6 tough questions and 6 hard answers……

It has been a very tough week for anyone in the interest rate market as 10yr. Treasury yields had their biggest up week in over a year rising from 4.67% to 4.86% in 5 days.Question #1: The Fed raised the funds rate on Tuesday to 4.75% which was
expected so why did long term rates rise 19 basis points this week on news
that was already in the market???

Answer: Yes the bond market expected the 25 basis point increase in the
funds rate but did not expect that the accompanying statement to contain
the words “energy and other commodities have the potential to add to
inflation pressures.” Market participants were hoping for something that
would lead them to believe that the Fed was at the end of its tightening
cycle and the next move would be an ease in short term rates later in
2006. Inflation is the ugly word when one speaks about interest rates
because long term rates are a function of future inflationary expectations
and if the head of the Fed (Bernanke) fears inflation on the horizon then
it scares investors and drives long rates higher. But the key word from
the Fed was “potential” and energy and commodity prices have been rising
for over a year and this has NOT had much of an effect on current
inflation. This morning the Fed’s (Greenspan) favorite inflation indicator
(PCE) showed that core inflation continues to increase at a 1.8% rate
which is consistent with its growth rate of the past few years. The
potential for inflation has been overhanging the bond market for the last
21 months since the Fed began raising short term rates (6-30-04) but
higher energy prices have directed consumer spending away from other items
so energy consumption has not fallen as would normally be the case from
rising prices.

Question #2: If the Fed continues to raise short term interest rates will
long term rates follow and go higher??

Answer: There are only two ways that long rates can rise appreciably from
these levels (4.86% on the 10 year T-Note). The first would be if the
market believes that the Fed is BEHIND the curve in the sense that the new
Fed Chairman will be slow to react to an increase in inflation and then be
“chasing” a higher inflation with Funds rate hikes. This would be a 1970’s
style Fed policy similar to when William Miller and Arthur Burns were Fed
chairman and I believe the chances of those events repeating are very low.
The 2nd set of events that could cause long rates to rise would come from
a higher actual inflation rate. This could be caused by an increase in the
money supply and multiplier which would then create demand from business
due to a fear that “all prices” will be higher in the future so let’s
stockpile inventories now in anticipation of more inflation. This was the
late 1970’s/early 1980’s movie that had a disastrous ending for all
viewers. I would put the chances of this occurrence at less than 10%. The
longer that core inflation remains under 2% the more pressure that will be
put on long rates to decline as worldwide investors will seek a high real
return (nominal rates less inflation) and this will drive the dollar
higher and long rates lower.

Question #3: (from the hundreds of real estate professionals that read
this e-mail) I need to lock a 30 year loan, when will be the best time to
lock??

Answer: It is very tough to predict the path of interest rates over a
monthly and yearly basis, trying to time rates on a daily basis is next to
impossible but bond market sentiment is nearing an extreme as only 5% of
traders are currently betting on lower rates while 95% are predicting
higher. Contrary opinion is an important tool in market forecasting but is
often early and it’s important to note that sentiment often turns before
prices so it could easily be a few more weeks before we hit the high in
rates for this cycle. I have written lately about the STRONG seasonal
pattern that has seen long rates rise for 39 out of the last 40 years.
Long rates have risen an average of 99 basis points from February 2nd to
April 22nd and we are only up 51 basis points so far in 2006. Memories can
be short but I remind everyone that since 2000 this pattern has seen the
last six years where we had increases of 77,71,60,52,119 and 64 basis
points. If you would like a copy of the grid that list the 40 years
results please e-mail and I will send to any of my readers or their
guests.

Question #4: I currently have a variable rate mortgage, should I fix the
rate now or wait???

Answer: If the recent rate increases are causing sleepless nights then
it’s time to fix the rate. Betting on interest rates is not for the feint
of heart and emotional stability and peace of mind are more important that
saving a few dollars on a mortgage payment. If you can stand the pain for
a few more months I believe you will be rewarded with much lower long term
rates and mortgage payments. Yes the Fed has increased the Funds rate
above what I believe is the correct rate given the current inflation rate
but that has not changed my opinion of where long term rates will settle
given a 2.0-2.5% inflation environment.

Question #5: The price of oil is rising again, what effect will this have
on interest rates??

Answer: A price of $70 or more on oil has the potential to act as a huge
tax on consumer spending and actually may happen if the bottleneck in
distribution of ethanol continues this summer. With the changeover from
MTBE to ethanol and the fact that ethanol must be transported to locations
many miles from current plants we may see spikes in the price of gasoline
in many areas of the country. The effect on rates would be sudden and
downward as most of the inflation fears come from a mistaken belief that a
strong economy creates inflation and a weak economy produces deflation.
Again that is 1970’s and 1980’s style thinking and doesn’t apply in this
economy.

Question #6: When will the Fed begin to LOWER short term interest rates??

Answer: The Fed will soon realize that its inflation fears are unfounded
and stop the increase of the Funds rate. Normally history has shown that
it takes approximately six months for the Fed to change policy from
tightening to easing but it will not ease until it sees loan demand fall
and that is clearly not happening today. Commercial and Industrial loan
demand is growing at a 12% annual rate and real estate loan demand is at a
frothy 14% annual rate. It will take months before we see these rates fall
back to tolerable numbers. The good news is that the bond market has a
great track record at sensing a slowdown in loan demand and long rates
will begin to decline at the first sign of trouble in the real estate
market. For those that still believe in the growth of real estate prices
there was a great article in this morning’s San Francisco Chronicle about
last weekend’s Real Estate seminar that drew 61,500 real estate novices
who paid from $49 to $499 to hear the “secrets” from Donald Trump. If this
event doesn’t signify the top of the market, we must be close…..

Tomorrow is the beginning of a new era

Twas the night before the FOMC meeting, when all through the financial community, not a bond trader was stirring, not even Alan Greenspan whispers could be heard hoping that the Big Ben takes advantage of his new opportunity….

Fed predictions were crafted by economists who care, in hopes that Fed Chairman Bernanke would announce a Fed Funds increase to 4.75% delighting those who trade like a bear…..

Real estate professionals were nestled snugly in their mortgage beds, while visions of lower interest rates danced in their heads, but new Fed Chairman Bernanke seems confused and his actions could cause Wall Street to soon see red.

Tomorrow is the BIG day and the beginning of a new ERA in Fed history, one that we have only seen five times in the last 50 years. Yes everyone is expecting a 25 basis point increase in the Fed Funds rate to 4.75% (Prime rate will be increased to 7.75%) but these “experts” are also expecting a equal increase in long term interest rates. Yes the Fed is probably surprised and frustrated that long term rates have not risen as they have with previous Fed tightenings over the past 40+ years. It all comes from inflation and the fact that despite higher commodity (oil, metals, etc.) prices overall inflation indexes have not risen in the past few years and are NOT rising in 2006. The Fed’s key measure of inflation is the PCE index (personal consumption index) and the February reading will be released on Friday (3/31) and it will again show a CORE (ex food and energy) reading of sub 2%.The good news is that despite growing fears of inflation long term rates (10yr. Treasury) have risen only 41 basis points in 2006 despite a very strong seasonal trend that has seen rates rise an average of 99 basis points between February and April of every year since 1966 (except 1995).

Just in case Mr. Bernanke and the members of the FOMC need a little help with their Tuesday decision……The average spread between the Fed Funds rate and the core PCE index over the past 40+ years is approx. 2.5% and with the Funds rate at its current 4.5% and the PCE at 1.8% that gives a differential of 2.7%……enough to stand pat for the next few months and then IF inflation increases they can raise the Funds rate…For those worried about wage inflation I remind the Fed that the ECI (Employment cost index) is up less than 3% in the last year and that is down from 3.8% in 2004. YES commercial and industrial loan demand continues to increase at a 12% rate but much of that is for purchases of raw materials that are a hedge against a fear of higher prices in the future…..The Fed has never asked for my advice and probably never will but my vote would be for an unchanged Funds rate with a statement that said Fed policy is neutral and will follow the path of inflationary expectations and NOT worry that a strong economy equates to higher inflation….that’s a policy that worked in the 70’s and 80’s but not in 2006…

The best news for the many real estate professionals that read this e-mail and desperately want and need long term rates to fall is that the interest rate boat is now overflowing with experts that are predicting higher short and long rates. In today’s USA Today business section there was an article entitled “Economic prognosticator sees minefield of risks ahead for interest rates.” The article surveyed the “top 10″ US economists and everyone of them predicted higher Fed Funds rates at the end of 2006. The Wall Street Journal Q&A column lead question was how can the small investor bet on higher interest rates. I have written many times before that the market’s biggest enemy is uncertainty and until 11:17am tomorrow morning we will not have the answer to the most often asked question of each day: “What is the Fed going to do and what are they going to say??” Both questions will be answered tomorrow and I expect a “relief rally” in the bond market which will push long term rates lower for the next few weeks. Whatever the announcement from the FOMC we will finally have some degree of certainty until at least the next Fed meeting on May 10th.

I will have much more to say tomorrow after the announcement……

New Fed Policy???

We have a new sheriff in town but can he shoot straight??

Although the next FOMC meeting will not take place until Monday/Tuesday March 27-28 we were given an extraordinary preview of the future by Fed Chairman Ben Bernanke in a speech given earlier tonight in New York. Mr. Bernanke’s speech was the first glimpse of the future of Fed interest rate policy from the new Fed head and it is nothing at all like we have witnessed from his predecessor Alan Greenspan: http://www.federalreserve.gov/BoardDocs/speeches/2006/20060320/default.htm

Mr. Bernanke described current Fed policy as AMBIGUOUS which is defined in the dictionary as doubtful or uncertain. For the last 18 years we saw and heard anything but uncertainty from Mr. Greenspan and the markets can deal with anything except uncertainty. Mr. Bernanke’s first speech to the world investment community and he tells everyone he’s confused about future policy??? In a brief question and answer after the speech Mr. Bernanke bobbed and weaved with answers that affirmed his policy decisions would be made after reviewing current and future economic statistics and their effect on domestic activity 12-18 months from now…….This could be quite a shock to the bond market over the next few months as volatility (low during Greenspan term) is sure to increase as the markets try and guess the impact of each economic release. In his speech Big Ben said the Fed should feel free to change position frequently and use as many guides or landmarks as possible…..After almost 30 years of predictable Fed policy (Volcker & Greenspan) it appears we have entered an era of “ambiguous” Fed policy and that will not sit well in global interest rate and currency markets. Maybe we should give our new Fed Chairman the benefit of the doubt and assume he was a little nervous for his first big speech of his term as Fed Chairman…..or maybe he is confused as to what he wants to do about the Fed Funds rate in next week’s FOMC meeting….on Tuesday March 28th at 11:17am we will see the results of the new Fed Chairman’s first Fed meeting but without many of the comments we saw tonight in New York. One other interesting point from tonight’s speech can be found in Mr. Bernanke’s thoughts on the currently flat yield curve…he does NOT interpret the current yield curve configuration as an indication of slowing economic growth. Back in 1996 Mr. Greenspan used a NY Fed study on the yield curve to determine when the Fed should end its tightening but Mr. Bernanke has decided to use a new Fed study of the yield curve to come to a different conclusion: http://www.federalreserve.gov/pubs/feds/2006/200607/200607abs.html This paper written by a Fed staffer concludes that a flat or negative yield curve (short rates higher than long rates) is NOT a good future indicator of a recession IF the level of interest rates is low like it is today. I have a warning for the Fed: history is littered with the careers of those who thought that “this time is different” in their predictions of the economy.

The good news is that NOTHING has changed in the US economy over the past 2+ months and inflation continues to show a 2% or less reading each month (CPI, PCE, etc.). This is important because the minutes from the January 31st FOMC meeting read: ” Most participants expected core (no food or energy) inflation to move up slightly in the near term, reflecting some pass-through of increased energy and other commodities.” Sorry to say the Fed member are wrong again as the latest CPI numbers from last week show inflation at 1.8% and the PCE number which will be released on March 31 will confirm with a sub 2% reading. Yes it may be hard to believe but most of the Fed governors have poor track records when it is about the future direction of the US economy. Last week Atlanta Fed President Jack Guynn had the following quote that was missed by most journalists:” It’s important to recognize that our (Fed) policy path over the coming period is somewhat less certain and therefore as policy makers we should resist the urge to say more than we know.”

Many of you are asking about the future direction of long term interest rates…..The uncertainty of the past 45 days will soon give way to certainty as Fed Chairman Bernanke will make his first BIG decision on Tueday March 28th and no matter what happens the interest rate market will breathe a sigh of relief allowing long rates to decline which will give those involved in the mortgage market a better level to lock your long term loans.

Did you know Iraq is considered a safer??? economic risk than General Motors??? The Iraq 5.8% bonds due in 2028 are now yielding 8.7% and the General Motors bonds due in 2033 are yielding 12.5%…..

Last week Congress was bored with all of its normal activity (what do they do all day??) and passed a new debt limit for the the US at $9 trillion….How much is a trillion dollars???? The average American lives 77 years and if they spent $35.589 million each day from birth to death they would reach $1 trillion after 77 years but they would probably die of exhaustion from spending all of that $$$……very sad statement about our society and its leaders (past and present)

The price of corn (I may never eat corn again) has fallen sharply over the last couple of weeks at a time when everyone is writing about the new fuel “ethanol” but there is a major problem that needs to be addressed before ethanol can have an impact on energy consumption. Over 95% of existing ethanol plants are located in the midwest with transportation to consumption points a problem that will create bottlenecks if not solved quickly…..

Last month saw 240,000 new jobs created in the US but the Bureau of Labor Statistics quietly issued another report called “JOLTS” which is a more in depth analysis of the labor market. It appears that the gain in payrolls is NOT from companies hiring more workers due to increased sales and growth but from “separations” (people leaving or being fired) that are not declining as fast as normal for this period. It’s interesting material but better used for bed time reading because this will put you to sleep and fast: http://www.bls.gov/news.release/pdf/jolts.pdf

What happens to oil exploration when oil prices rise and rise and rise??? Oil exploration as companies become more convinced that high oil prices are “permanent”. Houston appears to be the best bet for job growth in the oil exploration industry: http://www.dallasfed.org/research/houston/2006/hb0601.html

This is all very interesting but my readers consistently want to know: When will the Fed begin to LOWER short term interest rates???? One of the keys to this most frustrating puzzle is found each Friday in the H.8 report issued by the Federal Reserve. Every Fed Governor and Fed Chairman analyzes the loan numbers (C&I and real estate) for signs of weakness. Last Friday’s stats showed what may be the first signs of a top in Commercial and Industrial loans. Since June of 2005 we have seen a 12% annual growth rate in this sector and it appears that recent short term rate increases are beginning to have an impact on demand for loans. A drop to a growth rate of under 8% would surely gain the Fed’s attention and set the stage for the first Fed Funds rate in the Bernanke era.

Bottom Line: Mr. Bernanke first performance on the world stage was not his best and the markets will shortly send him a message that the world needs a Fed Chairman that is clear about his intentions and silent about his what he finds confusing.

March 10, 2006

In 18 days the new emperor (Ben Bernanke) will appear from behind his curtain of silence for the first time since taking office on February 1st. Amazingly in the last six weeks both short and long term interest rates have risen with no input from the new Federal Reserve Chairman and economic statistics that continue to show a stable and non-inflationary economy. The following is a table of US Treasury interest rates on January 31st and today (March 10th)

1-31-06 to 3-10-06

2 year………………………………    4.73%     4.52%      +21 basis points

5 year………………………………    4.77%     4.45%      +32 basis points

10 year…………………………….    4.76%     4.52%     +24 basis points

30 year…………………………….    4.75%     4.68%     +7 basis points

The entire across the board increase in rates is due to one word: FEAR (False Expectations About Reality)  Has anything changed with inflation in the last 38 days??? NO….. Did the jobs report (+243,000) this morning show unexpected strength??? NO……Over 60% of the economic indicators released in February/March came in BELOW expectations of economists…..

After 18 years of transparency from our Fed Chairman we now have someone (Bernanke) that has decided he will not give any indication on the future of monetary policy until the next FOMC meeting on March 28th. Markets have a very difficult time with uncertainty especially from a NEW Fed Chairman. Interestingly it is the 30 year interest rate that has shown the smallest upward movement over this period of time and that is the one maturity that focuses entirely on future inflationary expectations.

The compounding effect of a strong seasonal bias towards rising long term rates has put bond traders and real estate professionals in a panic mode and it clearly shows in sentiment surveys that are now residing at maximum bearish levels. The seasonal bias towards higher long rates doesn’t usually end until mid-April but it is interesting to note that the 41 basis point increase in the 10 year from 4.35% (01/04) to 4.76% (3/10) is much smaller than the normal movement of 99 basis points we have seen since 1966. If you want to see the entire table (1966-2006) just send me an e-mail.

The key to future Fed policy is usually found in loan demand from the commercial and industrial and real estate sectors and this afternoon’s H8 report showed a slight slow down but we will need many more weeks/months of flat numbers before the Fed would even consider lowering the Fed Funds rate (currently 4.5%). What bothers me the most is that if the “experts” are correct and the Fed raises the funds rate to 5%++ it will be for one reason and one reason only…..break the housing bubble and that is NOT in the mission statement of the Federal Reserve and whenever a Fed Chairman has created a new agenda we have seen horrible consequences to the actions taken….Has everyone forgotten the summer of 1987 when Alan Greenspan took office and decided that maintaining a stable and low inflation economy was NOT the Fed’s main objective because he decided that the US needed a stronger dollar at all costs…..Mr. Greenspan proceeded to raise the Funds rate to attract more foreign money into the US which started a currency war and with it came the stock market crash in October 1987……I am NOT implying that Mr. Bernanke is about to go off-course because we haven’t heard him say anything so the “experts” are just assuming that he will continue what Mr. Greenspan started and that probably will continue to increase short term rates…..but WHY???? If Mr. Greenspan saw inflationary pressures growing wouldn’t he have increased short rates more than he did???? Something just does NOT seem right and my firm belief is that long rates have risen more because of the “unknown” (Bernanke) than a rising inflation giant arriving from???? It is important to remember that the Fed raised the Funds rate from 1.00% to 4.5% in a 19 month period (6-30-04 to 1-31-06) and during that time long rates were basically unchanged showing that the long end of the market was comfortable with this policy. Now with only rumors that the Fed will continue to raise short rates the long end has lost its balance and the 10 year has risen 24 basis points…..This is truly backwards because the long end would normally see long rates drop if it thought that the Fed was going to continue to raise the Funds rate because it would signify that the Fed is AHEAD of the inflation curve…..Mr. Greenspan described the last part of 2005 as a “conundrum” with long rates flat and short rates rising…I would say the last 6 weeks are a conundrum with the market somehow equating more Fed tightening with a rise in inflationary expectations???? This may continue for a few more weeks but I assure you that if the Fed raises the Funds rate to 5% or more the long end will see lower future inflation and long rates will drop quickly…….If you want to see much lower long term interest rates then join the team that is rooting for more Fed rate increases…

BOTTOM LINE: My forecast for lower long term rates this summer is unchanged and the good news is that IF Mr. Bernanke changes the course set out by Mr. Greenspan (neutral policy – no more increases) we could see a MAJOR economic accident later this year (like the stock market crash of 1987)…..2006 is off to a rocky beginning for many and the bumpy ride may just be starting……

P.S. I have hundred of readers of this report in the Las Vegas area…I will coming up to your area Tuesday evening for a Wednesday meeting and if any readers want to get together for coffee Tuesday evening send me an e-mail.

March 6, 2006

“Where have you gone Alan Greenspan? A nation turns its interest rate eyes to you….What’s that you say, Mrs. Robinson – All mighty Alan has left and gone away?? Yes to borrow a song from many years ago it has been only 34 days but the interest rate markets dearly miss the former Fed Chairman. On Mr. Greenspan’s last day in office the US Treasury 10 year was yielding 4.52% but today resides at 4.75% with worries that it will soon test the 4.89% mark hit on June 14, 2004. Unfortunately we are in the middle of a seasonal pattern that shows 34 out of the past 35 years long term interest rates rising an average of 98 basis points between February 2nd and April 21st but the market is clearly worried about the unknown (Mr. Bernanke). If Mr. Greenspan had not retired (mandatory) it is doubtful that long rates would be rising…the market had become somewhat complacent always knowing that if something were to change that there would be some words of wisdom in advance from the Fed chief. But this is the beginning of the Bernanke era and it has become obvious that the landscape has changed and unlike his predecessor there will be no “words of wisdom” until the FOMC announcement at 11:17am on Tuesday March 28th. Markets dislike uncertainty of any kind (good or bad) and the interest rate markets had settled into a gentle rhythm at the end of Mr. Greenspan’s 18 year term. The recent increases in long term interest rates and fears of more Fed short term rate increases are embedded in this uncertainty and once we can get past March 28th and know what direction monetary policy will take for 2006 it will allow rates to settle back down for the next few months. This does NOT equate to a Fed easing any time soon but I will stand on my (shaky?) forecast of much lower long term interest rates by summer (August 8th??). I find it reassuring at times when the interest rate market seems to be going against me to always ask the question: “Has anything changed??”

Inflation

The Fed’s (Greenspan) favorite inflation indictor has been the PCE index (personal consumption expenditures) and this continues to show inflation at LESS than 2%, it has been in a range of 1.00% – 2.5% for the past 11.5 years and shows no sign of acceleration despite cries that oil and other commodities have shown huge advances over the past 2 years. Inflation is when everything rises in price and consumers buy not because they need an item but because they are afraid that if they don’t buy today the price will be higher tomorrow. The only asset that falls into that category is real estate and Mr. Bernanke’s #1 goal for 2006 is to make sure that real estate prices do NOT continue their recent advance……..Inflation is also a monetary phenomenon and the M1 money supply is showing -0.6% growth over the past year……Did you notice that the price of milk has fallen to a 31 month low due to oversupply??? How about AT&T’s acquisition of Bell South where the end result will be a big cost saving for consumers??? Wages??? not exactly growing….the number of striking workers in February totaled a whopping 5,200 out of a work force of 150 million… If inflation were rampant workers would be picketing for higher wages to keep up with inflation……with many companies cutting back on retirement benefits workers are lucky to have a full time jobs…..Bottom Line: 10 year interest rates at 4.72% less inflation of 2.0% equals a real rate of return of 2.72% and that is enough to assure the Fed that monetary policy is right on target…if Mr. Bernanke decides he MUST raise the Fed Funds rate to 4.75% or 5.00% it will simply be a case of trying to prick the real estate bubble AFTER the market has already done much of the work and the consequences (12-18 months) for the overall economy in 2007 will not be any different from any other Fed tightening (too much and too late) with an economic accident surely on the way in 07….

Mr. Bernanke will be speaking on Wednesday at 9am and will have a question and answer session but I seriously doubt he will give any clues to what is planned for March 28th.

Real Estate

Whether you are a bull or bear on real estate prices you MUST read the just released study titled “Mortgage Payment Reset: The Rumor and The Reality.” http://www.loanperformance.com/infocenter/whitepaper/FARES_resets_whitepaper_021406.pdf This 33 page report has everything you want to know about the debt and equity levels of the average American household with more than a few startling facts. Let’s start with something for neg-am fans: For homes that with first mortgages originated in 2004-05 with starting interest rates of 1.0-2.5% an astounding 21.5% of homeowners have 0% or less equity in their homes at today’s inflated levels. For homeowners who originated a new first mortgage in 2005 with an adjustable rate loan 32.3% of these people have no equity or even worse are already under water with negative equity. The good news is that I do NOT see a crash in real estate prices but this is the last asset class I would consider buying for the next few years.

I am very concerned with a severe price erosion in condos. Last year saw 17,177 rental units (2.25%) converted in California and an amazing 24,736 units (10.38%) in Florida. This has temporarily increased rental rates as the supply of apartment rentals shrinks in many areas. Although this should be temporary it is having a devastating impact on many lower income families as witnessed by an article in last weeks Rocky Mountain News that stated 50,000 households in five Denver are counties may soon face homelessness. http://www.rockymountainnews.com/drmn/real_estate/article/0,1299,DRMN_414_4507784,00.html
When the speculators that have purchased many of these condos begin to realize that there really is NOT a new buyer around the corner they will be forced to rent these units and the supply of rentals will increase thus driving down monthly rates but that may take another 12-18 months.

The real estate price tug of war is continuing across the country as Massachusetts saw a 21% drop in home sales in January and an increase in active listings jump by 41%. http://www.boston.com/business/globe/articles/2006/03/01/mass_home_sales_plummet_21/
In Arizona home builders see nothing but sunshine forever as they are raising prices in anticipation of a never ending stream of buyers….http://www.azcentral.com/business/articles/0301newhomes01.html
I hope the builders have an exit strategy just in case their strategy needs a tune up in a couple of months as the supply of new homes in the US is now 5.2 months the highest since November 1996.Condos have a 6.3 months supply.

I know that everyone believes that “this time is different” because interest rates are low and the economy (jobs) is strong but there are two MAJOR problems with this theory….1) 40% of the job growth in the US over the past 5 years has come as a result of the housing boom and if home prices level off (no crash) it will prevent homeowners from continuing #2) tapping into the ATM machine (house) and refinancing to keep consumption humming……in the first 9 months of 2005 the appreciation in house values created 58% of the increase in household net worth and that is NOT going to continue in 2006 or 2007. BOTTOM LINE: If the Fed continues to raise short term rates the probability of a MAJOR economic accident in 2007 increases dramatically..(last accident was in August 1998 with Long Term Capital almost taking the world banking system under….)

Loan Demand

62% of bank assets are in mortgage related loans and this could easily become a liability for many small and medium sized banks that have not matched their long term liabilities with short term assets and again if the Fed raises short rates many of these banks will be breaking down the doors to exit the mortgage arena. Commercial and industrial loan demand continues to grow and is the main reason I believe the Fed will NOT ease until late summer. Although the Heloc category is flat the overall real estate sector is growing rapidly (commercial) and that insures a tight Fed for at least six months. A tight Fed in my model is one that sits and does nothing until overall loan demand softens….. I highly suggest you review the Fed’s H8 report each Friday that is released at 1:15pm:http://www.federalreserve.gov/releases/h8/Current/h8.pdf

Stock Market

I rarely have much to say about the stock market as my focus is almost entirely on the economy and interest rates BUT found a little bit of info to share…..There have been only three times in the past 100 years when the S&P 500 has not had at least a 10% correction over the previous 36 months (1965, 1987, 1994) and each time the stock market FELL over the next year. Next week will mark the fourth occurrence as the S&P 500 has not dropped 10% (from the high) since March 2003. We’ll see…….

Japan

Japan’s CPI (consumer price index) rose 0.5% in January and the country is excited (the US would be in a panic) and hopes are high that the Bank of Japan will end its ZRP (zero interest rate policy) and begin raising interest rates later in 2005. After 11 years of declining prices (deflation) the government has been trying to find ways to create inflation and although it hasn’t succeeded yet it better be careful because it might find that inflation is actually as bad as deflation. My suggestion is for the Bank of Japan to hire Mr. Greenspan as its chairman……….

It’s almost midnight and that is my self imposed deadline….the jobs number is Friday at 5:30am and the market is expecting 250,000 and that number seems to be growing daily…I have much more to say about the current and future state of interest rates so I will try and write again on Wednesday or Thursday of this week. As always I welcome any comments or questions.