Dow declines and Treasury rates plummet

Yesterday’s Dow decline of 416 points created headlines around the world and US Treasury rates plummeted with the 10-year nearing the crucial 4.50% level. Most newspapers listed the Chinese stock market’s Monday decline of 8% as the cause of a worldwide sell off in equities. In my opinion the liquidation by hedge funds of the “yen carry” trade produced much of the selling in the US stock market. The yen strengthened from 120.5 to 118.1 and created much pain for the “hedgies” and forced the exit of their high yielding investments in US, New Zealand, Australia equities and commodities such as gold, silver and corn. The key to more stock market declines lies in the level of the yen and a move towards 115 will cause another steep Dow decline.

Fed Chairman Bernanke’s comments this morning to the House Budget committee temporarily calmed the domestic equity market but his remarks were unchanged from his testimony to Congress in the last month. The 4.50% level remains a key level and only a penetration below for at least two weeks would cause the Fed to lower the Fed Funds rate (currently 5.25%).

The consensus that the recent problems in the sub-prime mortgage area reminds me of the television commercial that “what happens in Las Vegas, stays in Las Vegas.” The problem is that is will be almost impossible for the “prime” mortgages to be unaffected as underwriting standards are tightened across the board and borrowers realize that their house is no longer an ATM machine. Freddie Mac’s announcement yesterday that they will only buy sub-prime mortgages that are underwritten at the fully indexed rate is just the beginning of pain for many borrowers.

The outlook for long term interest rates is unchanged and I fully expect much lower long-term rates later this year giving everyone an excellent opportunity to refinance existing debt.

Finally, a story of a hedge fund that closed on Monday due to a “lack of short selling opportunities” shows that even the best in the business can have terrible timing.

I will have more on Friday…

February 23, 2007

Partly cloudy/partly sunny

The yellow/green flag remains our theme for the first part of 2007 as the long-term outlook is for much lower long-term rates, but the next few months may show the continuation of the recent trading range. Until the US 10-year Treasury note falls below the key 4.50% level the Fed will have no reason to lower the current Fed Funds rate of 5.25%. Minutes from the January FOMC meeting, that were released on Wednesday, clearly show that the Fed is closely watching the interest rate markets and their reaction to daily economic releases. The Bernanke Fed is very different from the Greenspan Fed that became as comfortable as my well worn jeans. Mr. Bernanke will wait and wait and wait until he is absolutely sure of his next move and has the economic stats to back him. Mr. Greenspan was unafraid to step out and change policy based on a “gut” instinct or a new stat that was not widely followed by financial markets. The worst result for any Fed Chairman is a change that must be reversed quickly. Credibility is something that is earned after years of correct policy decisions but the markets are very skeptical in the early years of a Fed Chairman’s term (including Volcker & Greenspan). These risk premiums are seen in the daily TIPS yields (inflation indexed bonds) as inflationary expectations have fallen in the first year of Mr. Bernanke’s term but his “fed cred” rate (TIPS) has risen almost 35 basis points.

Inflation steady but the economy weakens?

Wednesday’s core CPI (ex food & energy) showed a monthly increase of 0.3% due to an 0.8% increase in medical care and a bizarre 3.1% increase in tobacco prices (are more people smoking?) but the yearly change continues to remain in the comfortable 2.5% range. With so many condos (Florida, Nevada, California) now seeking tenants to help with the mortgage payment, I expect the rental component of CPI to show a decline in the next few months and this will tip the core CPI to a sub 2% level enabling the Fed to lower the Funds rate once the 10-year falls to below 4.50%.

The growth in the US economy may be slowing to levels usually associated with recessions and 0.0% inflation. A little known statistic compiled by the Federal Reserve Bank of Chicago is showing current activity that in the past was soon followed by falling long-term interest rates.

The yen carry trade continues

Tuesday evening (Wednesday in Japan) the Bank of Japan raised its overnight lending rate by 25 basis points to 0.50%. A necessary move by the BOJ, but this will have very little impact on the growing yen carry trade that I have written about for months. Hedge funds have been big borrowers in Japan at very low rates and investors in high yielding countries (New Zealand, Australia, etc.) and various commodities (gold and corn). The Japanese central bank could end the carry trade in a day through higher short term rates but this would terminate the early state Japanese economic recovery and commit political suicide and is common knowledge by the hedgies. As a result the yen continues to fall to new lows (121+). When this easy money train finally crashes, the impact will be felt all over the financial world. If we see the yen rise to the 115 level these fast moving funds will be forced to liquidate their positions and the beneficiary will be the US bond market with long rates headed for the low 4.00% level.

Farmland: An early stage bull market?

With housing prices clearly past their peak and commercial buildings at the lowest cap rates in years I am asked every day about the best place to invest $ from 1031 exchanges and other investable funds. One of the often overlooked areas has been US farmland due to low agriculture prices. But with corn (due to ethanol demand) prices rising to levels not seen for many years it might be time to look into the purchase of farmland. According to the Agriculture department the average price of farms rose 15 percent in 2006 and amazingly have increased in value 34 of the past 37 years. Unless you have experience in managing a farm you will need to hire someone but the demand for ethanol is sure to increase over the next 10 years and farmland appears to be one of its best sources.

Sub-prime lenders are bleeding, what’s next?

The big question facing every interest rate forecaster is “will the sub-prime mortgage problems spill over into the prime (high quality) loan market?” Before we can give an answer it’s important to note that the sub prime market problem will NOT be solved in a couple of months. One of the most interesting stories of the past week comes from the failure of ResMae, a major sub-prime lender. The best quote from the following article is “the underwriting quality was disastrous.” Yes, underwriting guidelines have tightened but lenders still exist that are offering loans with neg. am’s to borrowers that will have a difficult if not impossible time making the monthly mortgage payment.

The housing problems are not confined to lenders, mortgage brokers and real estate agents as many believe and unfortunately the temporary bottom is nothing more than a ledge that will break again in the fall. Furniture makers have fired 28,000 workers in the past year, plumbing and heating equipment makers are eliminating workers as well as other industries that benefited from the housing boom. The stock market’s recent strength is masking an economy that is slowing rapidly but with so much stock being retired (buy backs) or eliminated (takeovers) a little bit of equity purchases moves prices higher.

Foreclosures: Catching a falling knife

The way to make $$ today is through foreclosures….at least that is what is written in the press and taught in the many classes advertised by so called “experts” who made big profits in the 80’s and 90’s and of course history repeats itself every time…….A story from Sunday’s Kansas City Star shows that catching a falling knife can be dangerous if you catch the blade before the handle. What appears to be a low price becomes a high price when the market continues to drop. It’s important to remember that prices can fall after you have purchased a property in foreclosure and that the house market doesn’t always rebound after a one year decline.

Patience = lower interest rates

Lower long-term rates are coming soon……patience is needed as the market frequently doesn’t see what is really happening until our patience is taxed to the max. Inflation is the #1 enemy of the Fed and credit growth continues to grow at a smaller rate than nominal GDP. If the Fed is about to make a mistake it will occur with holding on too long to the inflation fighting view and not enough to the weakness in the housing area that will spread to other parts of the economy. The second half of 2007 promises many pleasant surprises to those waiting for lower long term interest rates.

Partly cloudy/partly sunny

The yellow/green flag remains our theme for the first part of 2007 as the long-term outlook is for much lower long-term rates, but the next few months may show the continuation of the recent trading range. Until the US 10-year Treasury note falls below the key 4.50% level the Fed will have no reason to lower the current Fed Funds rate of 5.25%. Minutes from the January FOMC meeting, that were released on Wednesday, clearly show that the Fed is closely watching the interest rate markets and their reaction to daily economic releases. The Bernanke Fed is very different from the Greenspan Fed that became as comfortable as my well worn jeans. Mr. Bernanke will wait and wait and wait until he is absolutely sure of his next move and has the economic stats to back him. Mr. Greenspan was unafraid to step out and change policy based on a “gut” instinct or a new stat that was not widely followed by financial markets. The worst result for any Fed Chairman is a change that must be reversed quickly. Credibility is something that is earned after years of correct policy decisions but the markets are very skeptical in the early years of a Fed Chairman’s term (including Volcker & Greenspan). These risk premiums are seen in the daily TIPS yields (inflation indexed bonds) as inflationary expectations have fallen in the first year of Mr. Bernanke’s term but his “fed cred” rate (TIPS) has risen almost 35 basis points.

Inflation steady but the economy weakens?

Wednesday’s core CPI (ex food & energy) showed a monthly increase of 0.3% due to an 0.8% increase in medical care and a bizarre 3.1% increase in tobacco prices (are more people smoking?) but the yearly change continues to remain in the comfortable 2.5% range. With so many condos (Florida, Nevada, California) now seeking tenants to help with the mortgage payment, I expect the rental component of CPI to show a decline in the next few months and this will tip the core CPI to a sub 2% level enabling the Fed to lower the Funds rate once the 10-year falls to below 4.50%.

The growth in the US economy may be slowing to levels usually associated with recessions and 0.0% inflation. A little known statistic compiled by the Federal Reserve Bank of Chicago is showing current activity that in the past was soon followed by falling long-term interest rates.

The yen carry trade continues

Tuesday evening (Wednesday in Japan) the Bank of Japan raised its overnight lending rate by 25 basis points to 0.50%. A necessary move by the BOJ, but this will have very little impact on the growing yen carry trade that I have written about for months. Hedge funds have been big borrowers in Japan at very low rates and investors in high yielding countries (New Zealand, Australia, etc.) and various commodities (gold and corn). The Japanese central bank could end the carry trade in a day through higher short term rates but this would terminate the early state Japanese economic recovery and commit political suicide and is common knowledge by the hedgies. As a result the yen continues to fall to new lows (121+). When this easy money train finally crashes, the impact will be felt all over the financial world. If we see the yen rise to the 115 level these fast moving funds will be forced to liquidate their positions and the beneficiary will be the US bond market with long rates headed for the low 4.00% level.

Farmland: An early stage bull market?

With housing prices clearly past their peak and commercial buildings at the lowest cap rates in years I am asked every day about the best place to invest $ from 1031 exchanges and other investable funds. One of the often overlooked areas has been US farmland due to low agriculture prices. But with corn (due to ethanol demand) prices rising to levels not seen for many years it might be time to look into the purchase of farmland. According to the Agriculture department the average price of farms rose 15 percent in 2006 and amazingly have increased in value 34 of the past 37 years. Unless you have experience in managing a farm you will need to hire someone but the demand for ethanol is sure to increase over the next 10 years and farmland appears to be one of its best sources.

Sub-prime lenders are bleeding, what’s next?

The big question facing every interest rate forecaster is “will the sub-prime mortgage problems spill over into the prime (high quality) loan market?” Before we can give an answer it’s important to note that the sub prime market problem will NOT be solved in a couple of months. One of the most interesting stories of the past week comes from the failure of ResMae, a major sub-prime lender. The best quote from the following article is “the underwriting quality was disastrous.” Yes, underwriting guidelines have tightened but lenders still exist that are offering loans with neg. am’s to borrowers that will have a difficult if not impossible time making the monthly mortgage payment.

The housing problems are not confined to lenders, mortgage brokers and real estate agents as many believe and unfortunately the temporary bottom is nothing more than a ledge that will break again in the fall. Furniture makers have fired 28,000 workers in the past year, plumbing and heating equipment makers are eliminating workers as well as other industries that benefited from the housing boom. The stock market’s recent strength is masking an economy that is slowing rapidly but with so much stock being retired (buy backs) or eliminated (takeovers) a little bit of equity purchases moves prices higher.

Foreclosures: Catching a falling knife

The way to make $$ today is through foreclosures….at least that is what is written in the press and taught in the many classes advertised by so called “experts” who made big profits in the 80’s and 90’s and of course history repeats itself every time…….A story from Sunday’s Kansas City Star shows that catching a falling knife can be dangerous if you catch the blade before the handle. What appears to be a low price becomes a high price when the market continues to drop. It’s important to remember that prices can fall after you have purchased a property in foreclosure and that the house market doesn’t always rebound after a one year decline.

Patience = lower interest rates

Lower long-term rates are coming soon……patience is needed as the market frequently doesn’t see what is really happening until our patience is taxed to the max. Inflation is the #1 enemy of the Fed and credit growth continues to grow at a smaller rate than nominal GDP. If the Fed is about to make a mistake it will occur with holding on too long to the inflation fighting view and not enough to the weakness in the housing area that will spread to other parts of the economy. The second half of 2007 promises many pleasant surprises to those waiting for lower long term interest rates.

The song remains the same by Ben Bernanke

Ben Bernanke is one month younger than me but I’m sure we grew up listening to the same music and admiring the band of our era, Led Zeppelin. While watching the Fed head’s Congressional testimony earlier this week I was struck by the calmness of the Senate and House committee members when both asking questions and receiving answers. Mr. Bernanke had accomplished what Mr. Greenspan had never desired and that was to come and leave with no surprises. Fed policy remains on hold and the 10-year US Treasury continues to hold above the key 4.50% level. Economic statistics run a little hot and then a little cold each month depending upon extreme weather or faulty seasonal adjustments and remarks from all FOMC members remain the same. We have truly reached a point in history where worldwide investors understand where we are and more importantly why we might not go anywhere until there is a major change in economic direction.

The good news from a market that knows what to expect is that uncertainty is almost non-existent and surety brings rising equity and asset prices. This is surely why the stock market reached new highs (Dow Industrials, Transports, and Utilities) on the same day this week, a feat not seen since 1998. The skies stay sunny everyday in investment land and the forecasters’ predictions all blend into one cheery outlook so that each day’s activities begin to mirror each other and it becomes obvious that no one should try and rock the boat.

The potential dark clouds are created when complacency takes over, and then greed, as investors begin to increase seemingly riskless positions believing that the chances of losing have diminished to negligible levels. Housing seems to have taken on some of these qualities as a consensus seems to be forming that a bottom is near and the worst is over. In a USA Today article on February 4th a survey of economists found that 87% thought the housing market would bottom in 2007. When one searches history books of the last 30+ years it becomes obvious that we are nearing the same levels of price decline experienced over this time period. Why can’t we descend to new lows and then rest for a couple of years and then decline again? If the answer is that you have never seen this before you may find that a new chapter in US economic history is about to be written. For those in the Las Vegas area you might want to read an article from Tuesday’s Review Journal where a recent analysis found 57,999 planned or proposed condos, 11,124 units under construction versus 3,889 existing units. Unless the glitter city is going to begin paying people upfront $$$ to move, there is a glut of condos coming soon and that usually creates lower prices for new buyers.

Next week’s important economic events are centered around Wednesday with the consumer price index release at 5:30am. Core CPI (ex energy and food) should see an expected .2% increase leaving the annual inflation rate of around 2%. The Fed is clearly watching inflation but is cognizant of the fact that inflation is a lagging indicator and monetary policy that reacts to this measure is almost always too late and too little. The Treasury will auction $18 billion 2 year notes on Wednesday and $13 billion 5 year notes on Thursday. This is only significant for mortgage players who need to lock loans. If the bond market continues its recent rally and rates drop going into these auctions I would recommend implementing locks as markets that rally into auctions usually pull back quickly due to dealer indigestion.

This week the yellow “caution” flag remains in front of the green “all clear” flag as long-term interest rates continue in their normal first half of the year trading range. The longer this range stays in place the more “explosive” the move out of the range and that I expect later in 2007. The next big move is down for long rates as the interest rate market begins to understand that inflation is NOT headed higher and that the housing price decline has just begin and will last for 3-5 years and have a downward impact on consumer spending.

The weather is slowly changing………

It’s mid-winter and many times you can tell the weather is about to change by the slightest pick up in the wind. No clouds in the sky and every weather forecast predicting sunny and clear but your gut says something different is coming.

Every Friday at 1:15pm the Federal Reserve releases the H.8 report detailing outstanding bank credit at US banks. These loans cover real estate, commercial and industrial, consumer and a few other small categories. 99% of the time the stats are like the weather in Southern California, clear and sunny but that 1% remaining offers fascinating clues to the future direction of Fed monetary policy. The numbers have to be viewed over at least a four week period because of the now famous revisions that seem to be a problem at every government agency.

The two largest categories are real estate (3.35 trillion) and commercial and industrial (1.19 trillion). Interest rates are determined by demand for credit (borrowers) and the supply of credit (banks, etc.). Demand usually has a bigger impact on rates because of its tendency to change like a speed boat while supply is more like a large cruise ship. Banks always want to lend money but borrowers only desire credit when they have a need to invest or spend. In my interest rate classes I have spent much time going over one of my favorite indicators that predict an upcoming change in Federal Reserve monetary policy, the rate of change in C&I loans. I follow this category on a weekly, quarterly and annual basis finding that an annual rate of change confirms the trend while the quarterly rate of change frequently points to a new direction.

Pending revisions, today’s C&I loans show the 3 month rate of change dropping BELOW the zero line for the first time since June 16, 2004. This is very significant because the last time this rate of change broke above the zero line the Fed (Greenspan) altered course and raised the Fed Funds rate by 25 basis points to 1.25% on June 30, 2004. This was confirmed by the annual rate of change on Friday September 29, 2004 giving the Fed an all clear signal to continue to increase the Funds rate continuously to 5.25% on June 30, 2006. The Fed was also given “cover” by a real estate loan category that was growing by 10-15% so there was no reason for the Fed to even consider ending its Funds rate crusade to the heavens.

I have studied these loan stats for over 50 years and they have an excellent track record in predicting Fed Funds rate turns in advance BUT this is not a short term timing tool so I don’t expect any immediate action especially since the next FOMC meeting does not take place until March 20-21. If these loan stats are confirmed over the next 2-3 weeks (watch for revisions) it will give the Fed a reason to modify its next FOMC statement that monetary policy has reached “neutral” and the next move would be an ease to lower rates (5%).

The 3 month real estate loan rate of change is still close to 10% and the annual rate is close to 15% so there is no reason for the Fed to panic and change policy this month (conference calls can occur between meetings). The good news is that the previous two years of short term rate increases are beginning to have an effect on loan demand and an inverted yield curve is creating havoc for many mortgage lenders (see this weeks news about sub-prime lenders).

At this point every reader is asking: “How will I know when the Fed is going to lower rates?” The best answer is to watch the US Treasury 10-year interest rate which today is 4.78%. When, not if, this rate falls below 4.50% and remains there for a couple of weeks I would expect the Fed to follow the market and begin hinting (through Fed speeches) that it is about to make an about face in Fed funds policy. A rate below 4.50% would create an inverted yield curve that equates to a high probability of a US recession. The Fed mission statement is price stability and steady economic growth and that can only be accomplished if they are willing to be flexible when loan demand slows (today) and inflation remains low (2007).

I would not jump the gun on this policy change as loan revisions could cause a lengthy delay and the first half of the year traditionally (75%) shows an increase in long-term interest rates. I would load the truck with fuel and stand by because if my forecast is correct there will be boatloads of money made by those who know how to take advantage of this opportunity (consult your own investment advisor, real estate agent, mortgage broker for the most appropriate action for your risk level).

We will know more in the next few weeks and I will keep everyone up to date on these loan stats. It’s important to remember that Fed policy moves slowly and changes infrequently so there is no need to rush to action.

Wednesday (2/14) at 7am Fed Chairman Ben Bernanke will give his semi-annual testimony to Congress and history shows that these remarks often move interest rates by large amounts. I am sure that Mr. Bernanke will want to send a message to worldwide markets (saying nothing is a message) and unlike his predecessor Mr. Greenspan, he will speak in English to the Senate and House. If you are not able to watch live I suggest you set your Tivo to CNBC and then watch at a later time to see an expert in action.

I wanted to write about the carnage in the mortgage industry but have run out of time and space but read a quote in the Wall Street Journal on Wednesday that said 84% of option ARM loans closed in 2006 carried a prepayment penalty. That is an incredible stat and very sad as many of those unsuspecting borrowers (unless they had impaired credit) will be stuck in these loans as rates drop later this year.

Another interesting item from today’s Fed H.8 report is that consumer (credit card) debt is increasing at the same time that revolving home equity (Heloc) loans are flat to declining. It appears that consumers that were using their house as an ATM to continue high spending levels have turned to high interest credit cards as they realize their home values are no longer increasing. If this continues it will stop the US economic train and create a hard recession and much lower home values.

This week’s sub-prime lender news only confirms my belief that this real estate bear market is still in the beginning stages and it will take at least 5 years of slow bleeding before it levels out. I know many of you remember the early 80’s real estate bear market that was accompanied by high interest rates but this upcoming period of real estate deflation is not going to be anything like what has been experienced in the past. It’s a brand new world for RE investors and flexibility, timing and patience will be needed to survive over the next few years.

The yellow flag remains in front of the green flag due to poor seasonals and short term interest rate action, but if the loan stats are not revised I will signal an “all clear” and raise the second green flag.

Only five more months until long rates begin to fall?

As many readers are aware, I spend a great deal of time studying seasonal interest rate patterns. Using daily data accumulated over the past 40 years I find it very helpful to know in advance that during certain times of the year interest rates have strong biases to move in a specific direction. Last year my call that long rates would peak on June 30th (actual date 6-28) was partially a result of strong early borrowing by the government and corporations that has seen rates rise 75% of the time during the first six months of every year. 75% does NOT equate to 100% so hanging on one branch of a tree will often lead to serious financial injury if one doesn’t pay close attention to other economic factors. 2007 has begun in typical fashion as the 10-year US Treasury dropped for the first two days of the year but has risen since by 22 basis points. Not bad considering that the average of the 31 moves higher since 1966 (1st half of each year) equals 132 basis points. BUT, in eight of the last ten years, long rates have seen their high for the 1st quarter in March so seasonals are still strongly against a peak in rates in February.

The good news is that the bond market sailed thru this heavy news week without any damage as rates actually fell 5 basis points despite a GDP number that was stronger than expected and a jobs number that again showed strong upward revisions. A market that can’t decline (higher rates) on bad news usually rallies on good news. Next week will have a shortage of economic news so the focus will be on the 3 government auctions of 3 year, 5 year, and 30 year bonds. $38 billion will be for sale and this should put a floor under rates until Thursday which is the last day of the auctions. I know many of you watch interest rates daily for your business and real estate loans so the advice for the next week is sit tight, we will go lower but may have to go higher first.

The Fed

This week’s two-day FOMC meeting produced the expected statement on Wednesday as the Fed left the funds rate at 5.25% which is where it has been for over 7 months. Unless the 10-year falls to under 4.50% and remains there for at least a couple of weeks the Fed will be under no pressure to change monetary policy. There has been a little bit of talk about a higher Funds rate but this could only occur if long rates rose above 5.25% and inflation rose to above 4% and I put the odds of that 2007 event at less than 3%.

Jobs

This morning the Labor Department announced that 111,000 new jobs were created in January with revisions to December 2006 (+39M) and November (+42M). Construction jobs showed a rise of 22,000 due to US temperatures that were 6 degrees warmer than usual in the first two weeks of the month. Temporary services rose only 6,000 and that continues a slow trend for the past year of 2,000+ per month. If corporate America were growing and spending $$ wouldn’t we see this category increase more than 6M? The key to the employment situation is to remember that each month’s stats are “seasonally adjusted” and a normal January is much colder than we saw this year. If we happen to see colder weather than normal in February or March the jobs number will plummet due to these seasonals.

Inflation, Economic growth and the Fed

The direction of both short-term (Fed) and long-term (inflation) lies in expectations that are rapidly building about the housing sector of the US economy. The growing consensus is that we have hit bottom and that the worst is over for the residential price and sales bust. Bear markets trap investors into believing that the decline is over and often create a temporary bottom that is nothing more than a ledge that soon breaks, driving prices to new lows. Nothing has changed in my forecast that it will take at least 3-5 years before the housing market shows signs of capitulation and the condo market will be hit the hardest.

Inflation continues to increase at a 2.1% level (using the PCE price index) and when rents begin to fall in a few months (due to an oversupply of condos) the official inflation level could easily go below 0.0%.

Economic growth (using real GDP) showed the usual 4th quarter strength in 2006 but it has forecasters confused with a belief that growth creates inflation and although that might have occurred in the late 70’s/early 80’s it will not be repeated in 2007. The Fed is clearly aware of the enemy (inflation) and under no circumstances will it allow any fears to ignite into an out of control fire. The Fed is very happy with a slightly inverted yield curve (short rates above long rates) and would like nothing more than to end the year as it began with a “no change” on the scoreboard after every FOMC meeting. It will get its wish for the first half of this year but the 2nd half is lining up perfectly to give us our long awaited decline in long term rates propelled by a housing market that begins its 2nd leg down.