5 more tough questions and answers

Question #1: Fed Chairman Ben Bernanke told Congress yesterday that the Fed may be close to ending its Fed Funds rate increases and yet the bond market’s reaction was to send long term rates higher…..why???

Answer: As they say on the street…it’s all about “cred” or credibility, and Mr. Bernanke and his FOMC members have not shown that they have the same “toughness” as previous Fed Chairmen Volcker and Greenspan. Last year I wrote about the fact that the market wasn’t paying attention to the fact that the new Fed Chairman was not going to be the same as the old boss (Greenspan). Being “tournament tough” is something that is “earned” not given with the job of being Fed Chairman. Mr. Volcker earned his stripes in the early 1980’s when he raised the Funds rate to record high levels to stop an inflationary spiral that was clearly out of control. Mr. Greenspan learned a quick lesson in “market dynamics” when he took office in 1987 and attempted to save the dollar by increasing the funds rate which then triggered the stock market crash in October. Unfortunately Mr. Bernanke is being tested by the interest rate markets and this occurs in the form of higher long term interest rates which are the rates that the Fed can NOT control through monetary policy. To pass the test Mr. Bernanke is going to have to take control and he can do this by making it clear that the Fed will not allow core inflation to rise above current levels and that the Fed will do whatever it takes to make this happen. Last week Mr. Bernanke told the world that the Fed is now “data dependent” and will be watching all of the economic statistics (which report the past) to determine what changes are needed for monetary policy. Have you ever driven your car by only looking thru the rear view mirror??? I hope not, because that would surely cause a crash with cars in front of your vehicle. A Fed that is data dependent is a Fed that is always late and always reacting to what just happened… something Mr. Greenspan would never allow to occur. The biggest reason long term interest rates have risen since 1-31-06, Greenspan’s last day as Fed Chairman, is one word and it is NOT inflation it is simply that we have a new Fed Chairman and his name is Bernanke.

Question #2: When do you believe the Fed will stop raising the Fed Funds rate (currently 4.75%), and how soon thereafter will they begin to drop the Funds rate?

Answer: Let’s start with the words from Mr. Bernanke’s speech to the JEC (Joint Economic Committee) because they sounded very familiar… “At some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook.” Amazingly close to the words from Mr. Greenspan’s mouth to Congress on February 22, 1995: “There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflation pressures.” This statement followed a 50 basis point increase in the Fed Funds rate from 5.50% to 6.00% on February 1, 2005. Mr. Greenspan’s remarks were prescient as the Fed’s next move was an easing on July 6, 2005 of 25 basis points to 5.75%. Could this be a repeat of 2005?? Probably not, and for two reasons: 1) Long term interest rates were just over 8.00% in November of 1994 and by February of 2005 were approximately 50 basis points lower, showing that the bond market was picking up signs of slowing loan demand and economic weakness. 2) Mr. Greenspan had almost 7 years in office and his “Fed cred” had increased to the point where markets believed that his ability to see into the economic future had been proven many times to the point where it was easier to follow the Fed than fight the Fed. Today we have long rates that have made new highs almost daily since January and show no signs of correcting so Mr. Bernanke might be flying solo on this journey into economic outer space. The best chance for an end to Fed tightening would be for Mr. Bernanke to get “tough” with his “Fedspeak” and not allow the world’s investors to be looking for something that may or may not occur in the next few months. Of course, if we see a softening in loan demand (likely), or a major stock market decline (?), or an outside economic accident the Fed would quickly react. However, it needs to put the emphasis on views from the front windows and not the rear or the confidence levels that Mr. Greenspan built over 18 years will be destroyed in a matter of months.

Question #3: Is China’s economic growth having an effect on US interest rates??

Answer: Yes. The easy money policy of the Chinese Central Bank has created a runaway property price boom, but yesterday’s increase in the one year lending rate to 5.85% from 5.58% is a start in the right direction, but booming exports and expectations of an increase in the Chinese Yuan will force many more tightenings in Chinese monetary policy. Most bank lending in China is asset based with only a 20% deposit required for residential property purchases. Many of these purchases (30-40%) in Shanghei and Beijing are coming from foreigners and that won’t stop until interest rates rise or down payments are increased to levels above 50%. Foreign capital enters China in search of an undervalued currency (yuan), and assets that have rising prices (land), that can be leveraged to the maximum. This has created a growing property price bubble that will deflate sooner rather than later much like the Tokyo property bubble of the early 1990’s. Demand from the insatiable US consumer for Chinese exports should slow later this year due to an inability of US homeowners to use their houses as ATM machines as property prices slow their double digit increases of the past few years. Investing in Chinese land now is like playing musical chairs….you have to hope you are not the one at the end with no place to sit..(or sell your land).

Question #4: Rising commodity prices (oil, metals, etc.) why haven’t we seen higher inflation levels??

Answer: We may not see higher inflation even though gasoline prices could hit $4 per gallon in the next few weeks. The Federal Reserve issues a 30 page report called the Beige Book which is a survey of businesses across the country regarding spending, price, loan demand and real estate patterns: http://www.federalreserve.gov/FOMC/BeigeBook/2006/20060426/default.htm
It’s not easy reading unless you can’t get to sleep…but this week’s version had a few interesting highlights. 1) It found that many businesses were having difficulty raising selling prices. The increase in raw material prices were resulting in smaller profit margins and that is NOT inflationary. 2) In many parts of the country tourism is down as the high price of fuel is constraining consumers driving patterns, which is NOT inflationary. If you have a fixed salary and you have to drive to work each day the amount spent on gasoline rises and the amount spent on discretionary items falls. 3) In the Gulf of Mexico the rig count is close to pre-Katrina levels so the ability of companies to find oil should increase which will keep record inventories of oil around the US. Gasoline prices are rising due to the switch from MTBE to ethanol in the mix of at the pump gasoline. 95% of the Ethanol productions plants are in the mid-west and can only be transported by truck so we may see higher gasoline prices before this government sponsored mess is fixed. 4) The Massachusetts residential market currently has 16 months of inventory for sale but most of the houses are in the high end of the market. 5) Many of the residential mortgage lenders have increased the amount of mortgage loans they are retaining in their portfolio as margins have narrowed on loans sold into the market.

I do believe that commodity prices will have an impact on Fed policy from the standpoint that the Fed will not ease up on rate increases until they see commodity inflation decline…….although these price increases have not filtered through to consumer inflation they won’t take a chance even it they feel it has a low probability of occurrence..so keep watching the price of gold, silver, copper and oil because Mr. Bernanke said yesterday he monitors these prices all day while sitting at his desk.

Question #5: What’s next for residential real estate prices?? Steady or a crash?

Answer:  One of the keys to forecasting is watching seasonal patterns. There are specific times of each year that show tendencies to perform strong or weak each and every year. Housing prices show the most strength each year in the month of June with an average price advance of almost 4%. (the weakest month of the year is September). With interest rates increasing this year it will be important to watch prices in June to tell us how the support of the housing market. I found it amusing but not surprising to see the results of a recent Gallup poll that showed more than 70% of US consumers believe the US housing bubble will burst within the next 12 months but only 32% of these people believe that the price collapse will occur in their neighborhood. Obviously each part of the country has its own demand and supply pressures but the Massachusetts area seems to have a growing supply problem. According to a realtor in Boston: “the market is saturated with condos.”http://www.boston.com/business/articles/2006/04/22/multifamily_home_sales_boom_ends_4_year_run/
In Salt Lake City a billboard sign announces a “free big screen TV” to potential house buyers driving on Main St.
http://www.sltrib.com/portlet/article/html/fragments/print_article.jsp?article=3741214

A potential big problem for the real estate market may be coming from the Office of the Comptroller, the regulatory body that oversees bank underwriting of real estate loans. In a speech given in Los Angeles on April 20th, John Dugan (Comptroller of the Currency) worried about the fact that 30% of all mortgages issued in 2005 were interest only and pay-option ARM’s and that many of these loans were underwritten at the starting rate which is many times well under the market rate of interest. http://www.occ.treas.gov/ftp/release/2006-48a.pdf. I fully expect new regulations very soon from this agency that will make it much more difficult for many borrowers to qualify for a home loan that easily qualified in 2005 and early 2006. If you must buy a house and don’t have much for a down payment or reserves you might want to run to your local mortgage broker to be approved before these new regulations are implemented.

Question 5.5: Should I melt the pennies that I have saved for years in my piggy bank?

Answer: Not yet but if the price of zinc and copper continue to rise it will be profitable to melt those pennies. Each penny produced by the US Mint costs 1.4 cents so as usual the government has found a way to lose money on another business venture every day. Each penny in circulation is 97.5% zinc and 2.5% copper and there are 160 pennies in a pound so if see another 20% increase in the price of zinc and copper it might be profitable to melt but the cost of melting and selling the pennies (and inconvenience) might be more than the average US consumer can handle unless you have hundreds of pounds of pennies. If these metal prices continue to rise I see the US government eliminating the penny and changing the smallest coin to the nickel.

Bottom Line: It’s a new era and we have a new Fed Chairman that is about to be “tested” for endurance and a few other things that I won’t write about… After this testing period I continue to believe that long term interest rates will decline in the fall and offer an excellent opportunity to lock mortgage loans for a very long time…

April 19, 2006

High speed trains on a collision course

Every few years we witness an economic accident and although they are very difficult to predict in advance the odds are increasing that 2006 may see a collision between two tidal forces. Let’s call the first train “rising commodity prices” that include oil, precious & industrial metals and other commodities that are seeing new highs daily. Although many feel that these bull markets represent future inflation I remind all readers that inflation can only occur if the Fed allows money to be created that is then used for purchases that are made because of a fear that rising prices will continue “forever.” Worldwide hedge funds are “investing” funds as quickly as possible into these commodities and that has caused the recent price spike to accelerate the advance and not everyone will be able to find the exit door when the Fed finally yells “fire.”

The second train is one that appears regularly on the tracks of the world economy and its name is the “Fed” and it is now headed for a straight on collision with rising commodity prices. Chief conductor Ben Bernanke and his FOMC members have continued the tightening that began on 6-30-04 when Mr. Greenspan was head of the Fed. With its latest increase in the Fed Funds rate to 4.75% and every intention of going to 5% on May 10th the Fed is taking no chances that the gold and oil price rises will somehow convert into inflation. The good news is that with oil now above $70 we are seeing record high inventories so the demand is clearly coming from speculators hoping to make a quick score before the demand for gasoline falls as it will in the next few weeks. Last fall when oil hit the $70 level the US consumer was still flush with $$$ from house refinancing and other borrowings at very low interest rates against rising home prices. With higher interest rates and stable house prices the stretched to the limit consumer (high debt/no savings) will now pull back discretionary purchases to keep the tank full in the car that must be used to arrive at work each day. With the oil futures market now in contango (later delivery dates higher than current prices) there is tremendous demand from speculators who are buying oil in the spot market and paying for storage and then selling a futures contract for delivery in a few months or years to lock in a guaranteed profit. This will end sooner than later and won’t be a pretty result for the latecomers that are always slaughtered as the “free” money becomes a mirage for those that hop on the train at the last station before the end……

Japan bounces back

It has taken a few years but Japanese consumer confidence has risen to its highest level since 1988. The Bank of Japan’s ZIRP (Zero interest rate policy) has finally found traction in an economy that still has some deflationary spots that won’t go away. Employment is increasing but wages are still lagging behind so it will be another couple of years before the BOJ begins to raise short term interest rates which may bring some of the money invested in US Treasury securities back to its home base. When the BOJ begins raising short term interest rates it will be the first time in 15 years that the Fed, ECB and BOJ have all been on the same side of the monetary equation (raising short rates) and the world wide hedge funds may find that a painful position. (see my comments last week about Iceland)

Is the Fed confused?

In a letter written to a South Carolina congressman Ben Bernanke expressed confusion about the lack of follow through to consumer prices from the recent uptick in the price of gasoline/oil. He really shouldn’t be confused as the core inflation numbers (less food/energy) have been consistently under 2% for the past 2+ years and show no sign of increase despite recent commodity price increases that are driven more by speculation than inflationary expectations. This morning’s CPI core number rose at an annual 2.1%. Tuesday the minutes from the March FOMC meeting were released: http://www.federalreserve.gov/BoardDocs/Press/monetary/2006/20060418/default.htm
and there were a couple of items that warrant our attention. 1) “Outlays for drilling and mining structures continued to rise rapidly and appeared poised to increase further in the near term”. When prices rise, increase supply is on its way. 2) “The effects on spending of the substantial increase in short-term and intermediate-term rates since June 2004 had probably not yet been fully felt.” It takes an average of 12-18 months of Fed tightening to be felt in the overall economy. 2006 and 2007 will see a pullback in consumer spending and investment as a result of Fed policy in 2004 and 2005. 3) “Some meeting participants expressed surprise at how little of the previous rise in energy prices appeared to have passed though into core inflation measures.” The Fed never seems to learn the lesson that a strong economy does NOT always create an immediate increase in inflation.

Housing

A recent study by First American Corp. shows that 43% of first time buyers in 2005 paid no down payment. If housing prices do NOT rise in 2006 there are going to be many nervous home owners. According to the Boston Herald the number of condos for sale in Boston has doubled in the last twelve months while the number of single family homes for sale has increased 60%. http://business.bostonherald.com/realestateNews/view.bg?articleid=135042
One of the many important economic indicators I use is that of seasonal patterns. Since January of this year I have been writing about the fact that 39 out of the last 40 years long term interest rates have risen an average of 99 basis points in the first half of the year and in 2006 they are up 70bp. The key to the housing market for the remainder of this year lies in the price patterns we will see over the next 2.5 months. The strongest month of the year for house prices has been June with an average appreciation of almost 4% with March in 2nd place at 2%. (April and May are in 3rd & 4th place). If we see price appreciation over the next couple of months then the housing market is probably not ready for a fall BUT if prices are flat or even down a little then the message the market is sending is one of much lower prices in the fall. The weakest month for prices is September (-2%) so pay close attention over the next 75 days and you and the Fed will be ready for the 2nd half of 2006.

Interest rate update

The relief rally that I predicted a couple of weeks ago appears to have started (better late than never) but is being met by sellers in the long end who are afraid that the Fed may end the tightening too early. Much of the increase in long rates this year has come from the real rate embedded in the nominal rate NOT the inflationary premium. (I will go into detail on this subject at my interest rate class on 5/17) The recent increase in rates has been in line with the normal 1st half yearly increase that we have seen in 39 out of the last 40 years. In fact the 70 basis point increase is less than the average of 99 basis points and much less than the 119 increase that we witnessed from 3-16-04 to 6-14-06 (I’m sure many in the mortgage community have vivid memories of that period). The good news is that the 2nd half of 2006 will see a very favorable interest rate environment with October showing signs of having the best chance for significantly lower long term rates that will be used by many for lower rate refis. On a very short term note it appears that sentiment has finally bottomed and that is the first step before prices bottom so we are getting closer to the high in rates for this cycle but because sentiment almost always precedes prices we could easily see another 30 basis points increase in 10 year rates which would then make the 2006 equal to the average of the past 40 years.

Conclusion

It’s been painful for the mortgage community in 2006 as house sales & price increases slow and the Fed cautiously begins to wonder when to end its current interest rate (rising) policy. May 10th is the current consensus date for the last Fed Funds increase (5%) but the market doesn’t trust the new Fed leader at this point so long rates will have trouble falling until the summer when it becomes apparent that the Fed has finally caught on to the economic trend. It’s not easy being a Fed chairman as the few chosen have all had rocky beginnings and Mr. Bernanke may prove no exception. Hang in there, the Fed will NOT allow the inflation rate to increase and as a result we have NOT yet seen the low for long term interest rates in 2006.

April 10, 2006

Current state of the interest rate market

Since January 4, 2006 10 year US Treasury rates have risen 60 basis points (4.35%-4.95%) and if one reads the press or their mortgage statements it seems as if they have risen 160 basis points. In 39 out of the last 40 years (except 1996) long term interest rates have risen an average of 99 basis points between February 2nd and April 23rd. When this advance has begun in January it has risen an average of 111 basis points and ended on May 1st. Has everyone forgotten that in the first quarter of 2005 long rates rose 64 basis points, in 2004 we saw a rise of 119 basis points, in 2003 we rose 52 BP, in 2002 we rose 60 BP and in 2001 we rose 71 BP. I could list the last 40 years but I hope that you get the point that rates do rise in the first part of each and every year. The pain seems to be more intense this year and we haven’t even reached the average rise which would take the 10 year to the 5.40% level (7% 30 year mortgage rates). The good news is that time is slowly running out on the interest rate rally. Only 8 of these rate rallies lasted until June and 12 ended in May but it is still painful because so many real estate borrowers are finding themselves on a record amount of leverage or high LTV. The really good news is that sentiment is at an extreme with bond bearishness at levels not seen since the early 80″s (I’m alot older than you realize) and inflation statistics will continue to show moderation over the next few months which will bring in overseas buyers of Treasury securities (despite what you read in the newspapers).

The really good news is for the hundreds of real estate professionals that read this newsletter: We should see a dip in long rates beginning tomorrow morning that will lead to slightly lower mortgage rates later this week. Is this the end of the long rate rise for 2006??? Probably not yet but I still believe that we will see substantially LOWER long term rates by the summer (August 8th??)

Scanning the news

Donald Trump is entering the mortgage business (http://www.trumpmortgage.com) and I found his web site’s opening statement quite interesting: “Our mission is to match each of our clients with the right loan–one that takes into account individual needs and lifestyles, not just the rate and terms.” It will be interesting to see if borrowers are willing to pay higher interest rates for the privilege of doing business with the Donald. I am sure when this new business fails he will somehow place the blame on the market place or anyone other than himself…….If he is smart he will just sell the rights to his name being used for this enterprise and not have any ownership……His 28 year old son Donald Jr. may have tipped off his father’s true intentions when he mentioned that one of his father’s goals was to take over mortgage clients distressed properties if the real estate market takes a turn for the worse…..Just the kind of lender we would all like to do business with…

Let’s stay in New York for a couple of interesting stories…I have warned for over a year that when (not if) the real estate bubble begins to slow down the condo market will feel the most price pressure…According to a story in the Financial Times condos are 51% of current available housing inventory and 4-5,000 new units are expected on the market in 2006 & 2007. Price rises ALWAYS create new supply and New York City is no exception to the rule….

Let’s travel down to South Williamsburg in Brooklyn where a fixer-upper built in 1910 is on the market for $900,000 after being sold in January for $680,000 and that is after it sold for $235,000 in October 2005. This building has everything you would want for 900M….falling debris, broken windows, graffiti on all of the walls. What does this home have that makes it a must own for the sharp investor??? Is their an oil or gold beneath the ground??? Sadly none of the above but it has been used as a crack house for the past year and it seems its getting harder and harder for the dealers to find good space for their business dealings… http://www.gothamist.com/archives/2006/03/29/real_estate_bub.php

Housing prices

There is no question that housing prices have been rising far longer than anyone ever believed was possible but how unusual is this price behavior??? Robert Schiller has gone back to the 1600’s and compared prices from Amsterdam, Norway and the US in an article “Long-Term Perspectives on the Current Boom in Home Prices”.. even though he is an economist he kept his thoughts to just 11 pages: http://www.bepress.com/ev/vol3/iss4/art4/ I have to wonder what the recent buyers of investment houses (28% of sales in 2005) will do when prices begin to level off… (rent to whom??)

Commodity Prices

Oil is trading close to $70, Copper is setting new highs daily at almost $2.70 a pound, zinc, silver and other metals make new highs daily….when will the advance end??? isn’t this inflationary??? Yes some of the demand for these commodities is coming from producers who have orders to fill BUT there is also an insatiable demand from new speculative commodity funds and ETF’s (exchange traded funds) that are jumping on board a train that is very close to its price destination and I wonder who will take the place of these speculators when they want to sell their positions……In England many of the big manufacturers who have been buyers of these raw materials are now finding it difficult to pass on higher costs to their customers. If demand from the true end user starts to wane it could be a painful ride down the price escalator for late comers.

Iceland

How does a country of 300,000 generate so much press from the investment community. A stock market decline of almost 20%, a currency decline of over 20% and record interest rates of 11.5% has caused a mad dash for the exit door in an investment known as the “carry trade” for world speculators. With Japanese short term interest rates at 0.001% it has been easy to borrow in yen at this low rate and use these funds to buy Icelandic Treasury securities and earn double digit rates of return…….until someone decides to exit the party which is what has happened in the last month and it caused a panic in a very thin and underdeveloped market. I have a feeling that a major economic accident is waiting to happen somewhere in the world and recent events in Iceland could be the precursor of a massacre in the commodity markets if these new hedge fund positions are unwound quickly due to world central bank tightening. Remember inflation only occurs when central banks are caught napping and that is something that will NOT happen in 2006.

Chinese Steel

Overcapacity is something that usually occurs when prices rise and steel production in China is no exception…..China now has excess steel making capacity of 120 million tons or over 33% of its annual output. This is the result of a 650 billion yuan investment in new steel plants in the past five years with much of the money coming from Chinese banks who couldn’t wait to find borrowers who have now seen their steel profits fall by 75%. High prices create more supply which creates smaller margins which then results in forced selling and lower profits. The cycle always repeats no matter what the product or where in the world it is produced.