A new resident at the Fed head’s house?

The market’s biggest enemy, Mr. Uncertainty, has taken residence at the Federal Reserve’s think tank and that spells higher long term interest rates for the next few weeks. All market’s rise with certainty (even if it is bad news) but plummet when uncertainty returns like we heard Wednesday morning from Fed Chairman Bernanke in his testimony before the Joint Economic Committee. As most of you know I watch all of his speeches live during market hours to gauge the interest rate market’s immediate reaction and then tape the remarks for review later to pick up anything missed or important points that are made with emphasis by facial expression or tone of voice. This is much like a football or basketball coach that reviews hundreds of hours of tapes of his opponent’s previous games to prepare for this weeks big game. The question and answer sessions after the opening remarks are usually the most important part of the testimony and this week was no exception. Mr. Bernanke made it a point on many different occasions to emphasize that the Fed no longer would be giving “forward guidance” monetary policy and that the Fed’s current forecast for the US economy may not be correct. Forward guidance is something that former Fed head Greenspan perfected for everyone as he deftly moved short-term interest rates well before a change in the economy and/or inflation. With a new Fed Chairman comes a new way of handling a change in direction for the “key” Fed Funds rate which currently stands at 5.25%. The lack of guidance for the Fed is causing higher long-term interest rates because 1) any change in perceived Fed policy causes uncertainty and 2) if the Fed were confident in their forecast of lower inflation why would they pull back from their forecast? As a result long-term (10 year) interest rates have been unable to break below the key 4.50% level (which would have forced a Fed Funds drop of 25 basis points) and have risen considerably in the last two weeks with inflationary expectations leading the move higher. With April only a few days away and strong seasonal trends pointing to higher rates, borrowers used this past week to lock loans or wait until the next period of lower rates which should begin around late June/early July.

The jobs are coming, the jobs are coming….

Next week’s news is centered around Friday’s jobs report and market reaction will be muted due to a stock market holiday and a short (4 hours?) trading day in the bond market. Expert opinions for jobs created are for at least 150,000 BUT over the past 10 years the standard error for the March report has been over 100,000 and March shows the biggest misses of any month in the year. The good news is that the bond market seems to be reacting more to a rising oil price, fear of tariffs on Chinese imports, the price of the yen and finally the gyrations of the US stock market.

The best place to purchase real estate?

I am asked every week about the best city to purchase real estate. My best answer for those with deep pockets and a lot of patience is Detroit, Michigan. There is no doubt that Detroit will survive what has been the worst economic time in its history and it will certainly take years to turn around but a story about recent home auctions is a must read for everyone and is the closest thing we will ever see to the ringing of the bell at the bottom of a market. When houses sell for less than the price of a car, or its land value or the value of the lumber it is time to consider a strategy to enter the market. An apartment building is probably the least risky bet but as always due diligence and a good property manager are a must. Staying in Detroit, I thought it was interesting that according to the National Association of Home Builders the size of an average house will be declining over the next few years. Finally a story about a nursing shortage in Michigan that is sure to grow and of course when these nurses are hired at higher wages they will need apartments to live in. If you have a long, long horizon Michigan may be the place for the real estate investor seeking growth over the next 10 years.

Corn, corn and more corn

This mornings Department of Agriculture announcement of planting intentions (corn, wheat, soybeans) was the most anticipated in history and showed that farmers expect over 90 million acres of corn this year versus 78 million last year. This sent corn limit down on the opening this morning but I have to wonder if this is creating a near term bottom for a commodity that has now seen the worst news possible. 1) What if farmers don’t plant all of the acreage? 2) What if we have a dry summer? 3) What if the price of oil continues to rise making corn a cheaper ethanol substitute? Commodity speculation is not for the risk averse but after a couple of weeks of wash out, corn could put in a bottom that is not seen again in 2007.

Updated forecast

I continue to see clouds for the long-term interest market until the second half of this year when the realization that the mortgage/real estate market downturn is not a short-term event but the beginning of a very long-term and painful bear market. Unfortunately lower interest rates will have a minimal impact on the market as demand will be cut due to regulations, fear of lower prices and an increasing supply of homes from builders, investors and homeowners unable to meet their monthly mortgage payment.

If you must move into a home it is time to consider something we have NOT seen for many years, rent with an option to buy. Find a home that has been on the market for at least 60 days and have your RE agent contact them to see if they will rent for 1-2 years and give you an option to buy at today’s price anytime during that time period. The homeowner will receive income each month that enables him/her to make the mortgage payment and you will be able to move into a house and if the market moves higher (doubtful) you will be able to exercise your option. There are very few of these available today but a year from now they will be advertised everywhere.

The Fed gets ready to have a party that few will be able to attend

Wednesday’s Fed (FOMC) announcement that they were going to a “neutral but fearful of inflation” stance sent stocks into orbit (best week in last four years) as the long awaited “all clear” signal seemed to send bears back into their caves. For the past 40+ years a Fed easing has sent stocks higher but I’m not sure that history is about to repeat. More interesting was the reaction of long-term interest rates which fell for a couple of hours but rose significantly the last two days. The US 10-year Treasury note again could NOT stay below the KEY 4.50% level and now rests at 4.61%. The yellow caution flag is again in front of the green flag as we are about to enter the tough month of April where we have seen an increase in long rates each of the last 10 years that averaged 52 basis points when measured from the first low of the month.

Another concern is the recent increase in the inflation component of the 10-year interest rate. In the last 8 days we have seen a 12 basis point increase in the 10-year and 75% (9 bp) of that is from a fear of inflation by bond buyers. The yield curve is showing signs that a Fed easing is near and the yield curve has shown signs of steepening but I would much rather see a market where rates are declining because of a drop in inflation premiums.

Will housing rebound if the Fed eases?

The consensus opinion seems to be that either time (less than a year) or a lowering of short-term interest rates will cause a bottom in the housing market thus allowing homeowners another opportunity to use their house as an ATM machine. I wrote a couple of years ago that the end of this economic cycle would occur with lower interest rates but a DECREASE in loan demand and that appears likely in the 2nd half of 2007. With lenders and regulators making changes in underwriting and LTV’s it will be many years before borrowers are able to purchase a home with the high leverage they were able to obtain over the past few years. Remember that long-term interest rates are a function of demand for credit and future inflationary expectations. The Fed is closely watching commercial and industrial loan demand, jobs (workweek) and real estate loans. They will NOT ease just to bail out those who are drowning in mortgage debt but will wait for an actual slowing in demand for credit. This afternoon’s h8 report showed a dramatic drop in the amount of real estate loans (as of 3-14) but it appears to be an aberration similar to Wachovia’s purchase of Golden West Financial in 2006.

The home builders see dark clouds

Normally corporations put a positive spin on almost all news so it was refreshing to read Thursday’s earnings report from KB Home. The key quote comes from CEO Jeffrey Mezger who said “we believe current housing prices do NOT fully reflect moderating demand for new homes.” He could have said that they are confident of a bottom in 2007 or we are close to the end of the decline but instead spoke the words that few in the business are willing to reveal……..we aren’t even close yet. This is a very successful business that knows what it must do to stay alive and staying in front of bad news is always preferred by smart investors.

The Fed is watching…….

In congressional hearings this week (also known as the circus) many federal regulators were asked how they could have allowed the mortgage mess to occur?? With over 50% of mortgages issued by non-banks I’m not sure how the Fed, Comptroller of the Currency, etc. could have done more (they did warn and warn and warn) but in a speech given by Minneapolis Fed President Stern on March 9th the seeds of the next disaster are being watched carefully by the Fed heads in Washington. The key quote is: “As banks have disposed of plain-vanilla, readily securitized assets, their balance sheets have become more risky.” It appears that in an effort to increase fee income banks are selling off their least risky assets (loans) and keeping for their portfolios the higher yielding risky assets.

Sub-prime, Alt-A and Prime – it doesn’t really matter

We read daily that the mortgage debacle has been contained to the sub-prime area only and that might be true this month but the real problem is that risk has been mispriced and when too much money chases too little product the price goes up and the margins go down. With a 5-year fixed mortgage (5/1ARM) at only 100 basis points above the US treasury note it is obvious that something is going to change and quickly. Soon we will see the “prime” mortgages priced at higher spreads to treasuries and it would NOT surprise me to see Treasury rates much lower in six months but mortgage rates higher due to a cut back in demand from securitized buyers at current spreads. This is a story that will be growing throughout the year.

Summary

Nothing has changed even though the economic reports seem to show home sales rising (+3.9% last month). My assistant saw a graphic today on CNBC about home sales rising and immediately said “that’s because prices are falling”, showing that she has a knowledge of Economics101. Yes, prices are dropping but as I continue to write….we are at the beginning of a long bear market in real estate values and will NOT see the normal short-term crash that is typical of bull markets.

Long-term interest rates should have a very tough April before seeing my long awaited decline to new lows in the 2nd half of 2007. The stock market is rebounding due to a shortage of supply (buybacks and mergers) and sugar is setting up for a BIG move to the upside, especially if crude oil rallies to $70.

Do they ring a bell at the bottom?

The mortgage mess that is just beginning

One of the few advantages of old age is that I have usually seen this play before in the past 40 years or so. This week’s meltdown in the mortgage market is garnering much press and as a result creating a furor in Congress that almost always reacts after the barn has burned down. In this instance the first barn is gone and the vultures (hedge funds) are almost giddy that they have the opportunity to purchase loan portfolios from soon to be bankrupt sub-prime lenders. This has boosted the sagging share prices of many lenders who will soon be happy to learn an old adage that the first sale is the best sale in a bear market. In next week’s interest rate class I will spend quite a bit of time reviewing the different stages of a decline in home prices and we are only in the beginning stages of what will be written in history books as one of the biggest economic accidents in US history.

Fed Chairman Greenspan has been active on the speaking circuit the past week giving his opinion of current economic conditions. He must be disappointed that his view of the world no longer has the impact it did when he was Fed Chairman. On April 8, 2005 the former Fed chairman spoke to a Federal Reserve Community Affairs Research Conference and his speech contained the following quote: “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.” Narrow credit spreads in 2005 were appropriate because house prices were rising each year and defaults were almost non-existent. As hedge funds and other securitized lenders saw their insatiable demand grow at a faster rate than home loans could be originated by fee hungry brokers and home buyers who saw this as a risk free way to create instant wealth. In the spring of 2005 interest rates were low and no one even dreamt of a time where house prices could decline or stay even. Unfortunately asset price rises that are parabolic almost always end in disasters and this will be no exception. I fully expect the sub-prime problem to leak into the alt-a and then the prime area in the next couple of years and there really is nothing the Federal Reserve (lower short rates) or the government (legislation) can do to prevent the train from crashing. I have written for many months/years that we are facing a minimum 3-5 year slow, bleeding bear market in residential real estate prices and recent events only solidify my stance.

A side note to this growing crisis in the mortgage world comes from a soon to be retired Fed Governor, Susan Bies, who has spent much of her five-year term crusading for tighter regulations on home lenders. Curiously two days after a group of major US banks asked the Fed to reconsider tighter regulations on risk, Governor Bies submitted her resignation even though her term does not end until 2012. She gave no reason for the sudden departure which takes place at the end of this month.

For those that believe the “prime” lenders will not be affected by current conditions in the mortgage market please read an article from Wednesday’s Houston Chronicle that notes the inability of National City (major lender) to sell $1.6 billion in non-conforming loans. I am sure they were able to sell these loans but probably NOT at the price they desired. This story is certain to grow in the next few weeks.

Interest rates

This week the US 10-year treasury note failed again to penetrate the key 4.50% level that has held so well this year. The five year treasury notes have moved below their equivalent levels but this is more due a flight to quality move out of the yen carry trade and commodities into short term treasuries that I wrote about a few weeks ago (see archive). On Wednesday March 21st at 11:17am the FOMC will announce the results of their meeting and I expect a comment about the weak housing market but no change in the Fed Funds rate. The US bond market is reacting more to gyrations in the stock market as economic statistics take a back seat for the present time. In a few weeks we will again be moving to inflation, job and GDP numbers but not until we see temporary stabilization from the equity market.

Bottom Line

My forecast remains unchanged…much lower long term rates in the second half of this year, a housing market that is not even close to the bottom and sugar prices that will rise 40-50% in the next six months.

Sigalert for the 450 continues indefinitely…….

I was recently interviewed by CPA Selwyn Gerber on my views for the US economy, real estate and interest rates. Click here to listen to this podcast.

In Southern California a freeway sigalert is defined by the Highway Patrol as an unscheduled lane closing for more than 30 minutes and the 405 freeway near Wilshire Blvd. has the record for the most sigalerts. For history buffs the sigalert was created in the mid-1950’s by the former co-owner of KMPC radio Loyd Sigmon. The 1950’s were a calm period for interest rates as William McChensey Martin was in the early years of his 19 year term that ended in 1970.

Last Friday we found the 10-year US Treasury note resting at the KEY 4.50% level with the world (and homeowners) hoping for a move lower forcing the Fed to lower the Funds rate by 25 basis points to 5.00%. The 4.50% level is the equivalent of a sigalert to the Fed and every trip to this low rate land is followed by Fed speakers urging us to remember that the Fed fears inflation and a strong economy despite the woes coming from the mortgage market.

Job growth?

This morning’s Labor department news that 97,000 jobs were created in February sent the 10-year soaring to the 4.59% level. It’s all about expectations and the consensus for job growth had been lowered to around 75,000 due to an ADP forecast on Wednesday of 57 thousand. The interesting part of this is that the ADP number does not include government jobs and if you subtract the new 39,000 govt. jobs you arrive at 58,000 private jobs, almost perfect for ADP. Bottom line for the jobs number is that the market was caught long (lower rates) and everyone tried to exit the game at the same time this morning.

The fact that the unemployment rate fell to 4.5% from 4.6% helped erase Fed easing bets but when we dove into the actual report we found the rate drop was due to a decline of 190,000 in the labor force not a pickup in employment. Unfortunately for the ninth consecutive month the Labor Dept. revised the previous two months jobs upwards by 55,000 which again calls into question the government’s inability to create a reliable economic statistic. Lastly, I found it interesting that the average work week fell for the second month in a row by 0.1 hours. If corporations were hiring the work week would be expanding and overtime would be increasing.

Yes, these are real quotes

It has been quite a week for perusing the press and I will share a few of the most remarkable quotes that may eventually find the 2007 hall of fame.

We begin in Charlotte, North Carolina where this morning Fed Governor Susan Bies (retiring March 30th) told a risk management forum that “this is not the end, this is the beginning” of a wave of teaser-rate loans that are coming into full pricing.” This is significant because she is a Fed governor and is in stark contrast to the comments from Chairman Bernanke last week that everything was under control in the home mortgage business and well under control. I wonder if Ms. Bies wasn’t leaving the Fed in a few weeks if her remarks would have been as forthcoming.

On Tuesday Countrywide CFO Eric Sieracki told a Raymond James Financial conference in Florida that “60% of Countrywide’s customers using hybrid adjustable-rate mortgages (arms) such as “2-28″ loans would FAIL to qualify under the new underwriting guidelines by regulators where lenders must use the borrower’s ability to repay the loan at the highest possible rate during the life of the loan.” If they wouldn’t qualify under the soon to be higher reset rates, how does Countrywide expect them to make the monthly payment?

Louise Gissendaner, senior vice president at Cleveland’s Fifth Third Bancorp, the 10th largest US bank, said “We have found neighborhoods with abandoned homes, 200 at a shot.” Hasn’t everyone been telling us that the real estate bubble was only a problem in the areas that saw the most appreciation like Florida, California and Nevada?

The last quote comes from Jacksonville, Florida where Duval County ranks seventh in the country in number of home foreclosures with one out of 133 changing ownership.

Finally I found an interesting statistic on the frequently quoted 2.11% delinquency rates for real estate loans in the fourth quarter of 2006. This only includes mortgages currently held by US banks and not any of the loans securitized and sold to CDO’s (collateralized debt obligations). US banks are forced (we hope) by regulators to set aside reserves for non-performing loans. Pools of mortgages held by investors/hedge funds don’t have anyone overseeing the management and risk taking policies and we may see some earthquakes from this area later in 2007.

Chinese stock market

The 8% drop in the Chinese stock market was used as a reason for last week’s fall in the US market. It’s doubtful that this market’s gyrations would have any impact on global markets but it made for good press. Last Saturday’s Toronto Globe & Mail (I read 27 newspapers every day) interviewed a China investor, Li Daquing, who said that the Chinese market “is worse than a casino” but then added that at least a casino has rules where the Chinese market is controlled by the government. If you are considering investing in China you must read this story.

Summary

My forecast for lower long-term US interest rates is unchanged and it is NOT dependent on an easing of Fed policy. Fed chief Bernanke wants to follow the market and until we see the US 10-year drop below 4.50% for at least two weeks he will have no reason to move off the current 5.25% Fed Funds rate. Next week’s news will center on the yen/dollar level (currently 118) and Tuesday’s retail sales (consumer demand weakening) and Friday’s CPI (lower inflation). Patience will be rewarded for those waiting, needing or betting on lower interest rates and higher sugar prices.

It’s all about the Japanese Yen

I was recently interviewed by CPA Selwyn Gerber on my views for the US economy, real estate and interest rates. Click here to listen to this podcast.

On January 5th of this year I wrote (see archives) about my three surprises for 2007. The first was that the price of sugar would rise 40% in the next six months. It has risen only 1.0% in the past 8 weeks to a current price of 11.22 cents and since I have not changed my forecast, the best is still ahead for those willing to take a high risk play.

The second surprise was that the stock market would suffer a major decline and my focus was on the NASDAQ. I wrote that when, not if, the yen strengthened we would see quick liquidation of assets (stocks) by hedge funds. At today’s close of 1726 the NASDAQ 100 is down 3.3% and headed for lower levels over the next couple of months.

Finally I stated that the housing market had not seen its lows and that long-term interest rates were headed for new lows. The 10-year US Treasury note has fallen by 15 basis points since early January and has NOT seen its lows for 2007.

Three surprises that are right on target and FREE! Please remember to consult your own investment professional before making investments that carry risk of principal.

Stock market update

This week’s dramatic decline in stock markets around the world was NOT caused by a drop in Chinese stocks as we read in the press. The move was a reaction to the strengthening in the value of the Japanese yen which rose 3.3% against the dollar and closed today at 117.60. The yen decline from 114.50 in early December gave the world wide hedge funds a low risk opportunity to borrow yen at 0.5% and invest the funds in worldwide stock markets (US, etc.) that were exploding on the upside every week. As usual the party had to end when the investing arena became so crowded with stock bulls/yen bears that any misstep was sure to cause an accident. This week the “hedgies” gave back profits but if the yen rises to the 114-115 level it will cause a much deeper level of pain and force quick liquidation of more assets (stocks, gold, other currencies) and send these formerly bull markets into a tailspin not seen for many years. One way to end the carry trade would be for the Bank of Japan to raise overnight (0.50%) lending rates. Although that would surely send the currency into orbit (along with a few traders whose careers would end) it would not be beneficial for the struggling Japanese economy. Last night Japan announced that January’s core CPI rose by 0.1% (any inflation in Japan is good news) but they will be lucky to have a 1.0% rate for the entire year. Raising rates in a low inflationary environment will end any consumer demand and force the country back into a recession. Finally I am often asked “How big is the yen carry trade?” Japanese finance minister Hiroshi Watanabe said Thursday that it might be “several 10 trillions of yen” but then added they don’t have any reliable statistics. Can you imagine the markets reaction if Fed Chairman Bernanke announced he didn’t know how many dollars were floating around the world?

Long term US interest rates

Since Thursday, February 22nd the US 10-year Treasury note yield has fallen 23 basis points and rests tonight at the KEY 4.50% level. Will it move below and force the Fed to ease the Funds rate or rise back to the 4.60-4.85% recent trading range? To find the answer we begin by analyzing the recent move down and we start with the key inflationary expectations component of the nominal rate (4.50%). There have been two distinct moves down with the first beginning on 1-29 (4.89) and the second on 2-22. The move from 1-29 represents 39 basis points with only 5 coming from a lowering of inflation expectations and 34 from a fall in the real rate of return. The move from last weeks high (4.73%) represents 23 basis points and only 3 from inflation. The bottom line is that long rates have fallen but not for the structural reasons that usually point toward a permanent move down. Most of the buying of US Treasuries appears to have come from the “hedgies” who have liquidated their “yen carry” trades and are now parking their $$$ in Treasuries. Under this scenario only a continuation of the yen’s rise and falling stock market will enable US long rates to fall under the 4.50% level. It would take a HUGE drop in the stock market (10%+) for the Fed to even consider a “bailout” for those in pain in what used to be called the “Greenspan put” and lowering of the Fed Funds rate. Chairman Bernanke calmed the markets on Wednesday with his comments that nothing seemed abnormal in the economy and markets. BUT and its a big one, one must remember that the Fed usually moves only when it is surprised by what its sees in the economy and currently the Fed forecast is for sunny, a few clouds but no changes seen for the remainder of the year. The Fed is clearly hoping that the 10-year does not stay below 4.50% for at least two weeks but if that occurs it is prepared to lower the funds rate by 25 basis points.

Housing update

With house prices flat at best and condo’s wishing they could stay flat, builders are making a fast dash to cancel projects and turn them into apartments. One of the reasons inflation has been stuck at the 2.5% level has been the rising level of apartment rents as consumers who can’t afford to purchase housing are forced to rent into a shrinking apartment market. An article from this morning’s Washington Post confirms this new trend toward more apartments which will drive rental rates lower and thus allow the CPI to fall under the key 2.0% level and give the Fed another reason to lower the Funds rate.

It’s been a tough business this year for most mortgage lenders and this morning’s news from the Federal Reserve is sure to increase those seeking greener pastures. A memorandum from the Fed, Comptroller of the Currency, FDIC, Office of Thrift Supervision and the National Credit Union gave lenders another dose of “lessons in underwriting” as the government is now very involved in business where their guidance was needed years ago and now may be too late. The 16-page memo details more requirements for lenders that have found lending to homeowners with less than perfect credit scores and verifiable incomes. I continue to believe that we are at the beginning of a long “bear” market in house values and that there will not be a crash but a slow torture that will force many to leave a business that appeared to be full of gold for everyone.

Summary

The green flag is now in front of the yellow caution flag due to the recent stock market decline which has enabled long rates to again test the 4.50% level. Another leg down in stocks could easily push rates lower but the ultimate low in rates will not occur until the world markets realize the severity and “bleed through” of the US housing problems. In the meantime, sugar looks sweet and the US bear is growling so enjoy the profitable ride.