3 days until next Fed decision

The next Fed decision is just a few hours away (6-29) and although it appears that the FOMC will vote to raise the overnight Funds rate to 5.25% the language of the accompanying statement will determine the direction of long term interest rates for the next few weeks. The uncertainty that has surrounded the long term interest rate market for the past few weeks will end on Thursday at 11:20am with an FOMC decision that hopefully states clearly where current Fed policy is headed thus giving the interest rate market more certainty than it has seen since the Greenspan era which ended at the end of January. Amazingly the entire long term interest rate increase since 2-01-06 has come from the uncertainty of future Fed policy NOT inflationary expectations. The 10 year US Treasury note has risen for 154 days without a decline of 30 basis points and this is entirely due to the uncertainty over current Fed policy. The rise is only 88 basis points (10 year US Treasury) with the previous increase of over 150 days occurring in early 1996 when the 10 year rose 153 basis points in 169 calendar days. Most of the current increase has NOT come from inflationary expectations but the uncertainty over future Fed policy. Fed Chairman Bernanke desperately needs to clearly tell the interest market what his plans are for monetary policy and then execute these plans in an orderly and predictable method. Uncertainty in Fed policy will only create higher than necessary long term interest rates as the market adds an uncertainty premium that we haven’t seen since the late 1970’s-early 1980’s. Without firm leadership and clear, easy to understand monetary policy Mr. Bernanke will soon find long term interest rates much higher than necessary and inflation premiums that will stifle US economic growth. The world is watching to see what is inside the FOMC statement that will be released at 11:17am on Thursday June 29th. ( If you would like a table of every 30 basis point move in the 10 year US Treasury from 1962-2006 drop me an e-mail)

Houses for sale at reduced prices?

It was announced this morning that US homes for sale inventory is now at 6.3 months up from 4.3 months a year ago. With the Fed in a confusion mode it should only be a matter of a few more months before this inventory build up creates lower home prices. The ATM (house equity) window is slowing closing for many homeowners and unless we see a quick pick up in wage income consumer spending is sure to slow as we enter the fall/winter. In some parts of the country we have already begun the home price decline with a 4% drop in Massachusetts leading the way. http://www.boston.com/business/globe/articles/2006/06/27/mass_home_prices_drop_4_as_sales_fall/

Bernanke speaks to Congress

Fed Chairman Ben Bernanke will have another chance to raise his leadership and credibility status when he gives his semi-annual monetary policy report to Congress on Wednesday July 19. With the next FOMC meeting on August 8 this will be an opportunity to send a message to the financial markets between meetings.

Confusion reigns in the interest rate market

Markets that face uncertainty always decline and the US bond market saw an 11 day streak of lower prices end today with a modest bounce. I had to go way back in my memory bank to find a similar period in history (April 1974) when the 10 year Treasury yield rose from 7.42% to 7.66% over an 11 day period. I am hopeful that no matter what the decision from the FOMC on Thursday that long rates will decline simply from knowing that the guessing is over and certainty has set in for at least a few weeks. Mr. Bernake clearly needs to be reminded that former Fed Chairman Greenspan has left the building and the world desperately needs him to put his own signature on monetary policy.

Inflationary expectations are NOT rising

Every evening before I leave the office (11:59pm) for my five minute drive home I review a chart of current 10 year bond yields and am stunned that of the 64 basis point increase since February 1st (Mr. Bernanke’s first day in office) 60 basis points are from an increase in the real rate of interest. Everyone is talking about higher inflation being the reason that interest rates are higher but in fact only 4 basis points of the increase is from inflationary expectations. What the bond/interest rate markets are worried about is the credibility of Fed policy NOT inflation. When, not if, Mr. Bernanke wakes up and realizes that a Fed Chairman must be consistent will all remarks and policy we will begin a MONSTER bond rally and dramatic drop in long term rates…….hang in there, the best of 2006 is yet to come…

F.E.A.R. = False expectations about reality

Where’s Waldo (inflation)?

Much like the children’s game of Where’s Waldo I am left at the end of this long week wondering where is the inflation that has the Fed so worried? Wednesday’s report a 0.3% rise (due to a temporary rise in rental rates) in core CPI (consumer inflation less food and energy) sent the experts and press into a frenzy where words of “rotten”, “corrosive” and “awful” sent the bond market tumbling and 10 year treasury rates rising to a current 5.13% accompanied by a new forecast that the Fed will increase the Funds rate to 5.25%. Unfortunately with Fed Chairman Bernanke announcing last month that the Fed was “data dependent” he created an atmosphere where the interest rate market hangs on every economic release and then reacts violently in the opposite direction of what was expected by the consensus. What is most interesting about the CPI number is that if the rise was only 0.2% the markets would have been ecstatic and long term rates would have dropped quickly and the forecasters would be telling us that the Fed would not raise the Funds rate another 25 basis points on June 29th. One tenth of one percent move on a monthly statistic drives the world wide markets….is it no wonder that many traders are dizzy from being turned around and around by the new Fed Chairman in his game of trying to pin the tail on the donkey?

The inflation that created world wide headlines this week is based on fears from the 1970’s (double digit inflation). But the Fed is telling us that it’s inflationary expectations in the future that is driving monetary policy. It’s favorite inflation index (PCE – personal consumption expenditures index) is showing an annual growth rate of only 2.2% which is the same level it has been at for the past 2 years. Another Fed favorite is the TIPS (Treasury Inflation Protected Securities) is showing a future inflation level today of only 2.60% which is less than the 2.72% in March 2005 and the 2.71% in May 2004 (the last two inflation scares). So the question becomes why have long term interest rates risen if inflationary expectations are NOT higher according to the market? (much more reliable than wall st. economists) The answer lies in the other side of the equation….nominal interest rates (10 yr. today = 5.13%) are composed of an inflation component and one for the real rate of interest and since we know that the inflation component has not even gone to new highs by elimination it must be the real interest rate part. In other words investors belief in the ability of the US economy to stay sound has lessened so the buyers of US bonds are demanding a higher interest rate to compensate their risk of being paid yearly interest and principal at maturity. It is easier to see in the following table of 10 year interest rates.

Date                         10 yr. treasury         real interest rate         inflation component

June 16, 2006                 5.13%                         2.53%                             2.60%

March 25, 2004             4.59%                         1.87%                             2.72%

May 14, 2004                 4.81%                         2.10%                             2.71%

The Fed is in a box it built

If inflationary expectations are rising why is the Fed considering raising short term interest rates again? My best answer is because Alan Greenspan is no longer Chairman. The former Fed chairman knew that waiting for inflation to peak and begin heading downward would put the Fed in a position of chasing the economy downward instead of staying a step ahead. Mr. Greenspan relied on his “gut instincts” and knew from experience that CPI was a flawed statistic and that a Fed that was targeting a specific inflation number would be changing monetary policy frequently due to the normal ups and downs of economic stats. Our new Fed Chairman is still in the “teething” stage and the interest rate market is making him pay mightily for his inexperience and it is one of the reasons the “real” rate of interest has increased instead of the inflation component. If Mr. Bernanke insists on raising the Funds rate on June 29th he will making a mistake that history is sure to report unfavorably as it is never good for the economy when the Fed tightens into a slowdown. I remember vividly a famous quote from Fed Chairman William McChesney Martin (1951-1970) that “the job of the Federal Reserve is to take away the punchbowl just when the party is getting good.” Further Fed tightening will be the equivalent of keeping everyone at the party but taking away the water that is necessary to maintain a growing economy with little inflation. Remember that 70% of inflation comes from wages and unit labor costs are increasing at less than 2% on an annual basis.

Housing prices

Every day I receive at least one call from someone asking where in the US is a good place to buy a house? This week National City Bank released a study showing the approximate overvaluations (Florida, California) and undervaluations (Texas) of almost every major city in the US. It is a good place to start with a caveat that these are educated guesses and any buyer should due their homework before entering into this arena where the vast majority of houses have seen their peak prices for this cycle.

Sell your house and rent an apartment?

This is the second most asked question I receive each week and again there is no right answer that fits everyone but one of the bright minds at PIMCO (where is Bill Gross hiding?) wrote a piece this week about the sale of his house and moving into an apartment. (I wonder how his wife and family felt about this decision?) It is much easier to sell and buy liquid assets (stocks, bonds, commodities) than housing (and much less emotional) and the tax benefits from house ownership can NOT be found from renting an apartment but it does make interesting reading.

Hot business: For sale signs

Cupcakes were the hot business in 2005 but for sale signs are now in demand as many cities across America have seen increasing inventories of houses that aren’t selling as fast as they were in 2005. Sacramento has a near record 13,146 homes for sale (an increase of 1,800 in May). The other interesting fact is that 20% of Sacramento’s new homes are finished but have no buyers moving in. Lower prices and higher inventory are usually associated with a weaker market in the future.

Major condo projects canceled

From Washington D.C. comes word that tow major condo projects have been cancelled due to slowing demand. Although rental rates for apartment dwellers rose last month due to a shrinking supply of rental units I expect that many of the condos purchased in the past couple of years will soon be added to the rental supply as these buyers find out the hard way that the real estate boom is over and the best alternative to selling at a loss is to rent for a few years or more…

Good news: The Japanese are coming to the US to buy real estate

With interest rates about to rise in Japan after a 10 year period of deflation (YES, deflation) real estate investors have decided to test the waters in the US after being burned badly in the late 1980’s. Initially they will be looking at small buildings with relatively low leverage. Hopefully this time they will have better luck and not be buying at the top of a cycle like they did 20 years ago.

The regulators are coming, the regulators are coming…

Fed Governor Susan Bies gave insight into what is coming later this year for mortgage lenders for both commercial and residential real estate. On the commercial side the Fed is very worried about the percentage of bank assets that are invested in mortgages. From 30% in 1985 they have now reached 60% so I expect to see banks attempt to diversify their holdings through more commercial and industrial loans. On the residential side Governor Bies made it clear that underwriting standards are going to soon change with higher credit scores, lower loan-to-value and debt-to-income ratios, higher net worth and more liquidity required for most borrowers (especially sub-prime). The times they are a changin….for the Fed, for real estate investors, for home buyers and for the mortgage business.

Final thought

The best stat of the week comes from the chief economist of the Texas A&M real estate center (Mark Dotzour) who said that for the first five years of the 1990’s one new home-building permit was issued for every 7.5 people and in the period of 2000-2005 one permit was issued for every 1.3 new people. Unless the average family size has shrunk to around 1 we have too many houses and not enough people to buy them so prices must start to decline…..

The Fed is done – Part 2

Everyone is talking about the Fed

Amazing what can happen in just a few days when the markets are so jittery about future Fed policy. Friday’s weak jobs number was a clear signal to me that it was time to raise the green flag on interest rates. But Fed Chairman Ben Bernanke didn’t want to take any chances with the next FOMC meeting still three weeks away so yesterday he sent a Greenspaneske message to the world’s financial markets. In a speech to the International Monetary Conference he began by speaking about the US economy entering a period of transition but ended with a flurry of remarks about inflation. This struck fear in many of the world stock markets as the Dow fell 199 points but interestingly the bond market showed almost no reaction. It appears the stock players are worried about future Fed tightening but the bond vigilantes are applauding Mr. Bernanke’s willingness to fight future inflationary forces now instead of chasing them like Paul Volcker did in 1980.

Although every newspaper, TV, radio, web, etc. forecaster is now sure that the Fed will raise the Funds rate to 5.25% on June 29th (they were saying the opposite on Friday afternoon) I will stand waving my green flag and hold to the now lonely view that the Fed is done for this cycle. It will take at least six months for the Fed to begin lowering short rates but as economic stats are released each week of the summer the bond market (long rates) will drop back to levels we have not seen since the fall of 2005. The next three weeks will be full of diverse opinions about the FOMC meeting on June 29-30 but it would economic suicide for the Fed to continue raising short rates when the Fed Chairman is telling the world the “US economy is entering a period of transition” and “consumer spending which makes up two thirds of total spending has decelerated noticeably in recent months.” As usual what worries the markets the most will soon be forgotten and I fully expect a major decline in long rates during the month of July as the uncertainty of the FOMC meeting passes and the certainty of a weaker economy (led by a housing slump) enters the marketplace.

Will lower long term rates cushion the housing slump? Only for a couple of months as many who missed the housing boom pile on in a mistaken belief that they are being given once last chance to sail away on the USS Bubble…

Gold

An interesting article from yesterday’s Sydney Morning Herald (Yes I read over 40 newspapers each day) about the price of gold and it’s deep pocketed buyers. My only comment is a reminder that holders of gold receive no interest so it becomes an expensive bauble with the Fed Funds rate at 5.00%.

The World Gold council reported that “old gold scrap” accounted for over 300 tons of supply in the first quarter of this year. This is almost the same amount that was mined bringing us back to one of my old economic principals: when the price of a commodity rises, increased supply follows.

Apartment rents to rise soon?

There has been much written about the impending increase in apartment rents due to a weak housing market and a decrease in the supply of available apartments due to many conversions to condos. I agree with the shrinking supply theory but what is NOT being factored into these opinions is the growing supply of homes being rented by owners who have not been able to sell.

Bottom Line

Long term (not short term) interest rates are headed much lower. The concern about inflation is overdone and the Fed will NOT chase the inflation rate to the top of its cycle because the risk to the overall economy is much too great. One of Mr. Greenspan’s greatest assets was being able to see that inflation always increases late in the business cycle and he stopped the Fed tightening before the inflation peaks of 1989, 1994, and 2000. Yesterday’s tough words from the Fed Chairman show that he is starting to understand his role as one of “talking big but knowing when to hold them and when to fold them.” The almost two years of Fed Funds increases from 1.00% to 5.00% is over and now we will enter a six month holding period where the Fed can watch long term interest rates for the remainder of 2006 before deciding it’s next policy move. With the 10 year US treasury rate at 5.00% and the Funds rate also at 5.00% history has shown that this relationship holds the key to future U.S. economic activity. A sharp decline in the 10 yr. rate will give the Fed “cover” to ease while an unexpected rise would give the Fed a reason to consider tightening. Color me green as I see blue skies for long rates the remainder of 2006. Of course I see dark clouds for housing prices and believe the historic rise in home prices is done and we have begun a very long and painful slow decline that will not end for another 7-10 years.

Raise the Green Flag – The Fed is done…

Where are the new workers hiding?

Last night I wrote that the average miss over the past 20 years by the “experts” was 89,000 for the monthly jobs number. Those forecasters had predicted an increase of 164,000 new jobs in May so when the actual number of 75,000 was released this morning at 5:30am it should have no surprise that the gurus were right again. Digging deeper into the labor numbers I found nuggets that are screaming out to the Fed “no mas.” With everyone (including the Fed) afraid of the inflation monster it is comforting to know that the two biggest growth areas of construction and real estate employment grew by only 1,000 each last month. If hiring was booming wouldn’t temp agency employment be rising? It fell by 3,000 and is down four out of the last five months. The retail sector has lost 71,000 jobs over the past two months with average hours worked actually falling by 0.1 hours. As most of you know I closely follow seasonal patterns and take special note when a seasonally strong period shows unusual weakness. Yesterday I noted that 9 out of the past ten years the April employment data was revised upwards, today it was announced that the March and April jobs numbers were revised DOWN by 37,000. Inflation is typically caused by wage growth and unit labor costs and they show only a 0.3% rise over the past 12 months and that is NOT inflationary. Slow job growth and low wage growth = a Fed that is done with its tightening phase.

Inflation = too much money chasing too few goods and services

My first college course on economics was all about the money supply and how its growth caused inflation. That was 35 years ago and not much has changed except the fact that not many people follow the money supply statistics that is released by the Fed every Thursday. Money supply growth this year has been almost nil as M2 and MZM are showing growth rates of only 1.5% & 1.4% giving inflation enthusiasts a reason to run and hide. Velocity has increased but not enough to cause any concern for the Fed.

If they build it…people will buy…

From Sacramento comes the story of a developer that has received loan approval for a $375 million project that will allow him to begin construction on a 54 story twin condo and hotel project. The best quote in the article is:” We’re creating the market.” It will be interesting to come back and visit this project in a couple of years and see if increasing supply creates new demand. Basic economics tells us that an increase in supply drives prices lower but maybe this developer has a way of relocating thousands of high income, high net worth people from somewhere in the US to Sacramento. Are we soon going to see billboards across America offering rewards ($) for people who wish to move to another city?

Can house prices really decline?

Real estate agents always tell me that house prices must rise every year because we are running out of land in the US. My response is that 95% of America has nothing on it and that price increases are more about zoning laws than land availability. According to the OFHEO (Office of Federal Housing Enterprise Oversight) average house prices fell in the first quarter of 2006 in the states of Iowa and South Dakota for the first time since 2002. Before this real estate decline ends I forecast that all 50 states will see price declines with California, Nevada, Arizona and Florida leading the parade.

Trying to sell your home, join a growing crowd

Pulte homes, the nations largest house builder announced early this morning cut its earnings forecast by 20% due to “rising inventories and higher cancellation rates.” Increased supply soon will lead to lower prices and this trend is just beginning…

Higher inflation in India…higher interest rates to follow

A CPI rate of 5% and a declining rupee have the Reserve Bank of India in a tight box that will soon end with an increase in the bank rate from a present 6.00%. Unlike China that has seen a booming economy with little inflation India has seen oil and other commodity price increases filter thru to consumer prices.

Canada’s oil reserves are creating environmental concerns

We wrote about the oil sands of Alberta a few months ago and the digging continues 24/7 across the oil rich province. An interesting article about the destruction to the environment may be a precursor of things to come in the United States.