new jobs in September (100,000 was expected) but revised August to +89,000 from -4,000 and July to +93,000 from +68,000. They also quietly told us that job growth for the 12-month period ending March 2007 was revised down 297,000. The stock market roared to new highs as all news is good news in equity land but bonds fell hard with the 10-year rising 12 basis points to end the day at 4.64%. As usual there is a lot more to the story than just the headlines which confirm that the government has no idea of how to count those working during the preceding month. The BLS uses a birth/death model which is similar to the seasonal adjustment we see with most economic indicators but the monthly revisions are often greater than the initial estimates. The government should delay the release at least a month or stop counting and begin throwing darts as they would find more success. People invest billions of dollars based on a number that always changes as time goes on and many times in a different direction. The birth/death model has accounted for over 68% of all job growth in the past year.
Analyzing the report, it is very curious that temporary help payrolls fell 20,000 in September and a total of 74,000 over the past 12 months. If the economy was booming and firms hiring wouldn't they be hiring temps before taking on permanent workers? One of the other important parts of the jobs report is the diffusion index. This is the percentage of industries showing job growth and in a strong growing economy will frequently be above 60%. Todays report saw a 2007 low of 52.5% which means that 47.5% of industries saw no job growth last month. Finally the unemployment report rose to 4.70% a high for 2007. The low was 4.40% in March of this year and this is one the most important reference tools for the Fed and usually a .5% increase from the low is followed by a recession. Look for a 5.0% rate in the next few months.
A couple of questions must be answered after last friday's jobs report. The first is upcoming Fed policy and whether the Fed is done easing for this cycle. Let's start with an important point that it is very doubtful the Fed knows where it is going at this point other than the next FOMC meeting will take place on October 30th & 31st. A speech given last friday morning by Fed Vice Chairman Donald Kohn sounded very much like it could have been written by Chairman Bernanke. http://www.federalreserve.gov/newsevents/speech/kohn20071004a.htm A couple of quotes confirm an observation and since the Fed was caught flat-footed this summer by economic events they seemed to miss they will be keenly observing the economy and financial markets before considering any action at their upcoming meeting. The first quote is: "Pending further evidence, a 50 basis point easing (9/18) was not an unreasonable FIRST approximation of what might be required to keep the economy on a sustainable growth path." Those waiting for more easing will hang on that quote until they see another Fed cut. The second quote is for the bears that believe the Fed is done for this cycle. " With news on inflation relatively favorable of late and with inflation expectations seemingly well anchored, look for an offset cut in the federal funds rate- if it turned out to be LARGER than needed - in time to preserve price stability. Next week's important data point will be Friday with the release of retail sales which should show little, if any, growth. The following week CPI will show a steady 2.0% inflation rate and for those that believe the actual inflation rate would be higher if the government included more items please read Thursday's Dallas Fed Pres. Fisher. His research department created an inflation indicator called the "trimmed mean" which includes everything except the one item that rose the most last month and the one item that declined the most last month. It is also growing at a 2% annual rate. http://dallasfed.org/news/speeches/fisher/2007/fs071004.cfm The problem facing the Fed remains the level of the three month Libor rate which stubbornly holds at 5.24%. This is 49 basis points above the current Funds rate and very close to the level it traded at before the Fed lowered the Funds rate to 4.75%. Most of the variable rate loans in the residential mortgage market are tied to the Libor rate and the Fed told us they eased to help the lack of liquidity in the mortgage market. They are worried about the Libor rate but also must be wondering what would occur if they eased again; Would the Libor rate fall? Would long term rates rise? Uncertainty is never good for any market and the Fed is clearly confused as to its next move and this is causing greater than normal volatility in global money markets.
The 10-year reached its low (4.32%) for the year on September 10th, eight days before the Fed lowered the Funds rate to 4.75%. At 4.64% (today) we have risen 32 basis points or 33.3% of the move down from 5.26% reached on June 12th. The rally in rates has come from an increase in inflation expectations of 19 bp and 13bp from the real rate of interest. This is a lot of numbers but nothing more than a normal reaction to a 96 bp move down in rates that took three months. Inflation is not a worry for the market even though the recent price rise in gold and decline in the dollar have many concerned about an increase in import prices. The US economy is in the early stages of a consumer led recession due to a contraction in the availability of borrowing outlets. Seasonal trends are a very important part of analysis in a very favorable time for lower interest rates. During the first half of this year you read here that we would see much lower rates after July 1st and that is exactly what occurred. With long rates rocketing higher today and a fear of inflation looming it is only natural to wonder if the low for the year has been seen in the 10 year. Reviewing 29 out of the last 32 moves down in rates in the 2nd half of the year did not reach bottom until October, November or December. The exceptions were 1999, 1988 and 1978. 2007 could be #4 with its September 10th low but their could be another move down in long rates as the market realizes the summer mortgage problems have not gone away. This week we saw many brokerage firms take huge write-offs from their mortgage and structured product departments and their stocks soared as investors are convinced that the good old days are back again. The commercial mortgage backed securities (CMBS) market remains in a chill with larger than normal spreads does not send a message that storm clouds have gone away. A move above 4.80% along with the seasonal trends you can look for lower long rates before the end of the year.
Thursday the House subcommittee on Commercial and Administrative Law created bill HR 3609 ( http://www.earlywarningwire.com/h3609.pdf ) which would allow bankruptcy judges to modify the terms of a mortgage in Chapter 13. It would allow judges to make changes to the maturity, interest rate, amortization, etc. of a mortgage. If this ever passes Congress with current language the mortgage lending business would come to a quick halt as the risk to the lender would skyrocket as they would never know what could happen in the future. When Congress gets involved with something the end result is frequently not what anyone would desire. This bill might have a better chance than many believe as it appears that very few sub-prime mortgages are being renegotiated. According to Moody's just one percent of these loans have seen terms eased by lenders and I'm sure Congress will use that as ammunition for this bill. ( http://www.ft.com/cms/s/0/3cfb843e-7214-11dc-8960-0000779fd2ac.html )
If you want to rent a house or condo why not go where there is a glut of unsold homes. How about Desoto County, Florida where owners are having trouble finding renters at any amount. ( http://www.sun-herald.com/Newsstory.cfm?pubdate=100407&story=tp1ch6.htm&folder=NewsArchive2 )
If you want to buy a house at a bargain price why not go where the supply far exceeds the demand? Flagler County, Florida has one of every five homes for sale but the city of Celebration has 50% of their homes for sale. You might even be able to buy the entire city for a reasonable price as the other 50% not for sale are probably wishing they could move. ( http://www.wesh.com/consumernews/14263316/detail.html )
If it wasn't so sad it would be funny, but this week the legislature in Michigan voted to raise the income and sales taxes in a futile attempt to balance its budget. Michigan has used this solution before and yet they still have not learned that a weak economy (car manufacturing) and high tax rate rates are not a good reason for businesses to move to your state. For those with an appetite for undervalued real estate and a lot of patience you will be rewarded when this state hits bottom (they all do, remember New York's problems in the 80's) ( http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_levin&sid=a9A0vwtCxHzw ).
It's quiz time - the following is a quote from a report issued on 9-25 from the Fed, FDIC, OCC and OTS (four government agencies) and is MUST read. http://www.occ.treas.gov/ftp/release/2007-102.h tm "Examiners noted a significant volume of loans with liberal repayment terms such as little to no amortization prior to maturity, reliance on refinancing as a primary source of repayment, and lack of meaningful financial loan covenants such as leverage and fixed charge coverage ratios. Examiners also noted the backlog of leveraged loan commitments that cannot currently be distributed without incurring potential market losses and may need to be retained in portfolio." The question: Doesn't this sound like something dealing with sub-prime house mortgages? Of course it does and no one would be surprised to be reading that at any time this year. The really, really BIG problem is that this report has nothing to do with the residential mortgage market as it pertains only to large commercial real estate loans. In February of this year we were told by "experts" that problems in the mortgage market were related only to sub-prime and the remainder of the market was healthy. A few months later Alt-A became a problem but again we were told it was not anything to worry about and was contained to a small part of the lending market. In May interest rates rose as the consensus jumped on the "strong second quarter with an increase in inflation" wagon that led to massive losses for those that bet on higher rates. The next consensus formed from those that told us commercial real estate remained strong so the housing market problems were again a small part of the economic landscape. Of course rates fell hard after July 1st (as we read here all year in the Interest Rate Update, as the reality of a weaker economy set in and expectations had to be changed once again by those that are riding a long losing streak with their forecasts. Lastly the Fed ease 10 days ago has been met with more forecasts of higher rates accompanied by inflation due to an easing of monetary policy. Now we receive this report from the Fed, etc. that the commercial market has the same problems brewing that cratered the residential market. Normally markets do a decent job of discounting future events but this occurs in markets that are much more efficient than the real estate and mortgage market. 2007 will be remembered by most forecasters as a year characterized by one theme..."I never thought this could happen and I had never seen this before." A quote from a Scottsdale, Arizona real estate agent said it best on Tuesday: "I think we are pretty much at the bottom at this point, it's probably one of the best markets I've ever seen for a buyer." (http://www.msnbc.msn.com/id/20985253/) He is telling us about the market from his history which may or may not be very long but it brings up the most important point for this year and that is again....we only see life from our own experiences. This realtor is seeing the real estate market from his past and if prices are lower next year (99% probability) he will again see prices as the best he has ever seen. My new question for real estate agents is: "How do you know when it is a bad time to buy real estate?" Would't you be very interested in hearing the answer to this question as the majority of agents we hear from say it is always a good time to buy real estate and that is of course true from their point of view because 1) every dip in prices over the past 30 years has been proven to be a good buying opportunity and 2) there is really no effective way to short (bet on lower prices) real estate so everyone looks at the market from a long side approach only. The real risk for the economy is NOT the residential market but the unknowns from the commercial market which are clearly stated in the above report. If the CMBS (commercial mortgage backed securities) market does not loosen up by January 2008 then the economic contraction that began in June of this year will accelerate to levels we have not seen since the 1930's.
The 10-year US Treasury has risen 12 basis points since the Fed cut the Funds rate by 50 basis points on fears that this move will reignite inflation fears. These same bond bears point to the price of gold which closed today at $742.80 as confirmation of their worries. The next Fed meeting will take place on October 30-31 with a statement delivered at 11:15am. The action of the past 10 days reminds us of the early 80's with the "bond vigilantes" helping to keep rates in check and theoretically helping the Fed with its monetary policy. Gold has risen in the past few weeks from uncertainty regarding world economic trends as much as it has from inflation fears. It's important to remember that expectations are not always met with the same reality at a later date. Markets often expect events that turn out to be the opposite of what occurs and the May rise in long-term rates is a great example of markets moving on expectations that were clearly not met. The key to the next Fed move is the Libor rate which is the primary borrowing rate for corporations and most variable rate real estate loans. The three month US Libor rate is 5.23% and that is 48 basis points above the current Funds rate of 4.75%. The typical spread is about 10 bp so the recent Fed ease has put us back to where we were a few months ago. If the global liquidity situation does not improve over the next 30 days the Fed will come back and lower the Funds rate 25bp in an effort to reduce the US Libor rate. The Fed will be paying very close attention to Friday's (10/05) jobs report where the unemployment rate is expected to rise to 4.7%. Anything close to last month's disaster of four thousand jobs lost will put intense pressure on the Fed to ease again as it has clearly gone from inflation fighting to trying to save the economy in a matter of weeks. Consumer credit will be released on the same day as we can expect to again see the consumer loading up on credit card debt as the ability to draw cash out of a home has diminished. The bond market's reaction next Friday will be quick and volatile as trading will cease early for the long Columbus Day holiday weekend.
Last Friday morning's report that personal spending rose .3 and spending rose .6 shows the consumer still has energy and buying power but this is slowly coming to an end. When the consumer spends more than they earn there are two ways in which this occurs with the first an increase in borrowing or the other coming from an increase in the value of assets (stocks, etc.). We are witnessing an increase in credit card debt and the stock market advance is assisting the need to spend but for the average wage earner it will be the former more than the latter. This is why we continue to see high-end retail stores do much better than stores such as Wal-Mart and Target. The dollar's decline (especially against the Euro) has everyone worried about an increase in inflation and that is one of the reason's we have seen a slight increase in long-term rates over the past two weeks. Clearly the US Treasury (and Fed?) don't seem to mind a dollar depreciation because it brings in foreign buyers of our goods and services at what they see as bargain prices. But isn't this the same thing that happened to the Japanese in the late 80's when they purchased a massive amount of US real estate and then were forced to sell at much lower prices when their own economy (and real estate) plummeted into a recession accompanied by deflation? The world financial markets will soon realize the real estate problems are not confined to the US and as we have seen in England these liquidity issues are spreading to most major global markets. The dollar bears are in complete control for now and trying to fight them is probably a losing battle but sooner than later we will see the dollar rally as our problems become their problems.
We have NOT seen the lows in long-term interest rates for this cycle as the market has not yet realized how the real estate problems have spread to the remainder of the economy. The consumer is on life support and the commercial real estate market is wavering but at least our trade deficit is narrowing. For the next week pay close attention to the US Libor rate (5.23%) and the Yen Libor rate (1.03%). The yen closed Friday at 114.81 to the dollar and its next move out of the current trading range (113-116) will tell us much about the direction of world wide markets. If the US Libor rate does not begin to fall the Fed will be forced to move again with another Funds rate cut. Lastly it almost never pays to fight a bull market and bonds are clearly in an uptrend (rates down) so unless we see a move above 4.82% in the US 10-year you can bet on much lower rates in the coming months.
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