Green flag waving again, but…..

The green flag is back but the yellow flag has yet to come down. This morning’s GDP news showing 3rd quarter growth of only 1.6% versus 2.1% in the second quarter and 5.6% in the beginning of 2006 clearly illustrates that the housing market is having a major impact on the US economy. House investment fell 17.4% and caused a 1.12% reduction in the GDP growth for the 3rd quarter. The best news came from the inflation front where we saw the GDP price index rise 1.8% down from 3.3% in the previous quarter. The “experts” who have been looking for higher inflation and using that as a reason for more Fed tightening have gone back into hibernation wondering how they can get their pitiful batting average back to a more normal .300. It amazes me how many people who receive newsletters from “bank economists” actually believe that they are correct more often than wrong. I received one yesterday from a reader who works in a bank and the economist wrote about a Fed increase in the Funds rate by January; maybe January of 2009 but definitely not January 2007.

The Fed stays the course

The FOMC held an unusual two day meeting (usually one day) earlier this week and as expected did nothing to change their current forecast of the economy or the Fed Funds rate (5.25%). As I have written for the past few months, the only event that could cause the Fed to ease (lower rates) would be if the 10 yr. US Treasury note fell below 4.50%. We are currently in a trading range of 4.50-4.85% and I don’t see a change to that for at least a few months. The chances of a Fed tightening in the near future I would put at less than 1% and might even be 0.00% as the markets have not fully discounted the effect of the housing bear market.

Housing – the bear begins to growl

Yesterday’s news that new home sales rose 5.3% in September with inventory falling to only 6.4 months is a perfect example of a headline that tells only a small part of the whole story. Digging deeper we find that median prices fell 9.3% and this is an example of economics 101 where if prices fall demand will increase at the new lower price. The real estate market is very inefficient but actually working well today as buyers are reacting in a positive way through purchases at lower prices. BUT, and it’s a big but, the inventory levels don’t tell the whole story. Due to these lower prices many who were trying to sell their house have taken these homes off the market thus giving the inventory levels an artificially low reading. These former sellers are now attempting to rent their properties in hopes that the rental income will be enough to make the monthly mortgage payment. Of course they are waiting for the market to rebound which would allow a sale at a higher asking price. This is typical bear market behavior…waiting and waiting and waiting for the market to rebound only to find that it never happens and then finally (in a few years) throwing in the towel at much lower prices. This article from this mornings NY Newsday is a must read for those that believe that the housing market has hit bottom.

There is one more problem that is not being written about concerning home sales, and that is the nasty word that a home builder never wants to hear: “cancellations”. Earlier this week home builder Centex reported a 37% cancellation rate last quarter and since cancellations generally occur approximately 3 months after the sale contract is completed we are looking at sale numbers that are highly inflated and sure to be revise downward at a later date.

The next 60 days

November brings a couple of major events, the first occurring on Friday November 3rd with the monthly jobs report; with a consensus forecast of around 125,000. Due to the recent BLS revision showing 700,000+ jobs found from earlier in 2006, Friday’s number may not move the interest rate market because there will be a strong belief from players that a revision will be coming in a few months. BLS credibility has been impaired and it will take many months/years for this government statistic to have the impact it had before last month’s announcement.

November 7th is election day for the House and Senate and the current consensus is that the GOP will lose the House but keep its majority in the Senate. It has been documented that financial markets are more comfortable with a Congress that is in gridlock and can’t pass any meaningful legislation (a sad commentary about our political system) so expected results should not move markets.

The most important event is one that is emerging and that is a Fed that seems to be correctly forecasting a US economy that is slowing due in major part to the beginning of the housing bear market. They have also been correct in their guesses about inflation which is falling (lower oil, etc.) What makes this so remarkable is that earlier this year financial markets were increasing risk premiums due to a feeling that the new Fed Chairman could never be as good a leader as previous chairman Greenspan (yesterday he said the worst is over for the housing market). Wall Street economists were shocked when the Fed stopped tightening in June and have not let up in their forecasts for a higher Fed Funds rates due to a fear of higher inflation. This is a classic example of being wrong and afraid to change which would make them admit to another forecast error. Instead they stay with their current forecast and hope that like a broken clock they will eventually be right. This receives much press (written and TV) but the Fed receives no credit for the fact that they actually have performed with precision and look like the big winner of 2006. Best of all, their forecasts are FREE while big $$$ is paid by people to these economists for forecasts that have been wrong almost the entire year.

My free forecast has not changed, we will witness much lower long term rates when homeowners realize that the housing price decline is not temporary but one that has legs for a long run. So why the yellow and green flags? I continue to believe we are in a temporary trading range on the 10 year interest rate (see above) and sentiment and heavy speculator long positions make me somewhat uncomfortable to have the green flag wave without a little bit of caution. Nothing to worry about for long term players as those waiting for historic lows in long term rates will soon be rewarded for their patience over the past couple of years.

Interest rate movements – uncertainty or inflation?

Although this past week showed almost no movement in long term interest rates it is important to dig beneath the surface and determine the driving force behind the recent rise in the 10 year US Treasury note from 4.54% (9-25) and today’s rate of 4.79%. 25 basis point moves are common in the interest rate market so the recent move is not that unusual but the forces behind the move may tell us what the future holds for rates in 2007. Nominal interest rates (4.79%) are a combination of inflationary expectations and a real rate of return (payment risk). What makes the past few weeks so unusual is that the entire 25 basis point move has come from the real return rate and not the inflationary expectation part that we can derive by subtracting the TIPS (Treasury inflation protected security) from the current 10 year note. The Tips yield has increased by 27 bp while the inflation premium has fallen by 2bp so the market is telling us that it sees no inflation problem in the future but there seems to be a lack of confidence in economic policy. This is a short term trend but one that needs to be watched closely and conforms with my strong belief that long term rates are headed much lower in 2007 due to a lack of inflation and a housing market that will cause many borrowers trying to find an exit door in a theater that is clearly on fire.

Greenspan speaks about the world economy

One of the benefits of being a retired Fed Chairman is that you are free to speak about anything, anywhere without worrying about the markets reaction because you no longer have the power to create Fed policy. On October 13th former Fed Chairman Alan Greenspan sat for an extended interview with a Canadian economist and it was published in the Wall St. Journal. Unfortunately the link is only operable if you are a subscriber but I wanted to make sure my readers were aware of a few of his comments. 1) He feels that the greatest fear of the central government of China is that there will be an insurrection from those millions of people dislocated by the recent capitalism. In his opinion this is why the government refuses to revalue the currency in hope that the low value will encourage more job growth from foreign companies. 2) He does not believe the future of alternative energy lies in ethanol because there is not enough acreage in the US to plant the corn needed to convert to this fuel. 3) The most controversial comments were left for gold when he stated that the yellow metal is not an indicator of inflation but the market’s perception of world financial chaos. This surely would have caused an uproar if made while he was still Fed Chairman. Over the next few weeks I will address each of his views.

The trade deficit – does it really matter?

Every month we read that the US is importing more than it is exporting in goods and services to foreign countries. The number is usually around $70 billion and supposedly that is a negative that will force the dollar lower and send interest rates higher. Year after year this occurs and yet interest rates drop and the dollar trades in a broad range. One of the reasons that rates haven’t fallen is that foreigners are taking their dollars received in trade and reinvesting them in US securities. In August (latest info available) net foreign purchases totaled over $116 billion with the vast majority placed in US government and agency securities. In the last 12 months this totals almost $900 billion and most importantly the purchases are increasing faster than the trade deficit so we are receiving more back each month than we spend on purchases abroad. These foreign investors and governments do have a choice of where to invest every month and that decision is based upon interest rates, country risk and most importantly liquidity. The verdict continues to be that the US is the best and safest place in the world and until that changes (no signs yet) we will be an importer of capital that will easily finance our deficit with plenty remaining.

Housing market

I haven’t written much about house prices lately because even I got tired about reading the same thing over and over and over….but I do have a few comments today. Let’s start in Southwest Florida where Lee County has 22 months of inventory but the amazing statistic is September saw 746 single-family home permits issued. We have entered a vicious bear market that will last 5-7 years and permits to build are soaring? Why? Is this even possible? Of course because life is so easy to understand if you remember that we only see life as we have experienced it and almost everyone has only experienced a home market that pulls back for a few months and then roars ahead again. If that is your experience then you love to see a pull back so you can pull permits to build houses that you will sell next year at higher prices.  This is going to be a very painful experience for those that try and catch the falling knife (home market). If you catch the handle you win, but, if you catch the blade you are out of business for a very long time. The odds on this trade are not good and those that see a bottom in the market are projecting their hopes and not dealing with reality because they have no experiences with a real growling bear market.

From Sydney, Australia comes the story of families living in mansions but relying on charity handouts to buy food. http://www.news.com.au/dailytelegraph/story/0,,20581474-5006009,00.html We will be reading stories like this in the US in the next few years.

The last important point to make tonight is that many home builders told us that the only way the housing boom would end is if the economy faltered and that job growth was the key to increasing home prices. The Labor Department told us 3 weeks ago that they found another 700,000 jobs were created in the last 12 months showing that the one weak area of the US economy didn’t exist (they gave no reason for this HUGE error). The stock market makes new highs each day, the Dow crosses 12,000, corporations are sitting on record amounts of cash and record profits but the housing market is slowly coming apart. It appears that all of the experts were wrong again and that the booming job market and shortage of qualified workers isn’t enough to support the house market. It’s not about jobs, it is about income and although the government may have miscalculated the jobs number it is the income number (wages) that is important and unless wages begin to increase at 10%+ rates it will be next to impossible to save those that are surely going into foreclosure in 2007-2008.

When the ship is sinking…..

I have read many articles this week about new federal guidelines to residential mortgage lenders not applying because they are regulated by state agencies. Within a few months we will soon see state regulators joining forces with the Fed and Comptroller of the Currency and placing pressure on lenders to tighten their underwriting guidelines. The old joke was the purpose of the Fed was to take away the punch bowl just when the party was peaking, the story of 2007 will be the big fight between regulators and lenders that want the option arm, negative amortization, low doc, no doc, etc. party to go on forever and why wouldn’t they? If this is how you made your fortune, would you want the rules to change? For those that thought that 2006 was a tough year in the mortgage business it will look like a feast compared with 2007.

The Fed Breathes a BIG sigh of relief

The yellow caution flag was raised a few weeks ago before the 10 year US Treasury rate hit its recent low of 4.54, but in this business it is always better to be a little early with a forecast and take a few chips off the table. Long term interest rates had been falling since June 30th when they peaked at 5.24% amid a strong consensus that the Fed would continue to tighten and raise the Fed Funds rate thus fueling further long term interest rate increases. It always is a good idea to go back and read the major financial papers of the recent past to remind oneself of how wrong the experts can be at critical turning points in interest rate history. With a 70 basis point drop over a less than 90 day period it became obvious that the late comers would again find themselves having to exit the lower rate train just as they did in late June when it became comfortable to assume higher rates. Is it any wonder that these “experts” batting average hovers at near .300 for the past 25 years. In baseball terms that average can win a World Series (great pitching almost always beats big bats in the Big Show- see the Yankees recent poor performance) but interest rates trend more like a cruise ship than a speed boat and as long as you keep your eyes on the main road it really is hard to be wrong for more than a couple of weeks.

The minutes that tell the story

The big event this week occurred on Wednesday morning with the release of the minutes from the most recent FOMC meeting that was held on September 20th. The Fed clearly is fearful of a resurgence of inflation and shows no inclination to ease anytime in the near future. Although the minutes are only eight pages in length the theme throughout the almost five hour meeting was that the recent weakness in housing will be short lived and that inflationary pressures are being watched closely.

Two important questions must be answered before we can address the future direction of Fed policy. 1) Why did the long term interest drop so dramatically (70 basis points) in the past three months and why did the consensus change from Fed tightening to Fed easing so quickly? Let’s remember that all markets are much like rubber bands, they stretch and stretch and stretch but never break. Long term rates had risen for almost the entire 1st half of 2006 and were badly in need of a breather after following the normal seasonal pattern that has seen long rates rise 75% of the time between January and June. After 17 consecutive increases in the Funds rate the Fed wanted to “pause” and analyze the incoming data before it made its next move. This is not the old Greenspan Fed where almost everything was done by “gut feel”, but the Bernanke Fed where open discussion is encouraged and more reliance is placed on staff economic studies. There is also a tendency for the market to project its desires through its positions. In other words if you are long bonds and betting that rates will go lower and the market begins to go your way, you begin to believe that economic events will occur that will make your position even more profitable. One of my long held rules on knowing when to exit a position (either long or short) is to ask yourself whether you would enter the same position today, if the answer is “no” then exit your position immediately and don’t look back. It is not the news that makes the market move; it is clearly more about how the players are positioned. The markets always move in the direction that causes the most pain to players. Did you see the action in corn the past couple of weeks? With a severe drought in Australia, a major exporter of wheat has been turned into an importer. With the wheat market rising limit day after day, players that were short (bet on lower prices) were in the most pain and forced to buy corn to try and hedge their losing positions. That is not a good hedge and probably caused even more pain for these speculators who will not soon forget this experience.

The 2nd question that is important to ask about the Fed is whether they really had any intention of easing (lowering the Funds rate) as the market was hoping during the September rally in bond prices? I wrote for weeks that the 4.50% level for the 10 yr. was the key resistance line and as long as this level held the Fed would not be forced to lower the Funds rate due to yield curve and recession probability tables. The 4.50% level did hold and the Fed is back to where it feels most comfortable, pausing until it needs to move. The Fed minutes show that Fed staff forecasts see a GDP slowing for the remainder of 2006 but then a strong 2008 (did they forget about 2007?). Economic strength does NOT always equate to higher inflation rates so this forecast could be accurate but not affect the Fed’s willingness to change monetary policy in the next few months. This is clearly a Fed that plans on only moving when it is obvious to the world marketplace that it is “safe” to move the chess pieces in a game that never seems to end.

It’s all about savings

It took only one sentence but a major concern of Fed Chairman Bernanke is that the US savings rate continues in negative territory. A negative savings rate occurs when consumers spend more than they earn and this has been a result of homeowners’ ability to tap into their equity through the many different mortgage products available over the past few years. With the “bear market” in housing now clearly underway I look for the savings rate to increase back positive over the next 5-7 years and although this will have a negative effect on spending for a couple of years the long term effect will ensure a growing and low inflationary US economy. This is one of the many reasons I strongly believe that the Fed will not be in a hurry to go back to the Greenspan positively sloped yield curve (short rates less than long rates) that encouraged so much world wide speculation in real estate and commodities. I am often asked if the Fed will lower short term rates to bail out the homeowners in so much pain with their loan payments and flat real estate prices. Nothing is ever 100% certain but this one is as close as you can get. The Fed is NOT in the business of pumping back up former bubbles and the residential real estate market won’t see any appreciable price increases for at least 5-7 years.

Retail sales, gas prices and consumer sentiment

With instant access to information through the internet, it becomes an immediate expectation that world markets will digest, process and convert each day’s economic news events into a final result. This is unrealistic and is often the cause of frustration by many economic pundits whose forecasts are often correct but too early to be of any use to their loyal followers. This morning’s release of retail sales number showing last month’s decline of 0.4% is a good example as when we dig beneath the surface we find that without gasoline sales they actually rose 0.6%. Sure gas prices have fallen almost 20% since their highs of 60 days ago but the average consumer does not react as quickly as many would expect and increase their purchase of gasoline thus spending the same amount each month. Price changes of key products and commodities take time to influence buying decisions and the US consumer is still very much afraid that gasoline and oil prices are headed higher thus the slowdown in ex-gasoline retail sales.

The consumer confidence numbers released by the University of Michigan showed a dramatic increase (92.3 vs. 85.4) more because of recent stock market strength than expectations of lower interest rates and stable house prices. It’s important to step back each month and see the economic world as something that changes only major direction infrequently but hits speed bumps almost every week.

Conclusion

Although the interest rate bears seem to be in charge again (similar to early 2006) this rise in long term rates will soon pass as it becomes painfully obvious to everyone that the residential housing market has NOT hit bottom but is rather just resting before it resumes its slide. The Fed is a very comfortable position of watching as the market tries to guess its next move and laughing as even Fed Chairman Bernanke is content with the fact that he will just follow the leader (long rates) until he is certain that inflation has peaked for this cycle. Long term rates have NOT seen their lows but may not resume their downward trend for at least a few more weeks or months.

The US government needs a new calculator

With much anticipation I arrived at 3:30am this morning awaiting the soon to be released monthly jobs report. Barely two hours later the bond market started moving violently up and then down and then up again. It was obvious that someone had “leaked” information, but how could they know whether it was good or bad news? At exactly 5:30am the BLS (Bureau of Labor Statistics) announced that job growth in September was a much less than expected 51,000 (120,000 consensus estimate) so why couldn’t the market rally (interest rates lower)? The bizarre answer became obvious just a few minutes later as we learned that the original August job growth of 128,000 was revised up to 188,000 and that the Labor Dept. had found? an extra 810,000 jobs as of March 2006. This news sent the bond market into a tailspin with 10-year US Treasury notes rising to 4.70% and they may have gone higher but the bond market closed at 11am due to the Columbus Day holiday on Monday.

These massive revisions bring two problems to the interest rate market. First the labor market is not nearly as weak as had been estimated using previous government statistics. This is probably the reason that wage growth is running higher than the Fed would like for this part of the economic cycle. Will this translate into higher inflation? Doubtful but it gives the Fed enough reason not to even think about an immediate easing (lowering) of the Fed Funds rate which the market had begun to discount over the past couple of weeks. Second and a bigger problem is the “credibility” of government stats and this will have a major impact on how the market reacts to future releases from the Labor Dept. Increased uncertainty always results in higher risk premiums and for this reason alone long term interest rates will be higher than they would be without the worry about the reliability of government stats. Big sums of money are invested by mutual funds, pension funds, hedge funds and individuals based upon forecasts of future economic strength and resulting inflation. When market players can’t trust what is delivered by the government, investment decisions must be made with higher risk premiums and that converts to higher interest rates. Remember the old adage that markets love certainty even if it is bad, but dislike uncertainty. Today is a black day for the US government bean counters and the markets will pay the price for many months.

What caused this massive mistake by the BLS? It’s all about the seasonal adjustment factor (also called the birth/death model) that is basically a guess about events such as teachers going back to work in September, auto plant shutdowns for the summer, temporary help added at Christmas, etc. The government must correct these errors quickly or delay the release of these stats until they are known to be more reliable as people’s hard earned dollars are suffering from added risk due to government sloppiness.

How to make $$$ in a housing bear market

One of the reasons that the residential real estate bear market will endure many years of pain is that there is no effective way to sell short houses thus creating more buyers on the way down as they cover their shorts. But in Denver some sharp investors have found a way to profit in a down market through foreclosures. According to the Rocky Mountain News: http://www.rockymountainnews.com/drmn/real_estate/article/0,1299,DRMN_414_5040563,00.html condo units that sold for $110-120,000 last year were sold in foreclosure sales this week for as little as $18-20,000. Unless the condos are just shells these investors are sure to show a quick and probably substantial profit.

I would warn everyone to be very careful before running out and buying foreclosures and make sure you know your market. In Austin, Texas there is one foreclosure for every 142 households and there is no guarantee that it won’t get worse before hitting bottom. http://www.news8austin.com/content/your_news/?SecID=278&ArID=171472 This article’s title is: “Austin’s housing market is strong”, I am not sure why a high number of foreclosures equates to a strong housing market but everything is relative so maybe they are trying to convince people to buy?

If you must buy……stay away from condo’s

We are far from the bottom in residential housing prices but for many it’s more about needing a place to live than the economics of the market. For the past two years I have warned against those wishing to enter the condo market as the supply of condos has risen dramatically and demand is at best flat. Condo supply has increased due to over building but now we see that many of these projects are becoming more of a rental property than owner user and that spells trouble for those trying to finance their units. Lenders put a greater risk premium on buildings where the majority of units are NOT owner occupied and that leads to higher lending rates. The story in Florida: http://www.naplesnews.com/news/2006/oct/01/conversion_reversion

Census Bureau study shows surprising results

Earlier this week another government agency, the Census Bureau released statistics showing that only 66.9% of houses in the US are owner occupied (the other 33.1% are rentals) Assuming that these stats are accurate it shows that just 33.1% of NY city houses are owner occupied but Las Vegas has 66.6%. Not sure of their method of verification of owners versus renters but it is a very interesting read for those in the real estate business.  I welcome reader comments after reviewing these stats.

Gold at $570, a buy?

This is NOT an investment letter and I make no recommendations but I found an interesting article this morning (arriving at the office at 3:30am allows me time to read the London papers) in the Telegraph which detailed a recent sale of 100 tons of gold by European banks. It appears that these sales were done to meet a quota deadline and if there are no more, gold may be in the early stages of making a bottom in anticipation of a year end rally. http://www.telegraph.co.uk/core/Content/displayPrintable.jhtml?xml=/money/2006/10/06/cngold06.xml&site=1&page=0

Dollar begins a rally?

World traders seem to agree that the next move for the dollar is down but I will take the other side as they seem to be talking up their positions. Thursday the European Central Bank (ECB) raised their overnight lending rate by 25 basis points to 3.25% and gave clear indications that it may raise again before the end of the year. With rising euro rates and a Fed that is clearly on hold one might conclude that the Euro/US dollar rate would rise in favor of the Eurodollar but this did not occur and today the euro fell hard to 1.26 and showed that traders were caught long and wrong into the long weekend. Whenever a market receives good news (ECB rate hike) and does NOT rally it is time to head for the exit door and fast….the Eurodollar could easily be headed for 1.20 or lower.

Bernanke speaks through Donald Kohn

Wednesday saw two speeches by FOMC participants but Fed Chairman Bernanke’s talk received most of the press even though he told us what we already knew….the housing market is correcting its recent price advances. Later in the day Vice Chairman Donald Kohn addressed the Money Marketeers at New York University and gave a speech that could easily have been written by Ben Bernanke. This is the same audience that former Fed Chairman Alan Greenspan used each year to communicate his views on monetary policy and cleverly let the audience know what to expect from the Fed in the future. Mr. Kohn’s speech is a must read for those that want to know what the Fed sees for monetary policy in the next few months. http://www.federalreserve.gov/boarddocs/speeches/2006/200610042/default.htm It is clear that the Fed wishes to see a rise in the personal savings rate that is now negative and feels that this is important for future economic growth. The best way to create savings is to keep the negative yield curve now found in the US (short rates above long rates). The most important sentence in the speech was: “Long term rates are unusually low relative to short term rates.” It is clear that the Fed will only lower the Funds rate (now at 5.25%) if they are forced by the 10 year interest rate trading at a level of 4.50% or lower for at least 30 days and that probability is very low. According to the NY Fed model that the FOMC follows closely the recession risk is over 50% when the 10-year is lower than 4.50% and the Funds rate is 5.25%.

Conclusion

For the past three weeks I have raised the yellow flag as the three month bond market rally (decline in long term rates) needed a breather. Earlier this week we saw sentiment figures showing that bullishness on bonds/notes was over 90% (bets on lower rates) and that is just too high and too fast for this market. The next few weeks should see the pullback I have been expecting and result in higher rates that will be painful for those that just jumped on board the lower interest rate train. Our final destination is still within sight (4% or lower long term rates) but the train needs to stop and for a fuel refill and this will take at least a few weeks/months before we resume the long awaited trip to all time interest rate lows and a once in a lifetime opportunity to lock your loans.