Update 4/29/08

April 29th, 2008 9:14 AM

 

 Tuesday morning begins a two day Fed meeting that will conclude with another interest rate announcement at 11:17am on Wednesday. The consensus form the experts is another 25 basis point cut in the overnight Fed Funds rate but it is becoming clear that lower interest rates are not as important as the availability of credit. With only a few bullets remaining in their holster the Fed will announce a pause in its interest rate policy with a focus on clearing the credit pipeline of the residue from the mortgage mess of the past two years.

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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