Long term interest rates plunged today with the 10 year Treasury closing at a new low for the year at 2.56% and the inflation component at 1.65%. My initial target of 2.50% is only a few basis points away but with 98% of traders positioned tonight for lower rates we are overdue for a sharp pullback in bond prices before resuming the downtrend in rates.

History – it’s always important to review

Sunday evening, April 25th I wrote a short but very important update mostly about interest rates and the Fed. Barron’s published a poll of the top 100 money managers on the day before my update and it showed only one manager (someone not afraid to win alone rather than lose in company) was betting on lower Treasury rates while 99 were sure rates were moving higher in the next three months. The 10 year was 3.81% and everyone was sure we were headed higher accompanied by increasing inflation. I wrote that night: “The problem with playing the same side as the consensus is the profit is usually small when you win but losses are large when the majority is wrong as everyone tries to exit at the same time causing panic market conditions. I have been monitoring interest rates on a daily basis for over 40 years and don’t ever remember such a one sided position by portfolio managers that are convinced rates are headed higher.”

I also wrote that night about a sharp decline in the Fed’s monetary base and the correlation to the stock market. “If the correlation continues we should begin a stock market decline early this week” and the stock market did reach its peak for the next day (4-26).

Finally I concluded that night with “the move down in the 2nd half of the year will be to very low levels not seen since 2008 (under 3%). The next 90 days will be crucial for the Treasury and mortgage markets and will determine the next major trend for long term interest rates and my bet is much lower….”

It’s important to understand what makes markets move and what makes them move sharply is the majority betting the same way (because they need to lose in company) and then being forced to exit because of large losses at the same time as everyone else. Unless you are a professional investor it is very hard not to listen to the majority when making decisions because their words give you the confidence to follow in the same direction and yet that is exactly what causes the most pain when wrong. The recent move down in the 10 year from 3.12% to 2.56% in a month was caused by long term portfolio managers using cash to buy long term Treasuries once they felt confident inflation was not going to increase. The inflation component broke below the “key” 2.00% level on June 23 when the 10 year was 3.12% and I urged readers to watch this level for a signal rates would move much lower. The other reason for the dramatic decline in rates comes from the opposite end of the investment spectrum – fast money. The hedge funds that are driven by performance (most of their compensation comes from % of profits) were either betting on higher rates or out of the market. To create profits for the year they must find the hottest market and pounce quickly before the easy money is gone and that is what they have been doing the last few days. The Fed begins its Treasury purchases tomorrow with notes maturing in 4-6 years but the amount is not significant to move the market. With only 2% betting on higher rates it is tempting to go with the brave (or crazy) traders trying to catch a falling knife but it’s always important to remember sentiment almost always leads price. The 2.50% level should be used to lock loans that must be funded in the next few days.

The Chinese are NOT buying Treasuries

The Treasury reported today foreign investors bought $33.3 billion in Treasury notes and bonds in June BUT China sold $21.2 billion as they appear to be diversifying into other currencies and bond markets . Japan did purchase $17.1 billion in June their highest amount since September 2009. Interestingly foreign investors bought a record amount of mortgage securities ($20.4 billion) as they begin to reach for yield because Treasury yields are now so low. These investors remain distrusting of corporate bonds and sold $13.5 billion after sales of $9.0 billion in May. In the past the Treasury market has needed heavy foreign participation to move rates lower but this summer’s decline is clearly coming from domestic money.

Banks loosen credit but does it really matter?

This morning the Fed released its Bank Senior Loan Office survey for July with the good news large domestic banks appear to have eased credit conditions. Domestic banks have stopped reducing the size of existing credit lines for commercial and industrial firms for the first time since January 2009. Banks did report has narrowing of profit margins on loans due to the recent decline in rates and may now be seeking more than just AAA borrowers. BUT it takes two to make a loan and borrowers remain in hibernation because 1) credit worthy corporations are sitting on a record amount of cash and 2) why would they want to borrow when they aren’t expanding operations and creating jobs due to the uncertainty over economic policy, tax rates and increased regulation.

Gold/stock market

Gold rallied today as “insurance” buyers lined up for the best performing asset of the decade. I have advocated a long position all year and with a strong seasonal trend only a few weeks away (September) any sharp declines will be used by traders to add to existing positions. Although the US stock market receives 99% of the press in terms of the best long term investment tonight’s chart clearly shows gold outperforming stocks in the last decade.

For the first time in a week the NASDAQ outperformed the S&P on Monday holding an important trend that is often a good leading indicator for the overall stock market. With the exception of a few days in February of this year the NASDAQ has led the S&P since February 2009 and is one of the key reasons many remain long the market.

On Wednesday April 28 at 6pm (PST) I will be presenting a special “webinar” with a detailed analysis of the US economy, interest rates and many different financial markets. Advance registration is required at:  http://www.earlywarningwire.com/pdf/interestratewebinar2010.pdf
Readers that wish to have my updated views and forecasts five nights a week please visit: http://www.earlywarningwire.com/pdf/nightlyemailflyer.pdf

2010 can best be characterized as a year where too much money has chased too few assets resulting in significantly higher prices for stocks, many commodities (gold), currencies (dollar) and selected interest rates. As we rapidly approach the second half of the year the question that every investor must address is: will current trends continue? If not, will they reverse or hold in patterns awaiting the next leg up in this runaway train fueled by massive liquidity? I will address the key categories in this update but urge readers to subscribe to my daily update for a more detailed analysis and of course all of the subscription fees go to Food on Foot  a non-profit in Los Angeles that provides food, clothing and job opportunities for the homeless and poor.

Federal Reserve

Every market is influenced by Federal Reserve policy because it controls the rate of monetary expansion or tightness which filters through to price movements created by investors based on their expectations. The Bernanke Fed has done an admirable job of making policy transparent since the credit meltdown began in the fall of 2008 and there is little confusion today about the current stance of easy money with an overnight funds rate of 0.25%. It is remarkable that a year ago every word that came out of the mouth of the Fed Chairman was covered by all financial networks and most news stations. In the past month Mr. Bernanke’s testimony to the Senate and House was considered a non-event by these same financial networks and one had to go on the internet to find live coverage. Is Fed policy something that shouldn’t matter to investors? Hardly, the Fed will react to changes in the economic landscape and especially inflationary expectations and job growth. Although many believe the Fed continues to add liquidity to the system it has gone unnoticed that in the past few weeks we have witnessed a very sharp decline in the monetary base. This is important because it shows the Fed is concerned about the recent rise in asset prices (especially stocks) and the base has had a close correlation with recent stock market price moves.   The Fed is acutely aware of inflation expectations which remain contained under the 2.40% level.  U.S. unemployment remains stubbornly high and the length of time the jobless remain unemployed is creating a dangerous situation since job skills (and confidence) begin to erode when one remains unemployed after 12 months. The federal government’s hiring of census workers should boost the next three months payroll numbers giving everyone the false impression the economy is back on track. The key to any recovery is private sector hiring and most small businesses are struggling to maintain revenue levels unless they sell to the government. The National Federal of Independent Businesses releases an excellent monthly report showing the most important items affecting small business and currently they are poor sales, high tax rates and too many regulations. Those items are not the recipe for expansion and hiring unless they include large government contracts. The federal government (with the Fed) ended the rapid deceleration in economic activity last year but unless the private sector becomes convinced business activity is on a sustainable upward path we will have high unemployment for at least the next four years. As a result it will difficult for the Fed to tighten monetary policy through higher short term interest rates as that would make credit more expensive at a time there is little borrowing from the corporate sector. Economics 101 teaches us prices rise when demand increases or supply falls and the demand for credit is currently low and the supply abundant which can be seen by the $1 trillion+ banks have in excess reserves stored at the Fed.

Long term interest rates

The consensus among investors, economists, real estate professionals and anyone else with an opinion is that long term rates must rise in the next year. A Barron’s poll of portfolio managers this week found only 1% forecasting lower rates in the next year versus 78% believing rates would move higher. Increased supply is often used as a reason rates must rise but history has shown long term rates are influenced by supply for only a short period of time (weeks) and that long term movements are a function of a change in inflationary expectations and/or the real rate of return. The 10 year Treasury is currently trading close to 3.80% with the inflation component at 2.36% and the real rate at 1.44% and these are levels we have seen for much of 2010. Most of these bond bears use an increase in inflation due to massive money printing as yet another reason rates must move significantly higher. They are correct about the money printing but that alone does NOT create a surge in inflation pressures as the velocity of money has fallen at a record rate the past two years. Over 99% of the increase in the monetary base in the past year has been sent back to the Fed for safekeeping by banks that are unwilling to lend or invest their new found dollars.  If inflation expectations are contained the only way nominal rates can rise is an increase in the real rate which is usually a function of the expected growth rate of the economy. If world investors become worried the U.S. will not be able to service its debt or pay the full amount owed at maturity we could see a rise in the real rate (happening now in Greece) but the U.S. might benefit first from other countries needing bailouts.

Seasonally rates rise 75% of the time in the first half of the year and fall 75% of the time in the second half of the year. With good jobs news coming soon we could easily see the 10 year Treasury crossing 4% before reaching an unexpected (by the experts) high in June and then falling in the second half of the year. I’m probably the only person in the universe who believes rates are going to move lower but it wouldn’t be the first time (or the last) I have taken a very lonely position on a market’s direction. Market’s often move violently in the opposite direction of where the majority have placed their bets and the extreme negative carry (4%+) bond bears must endure each year would have them scrambling for cover if long term rates began to move down in the second half of the year. It is an investing axiom that markets move the most when investors/traders must liquidate losing positions and then reverse to go the other way (if they have any capital remaining) and the bearishness in government bond land is the most overwhelming I have seen in the last 30 years I have followed this market.

Japanese Yen

My best bet of the year has performed exactly as expected since the beginning of the year. After spending a few weeks under the 90 level we saw a significant break out after the Japanese fiscal year end on March 31. With the Bank of Japan and federal government agreeing deflation is the #1 enemy and must be extinguished at any cost zero interest rates and easy monetary policy will remain in place through the remainder of the year. As other countries begin to raise short term interest rates (China, Australia and soon Canada) the yen will be under pressure as interest rate differentials widen giving traders a bigger incentive to borrow in yen and invest in high yielding currencies. Japan has suffered from debilitating deflation for almost twenty years and creating any inflation won’t be easy or occur this year. As a result my target of 120 yen to the dollar seems attainable in the next 12 months.

For more of thoughts on the economy and financial markets please subscribe to my daily update sent five nights a week (Sunday-Thursday) at 10pm.

Trading and investing involves high levels of risk. Before entering into any investment, all readers should consult with their investment professional and discuss the possible loss of capital.

The publishing schedule for my FREE update will be on a monthly basis for 2010. Most of my time is spent on the daily update and running Food on Foot, a non-profit I started in 1995. FOF provides meals, clothes and job opportunities to the poor and homeless of Los Angeles.

I will be teaching a class for those who wish to learn how to forecast economic and interest rate trends. The class will be held on Wednesday April 21st from 6-9pm in Century City and seating is limited.

2010 Forecasts

I begin every year with my three best bets and this year’s list offers much promise for those with the patience needed to realize a profit with limited risk. While much of the financial community concentrates on trading profits that usually end with losses for customers and profits for the brokers, the biggest winners each year are always those with well thought out ideas and a road map of expected events and an exit strategy. Since investing is a zero sum game where winner’s profits equal the losses of those on the wrong side of the market it is important to start with an important question. What is it about your investment idea that is not already priced into the current market? In other words why is the person on the other side of your trade going to be wrong? Most of us can’t make a decision about an investment until we have read numerous articles or heard about the idea on financial TV shows which gives us the confidence needed to pull the trigger. Unfortunately this falls right into one of my key investing rules: People would rather lose in company than win alone and that is the main reason so many lost so much money in the bear market between October 2007 and March 2009. A lack of stop losses and the fact everyone else was holding on to their positions hoping the market would turn around froze most investors and prevented them from liquidating losing positions. If the financial press had told everyone in late 2007 a historic bear market was coming and everyone should sell it might have enabled more people to liquidate but the act of taking a loss is a skill not many investors possess. Many residential real estate agents were telling customers to buy just before the peak in prices and three years later tell everyone if they had known it was a price peak they wouldn’t have been so bullish. But how would these “always bullish” agents have known? Why would they listen to anyone who was predicting lower prices since following that advice would severely impact their income? The most important advice for investors is always to ascertain if their agent, sales person, etc. can be objective with their advice. If not, is it really advice or just a sales pitch to acquire more business for them. The theme for 2010 is patience and don’t be afraid to sit in cash even though it is yielding near 0.00%.  Most investors have learned the hard way in the past three years the return OF capital is more important than the return ON capital.

Best Bet #1 – Japanese yen moves lower in value

When the fundamentals line up perfectly AND you have the backing of the Bank of Japan it often results in a very nice investment. The Japanese have suffered from DE-flation the last 20 years despite so called “experts” fear of inflation in the 1990’s. The longer deflation stays in an economy the harder it is to remove and the Bank of Japan lowered short term interest rates to zero many years ago in an effort to end their economic slide. They quickly learned zero interest rates do NOT stimulate consumer demand if retail prices are falling each year. Interest rates must be below the level of inflation and since they can’t be negative any interest cost is too high.

Unfortunately the Japanese economy is export driven and with the recent rise in the value of the yen its products and services are not competitively priced in the marketplace especially versus the Chinese Yuan. A lack of raw commodities has also hurt the economy and combined with DE-flation has prevented any economic growth for most of the last decade. The new government originally thought deflation was a plus for consumers but when it realized it came with lower wages it changed to a more expansionary plan for the economy. With interest rates at zero the normal method of stimulation is impotent so the Bank of Japan has begun to send a message to markets it is willing to support a lower value for its currency that would hopefully increase exports to countries with strong consumer demand (Australia, Canada, Brazil, etc). Currency intervention can be dangerous if allowed to go for too long especially if a country is attempting to support one that is falling because of a lack of faith from the international community. The normal tool is higher interest rates (Iceland) but that is dangerous and usually causes unintended consequences (credit contraction). It is much easier for a central bank to cap currency appreciation by increasing the rate of growth of the money supply. The downside of this strategy is runaway inflation but since Japan has no inflation and the velocity of money has been declining this result should not be feared.

The all time high value for the yen was set in 1995 and then again in 2009 at 85 to the US dollar. The yen is currently trading at 90 and unlike other countries worried about excess liquidity the Japanese model has proven the enemy is De-flation and any increase in inflation would be welcome. If the Bank of Japan follows the current plan of encouraging a lower yen it might stimulate foreign demand for their products but at a minimum couldn’t hurt a badly sagging economy. The risk is a new high in the yen below 85 but the upside potential is larger with a move to 120 this year a likely probability. As always stops must be used and hopefully this trade will have the same profitable result as our best bet in 2008 which was a lower British Pound and 2009 when we predicted a higher Australian dollar (see archives). The easiest vehicle for individual investors is a short of the FXY which is an ETF with good daily volume and excellent liquidity.

Best Bet #2 – Buy 10 year Treasury Tips if rates rise to 3.00%

Although every so called “expert” has predicted the best bet of the decade is to short Treasury Bonds because inflation must rise soon (see Japan) our best bet #2 is the purchase of Treasury Inflation Protected securities but not because of future inflation risk. These bonds offer an annual fixed rate of return but also pay investors the equivalent of the inflation rate each year. Currently the 10 year TIP yields 1.44% (+ the inflation rate) and offers little value unless inflation reverses course and heads higher this year which is the consensus view. The real rate of return (1.44%) is usually an estimate of expected economic growth over the period of the 10 year life of the bond. But it also represents a risk factor the issuer (US government) will NOT pay off the bond at the maturity. Currently the market perceives the risk of a US default as very low and any set back for the economy and or administration policies this year could easily send this premium sharply higher giving investors an excellent buying opportunity. The easiest way to accumulate profits is when market expectations don’t equal economic reality and if fears of a US default rise this year it will be a good time for investors to go against those who are betting on something that has little chance of occurring despite a huge budget deficit and continued monetary easing from the Fed.

Best Bet #3 – Long term interest rates will NOT rise this year

This might be the most controversial pick of the year as almost everyone is sure rates will rise because of a massive amount of debt being issued by the US Treasury. Over a short time period rates often move slightly to changes in demand and/or supply but over the long run inflationary expectations are the main ingredients as lenders want to protect their assets against rising inflation while borrowers attempt to borrow at rates less than inflation. But rising inflation is not always the result of monetary easing by a central bank. If the money created is NOT being lent by banks and then spent by consumers and businesses it sits in vaults as excess reserves of the banking system. Almost 99% of Fed money creation in the past year is now back at the Fed and not being used by anyone. In the 1970’s this was called “trying to push on a string” and the Fed is closely monitoring the use of its money creation wondering when it will become a desired item. The velocity of money is the key to the equation for inflation and economic growth in the country and it has been steadily declining for the past two years. Until it picks up and it may not (see Japan for the last 20 years) there is very little chance of a pick up in inflationary pressures. With an increase in inflation, long term interest rates will cause much frustration and losses for those betting on lower bond prices as they will remain close to the “key” 3.50% level (10 year Treasury) for the past year. Those real estate holders seeking to refinance mortgages should use a move to 3.50% and under to initiate new loans and stand aside when the 10 year rises to the 4.00% level. Rates will remain in a trading range for most of this year and short term movements will be caused by the release of monthly economic stats or fears of an impending Federal Reserve move to increase short term rates.

2010 promises to be an exciting and profitable year for those investors who are able to see thru the many forecasts that are generated by so called experts who only see the future from their own past experiences. Those that are able to see the future based upon the current reality and not what they “need” the future to be will profit greatly this year.

I encourage everyone to subscribe to my nightly update which is e-mailed five days a week (Sunday-Thursday) at 10pm (PST) and contains my up to the minute opinion of the economy, interest rates and various different markets.