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.
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