Sunny but storms on the way?

Have you ever gone outside on a perfectly sunny day but intuitively knew that something didn’t feel right? You can’t put your finger on it but you just had a “gut feeling” that a storm was on the way. This week’s interest rate action was a repeat of last weeks when I wrote that a market that doesn’t respond well to good news is sure to fall hard when it receives bad news. Last Friday’s CPI release showing a 0.0% inflation rate was met with selling in the bond market and pushed the 10-year Treasury to 4.59%. In my bottom line section last week I wrote: “rates have further to go on the upside for the next few weeks” and today’s economic release of personal spending, personal income and PCE (personal consumption expenditures index) was better than the market expected BUT we saw more selling and the 10-year rate rose to 4.62%. (The rate in 2005 the day before Christmas was 4.55%). I know the markets are thin and many have left for vacation or chosen to take their chips off the table but it is not a good sign when rates rise on news that should move them lower. Next week is very quiet on the economic news front so it won’t be hard for rates to move in either direction. I will give my 2007 forecast after the New Year but it is very important to remember that history has shown a 75% probability for interest rates to rise in the 1st half of each year and then decline in the 2nd half of the year.

Rental rates to decline

One of my major predictions is that the housing bubble will not end in a crash but a long, slow painful decline that encompasses 5-7 years to unwind. I have also been extremely bearish on condos, as that is an area that has seen heavy speculation by highly leveraged buyers. As a result of weakening demand from end-users (homeowners) I wrote earlier this year that many of these buyers would find it difficult if not impossible to sell and be forced to accept rental tenants that would give them some $$ to make monthly mortgage payments. This week it appears that the rental market is finally seeing some of these condo owners succumb to the pressure of having to make another mortgage payment that they surely hoped would not be required. In Providence, Rhode Island a real estate agent is quoted: “We’re flooded with inventory, the rental market is terrible.” Just as important is the story from Tempe, Arizona where it appears that 98% of apartments are rented. Condo’s that aren’t selling are being converted to rental units and will soon be on the market raising the vacancy rate.

Although the vast majority of economists and analysts believe that the housing market will bottom in 2007 it will be years before we see any meaningful appreciation in house values due to the overwhelming leverage that needs to be unwound and this is not like the 80’s or 90’s decline like so many RE agents have told me they experienced. History does repeat itself BUT not when we need and remember just because you have made $ in the past from a market, it does NOT equate to future profits. The market owes everyone nothing except a lot of aggravation when you least expect it.

Finally, I wonder why no one is listening to the home builders who continue to tell us that they are having a difficult time forecasting future sales. Earlier this week Ara Hovnanian, President and CEO of Hovnanian Enterprises, a leading US home builder said: “We did not anticipate the suddenness or magnitude of the fall in pricing that occurred this year in many of our communities. The market is likely to bounce along the bottom for several quarters before pricing and sales improve.”

Stock market decline in 2007?

Most readers know I place a great amount of weight on sentiment as knowing where people have placed their bets tells an investor where the rewards are located if the consensus is wrong. This brings to mind an old Mark Twain quote: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
A Monday story on Bloomberg showed that the top 12 investment strategists at big Wall Street firms all predicted a higher stock market in 2007 with the average forecast showing a 9% rise in the S&P 500. The last occurrence of 100% consensus was 2001 and that year saw a decline in stocks. With sentiment figures hovering over 90% the last three months this usually sets up a nasty surprise for those who follow the majority.

I also notice that while the Dow Jones and S&P 500 have rallied to new highs this month, the Transportation average has NOT risen above its summer highs and just broke below October/November lows. If Transportation stocks are declining it is because these companies are seeing a cut-back in shipments and that is not bullish for the economy.

Bottom Line

I will not be publishing next week unless their is a MAJOR movement in interest rates (doubtful) and my 2007 forecast issue will be published on Friday January 5th (jobs data day). The yellow flag continues to fly in front of the green flag signifying that the short term trend of interest rates is higher but the longer term direction continues lower. Although we may see rising rates early in 2007, I continue to believe that much lower (high 3’s, low 4’s) rates are ahead when the realization hits that housing has just begun its decline and a soft landing is not something real estate prices will see for many years.

I wish all of my readers a happy and healthy new year and I will be spending Christmas Day feeding, clothing and finding jobs for over 800 homeless and poor in Los Angeles. This letter continues to be free of charge but if you enjoy the weekly e-zine I would ask you to consider a contribution to the charity I founded over 10 years ago in an effort to change the world one person at a time. http://www.foodonfoot.org

The Fed has been backed into a corner and may have to surrender

Today was a big day for EWW subscribers who took my advice all year that long-term interest rates were headed much lower later in 2006 as the US 10-year treasury rate today was 4.43%, 7 basis points below the critical 4.50% level.

Before I give you my current thoughts and forecast I ask for your patience while I review the highlights of this newsletters last 5 months (all found in the archive section at the top).

6-27-06 (one day before the peak in the 10-year at 5.24%) – “We will soon begin a MONSTER bond rally and dramatic drop in long-term rates”

7-19-06 (10 year at 5.05%) – “the BIG surprise for the summer of 2006 will be that long-term rates do the unexpected and continue to fall”

8-09-06 (10 year at 4.94%) – “For those with a longer term horizon long-term interest rates should be much lower later in the year offering much better opportunities to lock in lower fixed rate mortgages.”

9-08-06 (10 year at 4.77%) – “Market based long-term rates should stay in this area for the next few weeks before we see another leg down to new lows in the 10-year.”

11-17-06 (10 year at 4.69%) – ” 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.”

Yes, it has been that clear and that easy and hopefully all of my readers have profited from this FREE advice. When all of the top Wall Street economists (and newspapers) have been telling us rates were headed higher and the Fed would surely raise short rates, the exact opposite occurred (as usual) but as they often remind us that’s history and we need to know what the crystal ball is forecasting for 2007.

It’s been two weeks since my last newsletter so I could write for hours but that would only put many to sleep so I will only cover the basic themes. (I am considering taking on a few consulting clients for more specific timing of interest rates for their business, RE development or investment needs, if interested drop me an e-mail. As always all fees would be paid to Food on Foot.

The Fed model shows trouble on the horizon

The drop in the 10-year to 4.43% has placed Mr. Bernanke and his Fed team on high alert and I am sure the members of the FOMC are going to have more than one conference call next week to discuss the current monetary environment (Fed Funds at 5.25%). The problem they are facing is a 58% chance of an impending recession according to the now famous 1996 NY Fed study that measures the probability of a US recession based upon the current relationship of the Fed Funds rate (5.25%) to the 10-year (4.43%). The mandate of the Fed is low inflation and stable economic growth and it has become painfully obvious to them that economic growth is slowing (GDP 2.2%) while inflation remains at 2.4%. The Fed chairman has tried to hold the 4.50% level for months by sending out every Fed president and FOMC member he could find to tell the world that inflation was still an enemy that had more artillery and needed a strong and tight Fed policy to prevent an increase in future inflation. (Sounds like our current Iraq policy) but in reality the market (bigger than the Fed) has told a different story since June 28th. Long-term rates have dropped 81 basis points (5.24% to 4.43%) with 30 bp coming from a drop in inflationary expectations and 51 bp from a drop in the real rate (increase in Bernanke’s credibility).

December 12 FOMC meeting

The Fed has 11 days to decide its next course of action and inaction would be a huge statement from the FOMC. Does it hold the Funds rate at 5.25% and risk an economic setback led by the housing sector and tell the world that inflation fighting is the immediate goal or does it risk sending the dollar down the drain and admit that the market knows more than the almighty Fed? The wording of the press release at 11:17am on 12/12 may offer more clues than the actual change or no change in the Fed Funds rate. Fed credibility is at stake and Mr. Bernanke has worked hard to overcome his initial faux pas (Maria Bartiromo) and the drop in the real rate of interest has to be pleasing to the Fed Chairman so the upcoming Fed meeting will easily be the most important of his first year in office. It is clear that the Fed MUST ease as long as the 10-year rate remains under 4.50%. To announce that “this time is different” risks too much hard earned “cred” especially since interest rate history has numerous examples of ruined careers of those that tried to catch a falling knife (be a hero) only to find that instead of the handle they caught the blade and then were never heard from again. The Fed must either lower the Funds rate to 5.00% with an accompanying statement that this is clearly a one time event and they will keep the curve inverted until the inflation dragon disappears (does that ever occur?). The only other choice is to hold the Funds rate at the current level of 5.25% and announce clearly when they will lower the rate based upon certain conditions that have clearly been met but in Fed terms need more “seasoning”.

Is it time to lock my loan?

Of the hundreds of e-mails I receive each day (average 600) the most asked question today was “is it time to lock my loan?” and the answer is a clear “NOT YET” unless your time frame is the next few days or weeks. I have said all year that we are going to the high 3’s, low 4’s in the US 10 year Treasury and I see no reason to change that view. Yes the bond market is very frothy now and probably needs a pull back but we have yet to see the residential real estate bear GROWL yet and when that happens we will see the first signs of capitulation and that is how bear markets end……The consensus view is that we have hit bottom (or near) in home prices and that is more because investors/homeowners are wishing their thoughts on the market hoping that if psychology changes that the market will somehow listen, if it was only that easy. This housing bear has many years(3-5) to go and won’t end until those that believe this is the buying opportunity of a lifetime find out they were too early and exit with scars that won’t soon be forgotten.

The 2nd most frequent question I receive is: “How will I know when to lock?” The trigger for the best time to lock will be when the Fed lowers the Funds rate and everyone becomes convinced that the Fed will be easing for many years to come and that rates are a sure bet to go lower. Remember the typical investor/consumer/homeowner believes that the Fed controls long-term rates (not true) and when they read or hear that the Fed is easing they will become convinced that long-term rates are headed lower it will be the time to lock and we aren’t even close to that point. Everyone is so afraid that rates are going higher that I seem to be the only one who believes rates are headed much lower and I like to be in the minority. I often tell students in my interest rate classes that investors, etc. would rather lose in company than win alone and that will never change.

Conclusion

I have run out of time and space so I will send another newsletter Monday or Tuesday of next week because I have so much more information to share with you. The most significant event of 2006 occurred today as the 10 year broke the key 4.50% level. As long as we stay below 4.50% the Fed is under tremendous pressure to lower the Fed Funds rate. Interestingly 80% of all November economic releases (jobs, inflation, GDP, etc.) were below the consensus forecast of the expert economists and is significant because many of these prognosticators will be revising their forecasts for their big paying clients over the next few weeks. This will give the bond market another push with rates headed even lower but again we are overdone on a short-term basis and the market is in need of another “pause to refresh”. Sit tight, it’s been a great ride the last five months but this train is headed for lower destinations before it final resting stop in 2007.