The heavyweight championship of the interest rate world

The Fed versus the bond market

The dividing line has been drawn clearly at the 4.50% level in the US 10-year Treasury note. Today’s rate of 4.60% is identical to last Friday’s rate of 4.60% but much happened during the week to show the world how much the Fed does NOT want long-term rates to fall under 4.50%. Clearly the Fed does NOT control long term interest rates and their ability to “influence” long term rates is not as great as many market pundits believe.

The 4.50% level is important for a couple of reasons: 1) If the 10-year falls to under this level with the Fed Funds rate at 5.25% the odds of a recession according to a NY Fed study increase to 50% and that is not something the Fed wants to trigger; 2) This level has consistently seen sellers by major bond players and the 4.55 – 4.85% trading range of the past few months is still very much a part of every players battle plan. A move under will surely bring in those that have been waiting on the sidelines and probably be caused by a pullback in consumer spending. Most importantly it will cause the FOMC to make a quick and major decision that will probably result in the reduction of the Fed Funds rate by 25 basis points to 5.00%.

Almost all of the Fed speakers over the past couple of weeks have emphasized the need to control inflationary expectations through a policy of high short-term interest rates and tightening monetary conditions (negative sloped yield curve = short rates are higher than long rates). These almost daily comments from various Fed governors and regional presidents are the equivalent of defensive shots to hold the 4.50% line. The Fed clearly does NOT want to drop the Funds rate and would be quite content to leave the Funds rate at its present level for many more months to ensure that inflation does not rise back above the 3.0% level (core CPI). This weeks announcement that core CPI (Consumer Price Index) rose only 0.1% last month brought a sigh of relief by the Fed BUT instead of long rates declining, we saw them rise almost 5 basis points. Normally when a market receives good news but declines (bond prices down, interest rate up) it is a very bad sign but the bond market isn’t acting normal now and may not until the 4.50% level is either decisively penetrated or rejected with long rates rising back to 4.85%.

This mornings news that housing starts and permits fell more than expected sent long rates up again but this time only for about 60 minutes and then we saw a rally which drove rates back down to last Friday’s levels. Although many believe that housing has hit bottom, few realize that this bottom is temporary and soon to give way to another decline which will begin to change many opinions to the more realistic view that this is not something we have ever seen in our lifetimes. Bear markets are wicked and bloody but trick everyone into believing that temporary bottoms are permanent and a buying opportunity is at hand. We have yet to see the massive decline in jobs from the decline of housing prices and sales which will take at least a couple of years.

Earlier this week the National Association of Home Builders announced their monthly index rose to 33.0 in September up from the 30.0 level in September. As usual the first bounce is what is commonly called a “dead cat” bounce but has experts forecasting that we have seen the worst, let’s check back in a year and see what they are predicting. Remember these same economists have a stellar .317 batting average on interest rate predictions over the past 20+ years so what makes you believe that their forecasts are more accurate on house prices? I have written many times that those that make their living in the real estate market need higher prices so their opinions are clouded by the rosy past and their need for the market to rise like the tide so that all boats are again floating. Sorry not going to happen for many years and after most have left the business for greener pastures in other businesses (alternative energy?, defense?).

Foreclosures

Can you guess what city has the highest foreclosures in the third quarter? One would guess a city in Florida, California or Nevada but the #1 city was Detroit where one of every 80 homes is in foreclosure which is four times the national average.

This afternoon Realty Trac announced that total US foreclosures crossed the one million mark in October with an increase of 115,568 in October. The link has a table showing the number of foreclosures in all 50 states.

Mortgage Lender underwriting guidelines

As predicted in last week’s newsletter, the state regulators that oversee mortgage lenders that are NOT federally regulated have endorsed the federal regulations that were released a few weeks ago. Seven states have now agreed to adopt the new mortgage guidance and an updated list can be found at:

Bottom Line

Next week is short due to the Thanksgiving holiday (we will publish on Wednesday afternoon) and the economic news is light so action in the US bond market should be muted. As long as we stay in above mentioned trading range on the 10-year (4.55 – 4.85%) the Fed remains on hold but, when, NOT if we break the 4.50% level the Fed will be forced to begin easing and that will occur sooner than the Fed currently forecasts.

What happens in Vegas (housing) stays in Vegas (housing) ?

I’m sure you have seen the commercial about Las Vegas where almost anything that occurs is ok…economists and housing pundits seem to believe the residential housing price and sales decline are events that have no effect on the overall economy. Almost everything I read (50+ periodicals daily) tells the same story about a “correction” that is welcome and a rebound that is sure to arrive by 2007 or 2008. I find it amazing that on the way up housing was given credit for the increase in consumer demand, increased jobs and its positive impact on the US economy. But now that we have clearly seen a price peak it is shrugged off as just a blip on the scale of a trillion dollar economy. We are told that commercial real estate has taken the place of residential and that (according to the NAR) it is a great time to buy a house. Denial is always prevalent at the start of every bear market as the bulls that have made so much money on the way up tell us that “this time is different.” They are correct but not in the way in which they are predicting – this is a BIG, BAD, bear market that will last 5-7 years and have a devastating impact on residential homeowners that are highly leveraged.

If you have to buy a house…..

Despite everything you hear and read this is not the time to buy a house, BUT, if you can’t resist I suggest finding a willing (everywhere) seller and offer to rent for 2-3 years with an option to buy at today’s value. You will have peace of mind knowing that if house prices are at a bottom that you will have locked in a price at 2006 prices instead of those in a few years. The best news is that if I am correct in my forecast of lower prices you will be able to live in a house for a few years without the risk of home ownership; when did you ever hear the words “risk” with home ownership? Yes, you will lose some very valuable mortgage deductions, but able to save your down payment for a much better buy in a few years. I know this is a contrary opinion and very few will agree but I am truly an example of those that would rather “win alone” than “lose in company.”

Tuesday’s election

President Bush said that the Republican’s took a “thumping” when they managed to lose both houses of Congress. Not much to add and I try very hard to keep these newsletters to economics only, so I will focus on something I rarely write about: the stock market. Election results almost never affect markets over the long term but I did find an interesting statistic this week using the Dow Jones Industrial Average. Since 1896 the Dow has dropped almost 4% (approx 500 points) in the 21 trading days after an election in which the minority party (Dem.) wins a majority of the seats in the House of Representatives. With stock market sentiment near unanimously bullish it would appear to be a good trading opportunity for those risk takers that understand history is not always a good predicator of the future. (Please remember this is NOT an investment newsletter)

more from the election……

One of the first items on the Democrat’s agenda is an increase in the minimum wage now currently at $5.15 per hour ($6.75 in California). According to the Economic Policy Institute 14.5 million workers (total work force = 135 million) would receive a raise if the minimum wage level was hiked to $7.25 per hour. http://www.epi.org/content.cfm/bp178
20 states now have a minimum wage that is higher than the federal level and 1997 was the last time we saw a hike by those in Washington.

Consumer credit

Inflationary environments are characterized by an increase in borrowings as consumers realize that high inflation creates low or negative real borrowing rates. The greatest fear of markets today is higher inflation, but consumer credit FELL in September by $1.2 billion. In the last 10 years we have seen only one other fall in monthly consumer credit. Many homeowners have borrowed against their house equity and used the proceeds to pay down consumer debt but with home prices flat to down this seems to no longer be the case. Does the US consumer see something the experts are missing?

Trade Deficit falls

It didn’t get much ink but the US trade deficit fell $4.7 billion last month to $64.3 billion. Normally a trade deficit equates to strong consumer demand that is greater than our trading partners. The fall last month came from stronger exports and weaker imports which may show the beginning of a trend towards a slowing US economy due partially to the extension of a weak housing market. Whether it be real estate agents, mortgage brokers, construction workers, household supply companies, etc. the impact of a deep housing slowdown has just begun to be felt by hundreds of thousands that profited from the boom of the past 5 years.

11-14-06

Tuesday could be a big day for mortgage companies that are not federally regulated. (It’s also my birthday). The Conference of State Bank Supervisors is expected to release new regulations on nontraditional mortgages and that could make it much more difficult for home owners to borrow at high LTV’s and low monthly payments. (neg. am, option ARM, etc.)

Foreclosures and Bankruptcies

From Palm Beach, Florida comes news that one in every 153 households was in foreclosure in the third quarter – more than twice the national rate.

With an increase in foreclosures many are awaiting what they believe will be excellent opportunities to purchase homes at “bargain” prices in 2007. It may not work out as planned due to the new bankruptcy law as many lenders will prefer to work out payment plans with borrowers. If homeowners are forced into BK, secured creditors will have to share more of a debtor’s income with credit card, auto and other consumer lenders.

Interest rates

The green flag is again sharing the spotlight with the yellow caution flag. The 10 year Treasury rate continues in a trading range with 4.85% on the upside and 4.55% on the downside. Next week brings some important economic information with retail sales on Tuesday, CPI (inflation) on Thursday and then housing starts & permits on Friday. Any or all of these three events could easily push us out of this range with a downside break being the most probable. But patience is needed and no action is recommended until the key 4.50% level is broken. This would cause immediate action by the Fed in the way of a 25 basis point reduction in the Fed Funds rate. YES, I am still forecasting much lower long term interest rates giving everyone one last opportunity of a lifetime to lock in historic long term mortgage rates (low 4’s for 30 yr. mortgages)

As always I welcome your comments, questions and suggestions and hope to see many of you at my interest rate class on Wednesday November 15th.

The US government needs an abacus

It’s 5:29am this morning and anticipation fills the air on Wall Street as the BLS (Bureau of Labor Statistics) is about to release the monthly jobs number. With fingers crossed, interest rate players hope that the Washington number crunchers can finally get it right and give us a number that we can believe and use for economic and interest rate forecasts. But the darkness outside is a warning that bad news is coming and as the clock ticks 5:30am the announcement that only 92,000 jobs were created last month is overshadowed by yet another government accounting error. Last month the BLS told us that 830,000 jobs had mysteriously appeared over the past year and this morning they told us they had made errors in their August and September numbers. August was revised to 230,000 (+42M) and September is now 148,000 (+97M) which gives the appearance that the US economy is humming along at a rate much higher than previously announced and that the much hoped for Fed easing is now on hold. This is only a small part of why the bond market found that the first Friday in November turned into a blood bath sending long term interest rates almost 14 basis points higher. The BIG news is that the foundation of the interest rate market is crumbling beneath us as the credibility of government statistics is now in question as the BLS has no answer for the large revisions that have bond mavens scratching their head and wondering if they should be working in another market (sugar?, oil?).

I wrote about this problem last month and now it has become a MAJOR headache for a government agency that is in charge of information that is used to make billion dollar bets by money managers who control pension, corporate and personal funds. Can you imagine if a Fortune 500 company announced earnings and then revised them each month but couldn’t give its shareholders an explanation or assurances that the problem was being corrected? At a minimum, the CEO would be dismissed immediately and more likely the regulatory agencies would begin an investigation that wouldn’t end without someone’s head rolling…But it’s the US government so no one really takes responsibility and the beat goes on…..

The sad bottom line is that the US will pay higher interest rates on its debt, not because of higher inflationary expectations but because of a lack of credibility in government released stats.

It’s a great time to…..?

Did you see the ads in today’s USA Today and Wall Street Journal from the National Association of Realtors? The headline reads “It’s a great time to buy or sell a home”. I have watched and studied markets for many years and never have I seen a point in time when it is a good time for both the buyer and seller. The NAR spends most of the ad telling everyone why it is a good time to buy (prices will soon rise?) and if that is true (very little chance) then why is it a good time to sell? The ad closes with the typical sense of urgency line of “don’t delay” but for whom? I think they are right but it is the sellers that need to be in a hurry. This ad is an attempt to increase sales in a business that has clearly peaked and is at the very beginning of a slow, painful bear market that will have most throwing in the towel before we hit bottom in 2012? Just because you made $$ in real estate in the past does NOT mean it has to occur again, it’s always smart to recognize when you made $ because of luck rather than skill. http://www.realtor.org/files/home_buyers___sellers/good_time_to_buy_ad.pdf

Conforming loan amount to decline?

The current conforming loan amount of $417,000 is about to change based on the Federal Housing Finance Board’s survey that will be released on November 28. Each year this level has increased but with home prices down 3.1% in the 12 months ending in September we may see a decline for the first time in many years.

Freddie Mac announced that 89% of its loans in the third quarter showed cash out of at least 5%. This is the highest since the second quarter of 1990. The demand for cash out loans was driven in the past few years by lower interest rates but now we have cash out loans at HIGHER interest rates. The only reason a homeowner borrows at higher rates is if they really, really need the $$ to spend or make mortgage payments. This saga is just starting and not going to end with a soft landing like so many experts are predicting for 2007. Mortgage lenders continue to offer credit and soft credit analysis because of their ability to sell the loans so the perceived risk is minimal. Soon defaults will increase and the mortgage buyers will find they have indigestion and will say “no mas” to the lenders. It’s coming soon and the stories will be all over the newspapers and nightly newscasts.

Car sales and oil prices

Oil prices have declined 20% in the past two months and we hear predictions that the consumer is back with cash to spend from the savings in gasoline prices. Somehow everyone seems to have missed Chrysler as they reported Wednesday an inventory glut of 2006 models. The consensus that housing and cars are the weak part of economy is correct, unfortunately they are just beginning and weak demand will filter thru in 2007 to many other parts of US business.

The big cat sees darkness

Caterpillar Inc., the big heavy equipment maker is seeing a slowdown in business. The company’s economist said yesterday that they see a “significant slowdown” in the US housing market in 2007. For those betting that 2006 was the dip that refreshes for the house market 2007 could see a major increase in foreclosures.

Inflation worries?

The Economic Cycle Research Institute (http://www.businesscycle.com), an independent consulting firm, has a long track record in inflation forecasting. This morning it announced that its forward looking growth rate dropped this week to a -3.7% rate. This is a contrary forecast and very much against the conventional Wall Street wisdom and if correct will see long term rates dropping to the low 4’s in 2007.

Bottom Line

This is one of those days that I could write for hours but then my incredible assistant Rachel would have to stay here and although I work 18 hours a day it is not something I ask of others, so I will end with a forecast for the next few weeks. The yellow flag is back up after last week’s spilt with green. We remain in a 4.50%-4.85% trading range on the 10 year treasury and this gives the Fed more breathing room as it would have been forced to ease if we had dropped below 4.50%. Today’s bond massacre is not the harbinger of events to come just a panic from those that are upset about the BLS inability to count jobs each month. 2007 will bring rays of sunshine to those waiting for lower long term rates but hurricane force winds to those who desperately need home prices to stabilize.