Around the far turn and into the stretch…

This mornings GDP report showing the US economy growing at a 2.4% rate in the 2nd quarter enabled the bond market to close the week on its highs with the 10 year Treasury note closing at 4.99%. This is down from 5.24% that was reached at the height of Fed panic on June 28th when everyone (except me) expected that long term interest rates were headed to levels of 5.50%-6.00%. Fears of continued Fed tightening caused by high inflation rates (2.5%) continue even though almost all economic statistics released in July show a US economy that is clearly slowing led by a slumping residential real estate market. The GDP figure showed a marked slow down from the 1st quarter (5.6%) but is even more pronounced when one digs deep into the numbers that showed a $52.6 billion increase in business inventories that added 0.4% to the 2nd quarter number. It is apparent that businesses expected much more consumer demand not realizing that previous buying was a result of higher home prices that enabled consumers to again use their home equity as an ATM machine. When home equity dissolves the only other area to create consumer demand comes from an increase in income and today’s ECI (Employment Cost Index) report showed only a 2.8% yearly increase and that is almost equal to the current US inflation rate. There is no question that the Fed is now going to be forced to follow the economy which has begun a pause that should accelerate over the next 6 months.

Housing

June’s housing stats were very weak and when you consider the fact that June is normally the strongest month of each year it portends a major slump in housing prices that is going to prove frustrating to many who want or need to sell over the next 6-9 months. New home inventory has risen to 132,000 the highest level since December 1972. New home sales were down only 3% for the month but this does NOT account for the thousands of cancellations that are making builders wonder what they are going to do with the land they have tied up for future building projects. The quote of the week goes to Donald Tomnitz, D.R. Horton’s CEO (#1 home builder in the country): “Every time we’ve gone into a downturn in the home-building industry, they have always been longer and deeper than we’ve all imagined.” “We’re preparing for the worst, and we think this one will be longer and deeper than just the last six months.” By the end of the year it would not surprise me if the average time that a house is on the market is 12 months or longer. Every other housing downturn has been caused by a dip in the economy. This time over 40% of new job growth in the past 5 years has come from the residential home sector so we are for sure to see a job decline in the next few months from this major part of the US economy. Higher home prices have been one of the main drivers of growth in the past few years and will clearly lead the downturn which is now just in its early stages. In California the number of RE agents has topped 500,000 making it probable that every time we go to the market or restaurant we have a RE agent there with us…the ratio is 55 adults for every one agent…..this will soon change as many agents will go from eating at the restaurant to working at the store.

Copper

With the price of copper having risen from under $1 to its recent high of $4 (now $3.50) one would believe that the mining and processing companies were making billions in profits (like oil). Unfortunately these companies didn’t believe the price increases and Phelps Dodge announced Wednesday that they hedged their production at 95 cents per pound so they booked a loss of over $200 million in the second quarter. The hedge funds are clearly long these metals and riding the wave of inflation fears, but I continue to wonder when it’s time to get out it will leave them with the unanswered question that has marked the end of every bubble in history….”sell to whom?”…this story is going to have an ugly ending.. http://www.azcentral.com/business/articles/0727biz-phelps0727.html

China

If you have an interest in China (everyone should) you must read this article from today’s China Daily (one of 27 papers I read daily) as the Chinese Premier Wen Jiabao spoke at a meeting of the State Council. Concerning the booming Chinese real estate market he stated that there will be increased regulations on the property market (90% of local land transactions are “illegal”) and that they will “curb” skyrocketing house prices. Remember that most prices in China are regulated (gasoline is $1.50 per gallon), the free market is catching on a little slower than that reported by most press accounts. The other important part deals with an increase in the minimum wage for farmers and urban dwellers and a directive that the consumption environment needs to be improved. An increase in Chinese consumer demand will have major (good) implications for the US economy. http://www.azcentral.com/business/articles/0727biz-phelps0727.html

Last week the People’s Bank of China raised reserve requirements 0.5% to 8.5% which reduces available loan funds by RMB 150 billion (yuan = 8 per dollar). The bank did NOT raise the rates for deposits as it would only increase the amount of money that flows into China every month. Foreigners now must deposit at least 50% of the purchase price on properties valued at 10 million or more. Can you imagine if the Fed did that in the US? House prices would fall by 25% or more……..

Big money leaving the mortgage business

Last week Washington Mutual announced that it was selling a mortgage serving unit to Wells Fargo so it could concentrate on its credit card business. National City is seeking a buyer for its sub prime lender 1st Franklin and don’t forget that the Comptroller of the Currency is expected to soon release its long awaited, wide ranging new rules to mortgage lenders. I can assure you that this will NOT be something lenders will welcome with open arms. The new regs should put a big dent in the ability of sub prime lenders to underwrite the high leverage, low payment (pay-option arms), low credit score loans that have been so profitable for the past few years. Many borrowers and lenders are soon going to be faced with one of my favorite mantras…”never confuse a bull market with brains.” http://seattletimes.nwsource.com/html/businesstechnology/2003138960_wamu20.html

The lower interest rate boat takes another passenger

Bill Gross, the famous money manager from PIMCO wrote a piece this week called “The end of history and the last bond bull market” http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2006/IO+August+2006.htm

I don’t mind the company from such a wealthy and famous money manager especially one has recently been mocked by the media because of his poor 2006 track record on interest rates. In this business if you are right 40-50% of the time you are considered a “genius” by your peers. Interest rate forecasting is anything but easy and takes a good 12 hours or more of day of watching and reading everything you can find and then more importantly determining whether it is good material or just a road to a dead end. The best part is that it’s always changing and the scoreboard (interest rates) is there for the world to see on a daily basis.

Bottom Line

Long term interest rates are headed lower with the 10 year US Treasury dropping to at least the 4.85% level. Friday August 4th will give us the last piece of the Fed puzzle with the “experts” prediction of a increase of 145,000 jobs. Unless this number is well over 300,000 we have shut the door on another chapter in Fed tightening history. Many months ago I wrote that the date of August 8th was going to be the most important date of 2006. This is the date of the next FOMC meeting and we will see a Fed announcement that the Mr. Bernanke and his pals have come to the conclusion that the economy is slowing (mainly due to the slumping housing market) and that they have pushed the hold button on the monetary remote control and that it will stay on hold for many months. Wednesday August 9th will represent an excellent day for mortgage brokers and other real estate professionals to “lock” in their loans as the bond market will finally recognize what we have known for weeks…the FED is done………

Another nail in the soon to be closed Fed tool box

Another piece of the interest rate puzzle fell perfectly into place this morning at 7am. Fed Chairman Ben Bernanke gave his semi-annual monetary policy testimony http://www.federalreserve.gov/boarddocs/hh/2006/july/testimony.htm to the Senate Banking Committee. Long term interest rates rose yesterday as market players worried over what the Fed chief would say about inflation and the need to raise the Fed Funds rate another 25 basis points at the next FOMC meeting on Tuesday August 8th. As usual most of the “experts” were caught on the wrong side again as his remarks were anything but expected led by the key quotes “we must be forward looking” and “the FOMC is looking for a gradual decline in inflation in coming quarters.” He also spent more than a few sentences commenting on the slowing of the housing market that may restrain household spending. It took only a few minutes for the bears (betting on higher interest rates) to run for cover and that helped drop the US Treasury yield 8 basis points to 5.05%. The most amazing thing about today’s interest rate action is that so many people still don’t believe that the Fed is done and that long term interest rates have seen their highs for 2006. There is an old saying that bull markets love to climb a wall of worry and that is exactly what we have now…this will enable long rates to drop to the 4.85% level on the 10 year before the next FOMC meeting.

Housing

June is normally a very strong month for housing, but not in 2006 as we saw housing starts fall 5.3% and permits dropped 4.3%. I have often found that when a seasonally strong month doesn’t perform as usual then the next few months are unusually weak and that is the case for the remainder of 2006 as the housing market is sure to be the weakest part of the US economy. What concerns me is that I am seeing many “investors” who are anxiously waiting for the first pull back in home prices. The first price decline could easily be a temporary bottom at the beginning of a long, slow bear market in housing prices with the most damage being done in the coastal communities of the US. It seems that the “hot” money is going into partnerships to buy houses out of foreclosures. It looks too easy and big profits are rarely that easy…..

Inflation

At 5:30a, the CPI (consumer inflation) was released and showed that core inflation (ex food and energy) increased by 0.3% in June which Mr. Bernanke stated was not worrisome because the Fed is now focused on the PCE Index (Mr. Greenspan’s favorite inflation indicator) and that will be released on Tuesday August 1st. I think Mr. Bernanke is finally getting the hang of his new job….he has taken a page from Mr. Greenspan’s book. If an indicator looks bad, just choose another indicator……The most important news from today’s CPI release that did NOT get any press attention is that 2nd quarter real retail sales (ex inflation) fell 3.8%. This means that consumer demand is falling and that sales only rose because of a slight increase in prices NOT an increase in unit sales. That is a sure sign that the US economy is slowing……They say it takes money to keep an economy growing but 2nd quarter real M2 rose only 0.8% not enough for the economy to grow unless velocity (loan demand) increases and even the C&I loans seem to be slowing…..maybe Mr. Bernanke is becoming less “data dependent” and more “Greenspanesque” by doing what’s best for the country by looking forward into his crystal ball rather than using his rear view mirror as a forecasting tool.

The British are watching

One of the advantages of getting to the office early (today 3:30am) is that I get a chance to observe economic events in Europe and the UK. This morning the Bank of England released the minutes of their monetary policy committee meeting that took place on July 5&6. http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2006/mpc0607.pdf

Although much of the report dealt with the UK economy there was an interesting passage about the US economy: “The slowdown in the United States might prove more pronounced than had been assumed in May, and could adversely affect growth in other UK markets, especially the euro area.” The British keep very close tabs on the US economy because a slowdown in consumer spending (that is why we have a trade deficit) would have a strong negative effect on our trading partners.

Bottom Line

On July 7th I wrote “one down and three to go” and after today’s events we now have “two down and two to go.” The next piece of the puzzle will be filled in on Friday August 4th with the jobs report which I again expect to show weakness. The final part is the yield curve which continues to show all yields under the current funds rate of 5.25%. The longer the 10 year rate stays under the funds rate the higher the probability that the Fed will NOT raise the funds rate on August 8th. The BIG surprise for the summer of 2006 will be that long term rates do the unexpected and continue to fall……

The table is set….

A week that saw very little in the way of meaningful US economic statistics unfortunately was inundated with news of war in the Middle East that helped drive the price of oil & gold upward while sending the prices of US equities slumping to new lows for 2006. Next week the world’s attention will return stateside as the main events occur on Wednesday (7-19) with an inflation reading (CPI) at 5:30am and Fed Chairman Bernanke’s semi-annual testimony to the Senate Banking Committee at 7am.

The BOJ plays catch up to the Federal Reserve

Most nights I am able to leave the office a few minutes before midnight but last night was an exception as I wanted to hear the press conference (1am) by Governor Fukui as he announced that the Bank of Japan was increasing its overnight lending rate by 25 basis points to 0.25%. (Yes, the rate had been 0.00%). This is a Major move for the Japanese central bank as it had a ZIRP (zero interest policy for many years as it fought hard against the deflation of the past 10+ years). The good news is that this massive monetary stimulation by the BOJ finally caught traction as the Japanese economy is well on its way to the first solid growth (with a little bit of inflation) since the mid-1990’s. The bad news is that much of the world’s speculative community (hedge funds) borrowed money (yen at 0.00%) and invested in many of the markets that have seen price appreciation (metals, commodities, small economies, etc.) and this may cause a little bit of indigestion for these funds as the cost of holding these positions is now becoming more expensive thus putting a dent in their profitability. It is interesting that at a time the Fed is about to end its tightening the Japanese are just beginning…….but with 100% of oil imported to Japan and oil approaching $80 or more how much the BOJ can tighten is questionable….

Oil and the US consumer

This morning’s news that June’s retail sales fell 0.1% was overshadowed by the news of the Middle East and the stock market’s third consecutive decline of over 100 points (Dow Jones). Digging deep into the number I found that ex- autos retail sales rose 0.3% BUT this was all from gasoline sales. With oil closing today over $77 it has become painfully obvious to everyone (Wal Mart, etc.) that the average consumer (non home owner) is spending less on discretionary items so that they can continue to buy needed gasoline for work, etc. Consumer spending on food, energy, interest payments and medical payments as a share of personal disposable income has risen from 50% in 1999 to over 58% this year. With home prices leveling off and soon to begin declining, the last area of borrowing will soon be shut thus making the savings short consumer the leader of the parade to a slowing US economy. The problem I see with the price of oil is that August is seasonally the strongest month of the year with an average increase of 4.5% so we may be on our way to the magic $100 mark especially if the Middle East situation worsens…..$100 oil would send long term interest rates plummeting….it would be anything but inflationary. If you would like a copy of a chart showing the strongest and weakest months for oil prices send me an email.

Nickel, copper and other industrial metals

Nickel (mostly used to make stainless steel) has risen over 50% in the past month but amazingly is NOT in short supply so who is buying? China has switched from manganese but there is something more at work…..the hedge funds that have been borrowing yen at 0.00% (now 0.25%) are BIG buyers in these markets but because they are NOT end users this game of “musical metals” may have an ugly ending….When, not if the Japanese central bank raises short term rates to levels that cut into these “hedgies” profits the old question of “who do I sell to?” will be the most often heard expression around the world…..will China step up and be the ultimate buyer of all commodities at any price? doubtful as Chinese imports of copper declined 25% in the first half of 2006….this is a story that is just beginning and the ending is NOT inflationary. The biggest eruption will soon be coming from China where it was announced that its foreign exchange reserves grew over $200 billion in the last year to a record $941 billion. If they don’t allow their currency (yuan) to rise they will be facing massive inflation sooner than later.

Housing and inflation

A few years ago many “experts” said that the US inflation rate was understated because rising home prices were not counted in the CPI index. Now those same experts are complaining that inflation is rising due to increasing rental rates for apartment dwellers. Yes the CPI may show a little more strength in the next few months because of this rental component BUT that may be short lived due to simple economics 101, when supply increases…prices decline. According to an article in this morning’s USA Today an estimated 25-40% of condos under development or apartments that were converted into condos for sale will be put back on the market as rentals. That would easily lower rental rates as these owners are forced to rent at declining market rents. The crash in real estate prices is coming to the condo market in California, Nevada and Florida as there should be excellent rental bargains in those areas later this year. http://www.usatoday.com/money/economy/housing/2006-07-13-condos-usat_x.htm

Washington Mutual announced Thursday that it was cutting another 900 jobs after 1400 in May and 2500 in February. They see the storm coming and doing what any good business does when it is time to batten down the hatches…lay offs, lay offs and more lay offs. http://seattletimes.nwsource.com/cgi-bin/PrintStory.pl?document_id=2003125873&zsection_id=2002119995&slug=wamu14&date=20060714

The Sacramento area appears to be rebounding from a six month housing slump. Appears is the key word because home builders sold 51% more homes in the 2nd quarter than in the first part of this year. But again we dig and dig and dig for the details and find that the average second quarter incentive was $15,200 worth of freebies versus an average of $4800 last year. Economics 102 states that if you lower the price you will increase demand and thus sales will rise…..would the stock market be considered a BULL market if the Dow dropped 500 points on higher volume? Just as important is the fact that house sales were 66 percent lower in Yuba County and 60 percent lower in Sutter County due to higher gas prices and substantial discounts on homes closer to Sacramento.

Interest rates heading lower

Did you know that the 10 year US Treasury rate has dropped 18 basis points in the last two weeks? Probably not because most of the focus of the press is on the Fed Funds rate of 5.25%. Pay close attention to this rate because it is on its way to 4.85-4.90% over the next couple of weeks and this will give the Fed the cover it needs to hold the Funds rate at 5.25% when the FOMC meets on Tuesday August 8. The CPI and Bernanke testimony on Wednesday will be important but with recent stock market declines, middle east tensions, and the recent jobs report a Fed tightening to a 5.50% Funds rate would send the wrong message to world markets. Sit back and enjoy the ride as long term rates begin their long awaited decline…..

One down and three to go……..

On Monday I wrote there were four pieces of the interest rate puzzle that needed to come together in order for the current Fed tightening cycle to have ended on June 28th. The first piece fit perfectly this morning when the jobs number came in far below the “experts” prediction with an increase of only 121,000. On Wednesday morning (7/05) the ADP survey (with hardly any track record) scared US bond traders with a forecast of 380,000 and that sent the US 10 year Treasury note rate to the 5.23% level. Today’s actual number sent these same bond traders running to cover their shorts at big losses but also gave the Fed one more reason to stop the increase in the Fed Funds rate at its next meeting on August 8th. The 10 year closed at 5.13% and would have gone to lower levels if not for the increase in average hourly earnings of 0.5% (0.3% was expected). What I especially like is that so many of the “experts” are still predicting another Fed Funds increase in August and this will create more buyers in the next few weeks as they throw in the towel on their forecasts.

2nd piece of the puzzle

The next important event occurs on the morning of July 19th when Fed Chairman Ben Bernanke testifies before the Senate Banking Committee about the current state of monetary policy. The world’s financial markets will be analyzing every word to see if he is trying to send a message to the markets that the Fed is on “hold” with short term interest rates. The day before he speaks we will have the latest inflation figures (CPI) and the core inflation number (ex food and energy) will be the important focus for the Fed, but they are very aware that inflation is a late cycle event and with jobs growth slowing and consumer spending leveling off, any bout of higher inflation will be transitory. Although much is written about “retail” inflation the core inflation numbers have the best track record in predicting future inflation. An excellent report on core inflation and its predictive value was published on April 26th by the Federal Reserve Bank of Philadelphia. http://www.phil.frb.org/files/resrap/resrap-sr2006.pdf

3rd piece of the puzzle

The last major important economic event before the August 8th FOMC meeting will take place on Friday August 4th with another edition of the jobs report. July seasonals have a strong downward bias so it will take a major hiring program by US industry to create a number (200,000+) that would send long term interest rates higher and scare the Fed into believing that they need to raise the Funds rate again to 5.50%. By the time this report is released I expect the 10 year Treasury to be below 5.00% thus giving the mortgage and real estate industries a much needed breather from the summer heat.

Last piece of the puzzle

The most crucial part of the interest rate equation for the next 4 weeks will come from the yield curve. It is very important that the 10 year Treasury yield stay well below 5.25%. The lower the 10 year interest rate falls the higher the odds that the Fed is done for this cycle due to the fact that a 5.25% funds rate would be very restrictive versus a 5.00% 10 year rate and the FOMC would NOT want to make monetary policy a punitive weapon when the market is doing most of its work. The other key is that a 10 year around 5.00% would send a message to the Fed that future inflationary expectations are not rising and that is much more important than current readings of inflation. One of former Fed Chairman Greenspan’s greatest attributes was his ability to not let current inflation readings influence his opinion of future inflation. As a result he was able to end tightening cycles BEFORE inflation (CPI) peaked thus causing less pain for the economy than if he & the Fed waited until they saw the end of inflationary pressures in their rear view mirror. It appears that Mr. Bernanke has survived a very rough first 120 days of his term and the interest rate markets are going to allow (and encourage) him to make the correct decision in ending the increases in the Funds rate.

Summary

It was not easy the first six months of this year watching the Fed raise short term rates and being accompanied by rising long term rates due to confusion over Fed policy and strong seasonals (39 out of the last 40 years they rose in the first half of the year). Now we have entered a very favorable time for long term interest rates with an average decline of 143 basis points in the second half of the year. I’m not sure we can reach the entire 143 bp this year (that would put the 10 year at 3.81%) but we will see a very meaningful decline in the 10 yr. rate over the next few months. Any long term rate decline will NOT be accompanied by a decline in the Fed Funds rate for at least 6 months, but we clearly have seen the highs for this year in long rates. Sit back and enjoy and get ready to refinance your home loans at fixed rates that are much lower than we have seen all year.

The 2nd half is sure to be better than the 1st half

Although it appeared that long term (10 yr. US Treasury rate) interest rates rose more than usual in the 1st half of 2006 it was only the time not amount that was greater than normal. Over the past 40 years the first six months of each year have seen an average up move in the 10 year Treasury of just over 100 basis points in a period that has averaged 83 calendar days. 2006 saw a move up of only 90 basis points but it was the 161 days from start to finish that made it seem more painful than normal. (January 18 = 4.34%, June 28 = 5.24%). Using more data from my memory and Federal Reserve statistics it is comforting to know that the 2nd half of each year has shown a better than 75% chance of a major move DOWN in long rates that has averaged over 143 basis points over a 127 day period. That kind of a move would put the 10 year under 4.00% and I am not sure that is likely in 2006 (maybe 2007) as Fed policy is somewhat uncertain and that has added a premium into the long end of the yield curve.

The next Fed move

After Thursday’s Fed move that raised the Funds rate to 5.25% (which I don’t agree with) the next FOMC meeting will take place on Tuesday August 8th. I am quite sure that even the mighty Fed has no idea what it will or will not do at this meeting but there are a few important events that take place over the next few weeks that will give us (and them) some clues to future monetary policy. This Friday’s (7/07) jobs report is the first piece of the puzzle and the consensus is again looking for an increase of 175,000 but remember the “experts” have been overestimating job growth for most of 2006. Wednesday July 19th Fed Chairman Ben Bernanke will speak to the Senate Banking committee with his semi-annual testimony about the state of the US economy. With his past “missteps” in mind he will be sure that his message is easy to understand about the future course of monetary policy. Thursday July 20th the Fed will release the minutes of last weeks FOMC meeting and they will be analyzed closely for comments from other Fed members about the need to end the increase in the Funds rate. Finally on Friday August 4th we will again see a jobs number that should show slowing job growth especially in the housing related sectors. My best guess is that the Fed is done for the remainder of 2006 (and beyond) and that my long awaited decline in long term interest rates has just begun……

The keys to the monetary lock box

Economic and interest rate forecasting is not easy and the most important part is to always focus on what needs to happen for the forecast to be correct and just as important to know when something has gone wrong…..The most important part to focus on over the next five weeks is the level of the 10 year US Treasury note which is currently trading at 5.15%. As long as this interest rate stays below the current Fed Funds rate of 5.25% we have the “all clear” signal as it is hard to believe that the Fed would intentionally raise the Funds rate to 5.50% thus inverting (interest rates higher in the short end than the long end) curve and raising the odds of an impending recession. Yes the mandate of the Fed is to fight inflation but it also must keep the economy growing at a rate that will produce more jobs. If the 10 year rate stays below 5.25% (as I believe it will) then we will have come to the close of a 24 month chapter of Fed tightening and be looking forward (approx, 6-8 months) to a new chapter of Fed easing in 2007. Long term interest rates are much more influenced by future inflationary expectations than future Fed policy (except in the first few months of a new Fed Chairman) and will head lower in the fall of 2006 as inflation sees its peak, the housing market enters a slowdown and job/wage growth grind to a halt. I have written all year that June was the key month for house prices (due to a strong seasonal factor) and that if June wasn’t strong the remainder of the year would be weak……from what I can tell June was NOT a strong month……we’ve suffered through a normal 1st half of interest rate increases and now we will all enjoy (except savers) lower long term rates for the remainder of this year.