My New Blog

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. 

U.S. INTEREST RATES AND ECONOMIC INTELLIGENCE

March 18, 2008

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 Feds past and future

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.

The dollar

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.

The yield curve

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.

Summary

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.