Stagflation?

With this morning’s news that the 1st quarter GDP rose by only 1.3% and the price deflator (inflation) rising by 4.0% the word “stagflation” was quickly used by many financial commentators to describe the US economy. Stagflation is a term that was coined in the late 1970’s during a period of strong economic growth and rising inflation. The website http://dictionary.com describes stagflation as “an economic condition that is characterized by slow growth, rapidly rising consumer prices, and relatively high unemployment.” The first two parts seem to be confirmed by today’s news, but the current unemployment rate of 4.4% is at a low for this business cycle. The most important point of this partially futile exercise is to remember that we are analyzing lagging indicators. To forecast interest rates we must look into the future and not always assume that the past can be extrapolated into a continuing trend. The most difficult chore for the Fed is to keep its eyes on the road ahead and not what it sees in the rear view mirror. Changes in monetary policy don’t filter thru to the economy for at least 12-18 months and the interest rate volatility we saw in the early 80’s was somewhat caused by a Fed that reacted to current events with little regard for its effects on the economy. Fed Chairman Bernanke is very content to leave the Fed Funds rate at its current level of 5.25% and as long as the 10-year Treasury note stays above 4.50% and under 5.25% there will be no movement by the Fed. Two variables that would force the Fed’s next move are showing no signs of a change in direction. The stock market continues its rocket ship ride to new highs with a 6%+ move in the last 21 days and the previously mentioned unemployment rate sits at below normal levels. The next move in long-term interest rates will take be lower and begin in the second half of this year as the markets realize that job growth is slowing and the supply of equities (economics 101) begins to climb due to much higher prices.

News from around the world

We have written extensively about the “yen carry” trade and how every world market seems to be connected to the value of the yen (119.70/dollar). It is clear that the world’s major investors/traders are short the yen betting heavily on a lower value which encourages more borrowing of yen and lending/investing in other markets. 2007 has been a winning year for those in the yen carry trade as the currency has continued to depreciate but a change may be coming soon. Earlier this week S&P raised its rating of Japanese debt from AA minus to AA, thus giving Japan its first upgrade since 1975. Ratings are a function of perceived economic stability and ability to pay interest and principal. This year’s Japanese budget deficit is expected to be under 5 per cent of gross domestic well under the 8.2 percent seen in 2002. A stronger economy is coming to Japan and the Yen carry shorts may feel a “squeeze” later this year producing a massive run to liquidate positions in many of the markets that have seen dramatic rises this year (stocks, commodities, etc.).

May 21st will bring gasoline rationing to Iran as the price of gasoline will rise 25% for public consumption of 3 liters per day. Of course there will plenty of gasoline available on the black market but at a much higher price. It will be interesting to see how much time the Iranian government has for rhetoric against the US when its general population is sure to be complaining of higher gas prices leaving them with less to spend on other necessities.

News from the US

Former Fed Chairman Alan Greenspan has been very busy giving speeches and this week we learned that he has been spending his time writing a 47 page report for his former employer entitled “Sources and Uses of Equity Extracted from Homes” that was co-authored by James Kennedy (previous studies in 1996 & 2005). I have followed the Fed and its moves for almost 50 years and don’t remember a Former Fed Chairman ever coming back to the Fed to offer analysis so soon after their retirement date. There is nothing of note in the report that hasn’t been covered recently but I wonder if current Fed Chairman Bernanke is wondering when Mr. Greenspan will finally leave the building.

The Census Bureau reported this morning that the vacancy rate for rental housing rose to 10.1% in the first quarter of 2007 while the homeowner vacancy rate rose to a 10 year high of 2.8%. Again, nothing surprising but I expect to see these rates soar in the next few quarters as it becomes obvious that we are only in the very beginning of a long bear market for the residential real estate market. If you are thinking of buying a house, take a deep breath, take a long walk and come back in a couple of years. The first dip in a bear market is always tempting and has the look of a strong bottom (Japan 1993-1994) but gives way to the next leg down and the beginning of a panic for sellers who realize that this is not your typical correction in prices.

A sure fire way to have home prices rise

The best quote of the week comes from the Sarasota Herald Tribune in an article titled “Sarasota-Bradenton sales buck national and statewide trends.” This area actually saw an increase in sales for March of 834 homes from 721 a year earlier. One month does not make a trend change and we must not lose sight of the fact that Sarasota has a 110 week supply of homes for sale. It appears that one local realtor has discovered the way to rising home prices “I’d like to make an appeal to everybody who does not need to sell to take your home off the market.” She is correct that a decreasing supply should increase prices if demand remains constant but my question is: who has their house for sale that really doesn’t want to sell? Lower prices are coming to Sarasota and other Florida communities where supply overwhelms demand and buyers begin to realize that there is no need to purchase a home today when lower prices will arrive next year and the year after……

Mortgage rates higher but Treasury rates lower?

A tightening of lending conditions and a realization by lenders that their rates were too low compared to the risk they were taking in booking loans that soon had repayment problems has led to tough times for mortgage lenders. Indy Mac reported yesterday that 1st quarter profits fell by 34% due to problems in the sub-prime area. The quote in the press release tells us more than the profit statement and makes it clear that these problems are not even close to ending. “With respect to mortgage banking revenue margins, the spread widening in the private mortgage-backed securities markets that occurred in the first quarter will continue to impact margins in the second quarter.”

Next Week = Jobs

Friday May 4th at 5:30am we will receive the April jobs report and the consensus is for an increase of 120,000. As noted above the unemployment rate is one of the two keys to the Fed lock box and this weeks Conference Board stats show that we may be nearing a turning point in the job growth cycle. Their jobs hard to get series rise to 20.4 from 18.9 and their jobs are plentiful index dropped to 27.8 from 30.3 with both numbers seeing their respective highs and lows for the year. 2007 jobs numbers have been heavily influenced by weather (hot early, cold late) so the next few months may give us a better indication of how much the housing slowdown has filtered into the overall US economy.

Summary

This week ended much like last week with the stock market soaring to new highs and the yen’s weakness fueling much of the buying power for global equity and commodity markets. The Dow closed today at a new high and has now risen 19 out of the last 21 trading days. In the past 110 years this has only occurred twice (8-01-1927 and 7-05-1929 so I am not sure of the significance but it does make interesting reading. Interest rates spent much of the week in a trading range as the tug of war between a slowing economy and temporary higher inflation continues with no clear winner in view until later this summer. The good news for those waiting for lower long-term rates is that we are only two months away from the seasonally strong second half of the year when rates fall 75% of the time and this year should be no exception.

It’s all about supply and demand

Whether it be the level of interest rates, the price of an individual stock or the price of oil, each market has its own levels of demand and supply. It’s important to understand whether recent price action is due to a change in demand or supply and a quick look at today’s markets brings some interesting answers that are relevant to all global markets. There is usually one dominant theme and for 2007 it has clearly been the “yen carry” trade. The availability of unlimited yen borrowing at an interest rate of approx. 0.5% has enabled global investors to engage in a what has been an almost risk free trade for almost all of 2007. A chart of the yen and the S&P 500 for this year shows an almost perfect correlation as a weak yen allows investors to profit from a cheap borrowing source and an ever rising US stock market. Today’s action again was up, up and away as the Dow rose for the 15th day out of the last 16 and the 22nd out of the last 26, Since its recent March bottom, the Dow has risen 8.6% and 1027 Dow points. As I have often written throughout the years when a market has a big percentage change in a short amount of time it is important not to extrapolate the current move because the laws of gravity enter at the most inopportune time. One of the key reasons US stocks have rallied comes from the dwindling amount of stock offered for sale. In 2006 over $400 billion of shares were retired or purchased by other companies. With demand rising from the yen carry trade and supply dwindling the rocket ship of US stock prices has soared to levels few predicted early this year.

Interest rates
Again it’s about supply (issuers of bonds) and demand (borrowers) and for most of 2007 it has been a tight range as borrowers and lenders find themselves in equilibrium. The 10-year US Treasury reached its peak of 4.89% on January 29th and it most recent low of 4.49 on March 13th. Today’s level of 4.67% is almost exactly in the middle of that range showing demand and supply are at levels expected by the majority of market participants. That is the past and to predict the future we must dig a little deeper than most to uncover the next change in direction for this year. Seasonal trends are very important and history has shown a 75% probability that long-term rates will rise in the first half of each year and decline in the second half of the year. Demand for credit usually is the dominant force in determining interest rate levels and we are beginning to see a decline in credit demand by viewing the statistics released by the Fed in its H.8 report that is available to everyone each Friday at 1:15pm. http://www.federalreserve.gov/releases/h8/Current/h8.pdf. Commercial and Industrial loans have clearly slowed and may be reaching a long awaited plateau while real estate debt (especially Heloc’s) has begun a decline due to tighter underwriting guidelines by lenders. Credit is clearly driven by borrowers for both expansion (business) and spending needs (homeowners) and this should drive long rates down later this year. Inflationary expectations are a key component that lenders use to determine the level they wish to lend their hard earned money. Tuesday we saw inflation (CPI) news that showed a 0.1% growth for the core (ex energy and food) and a 12 month rise of only 2.1%. Food and energy are an important part of inflation but one must focus on the rate the Fed follows to help determine monetary policy. More importantly inflation is a lagging indicator (much like job growth) and a central bank that reacts to inflation will always be late with interest rate decisions and quickly lose its credibility with global interest rate players.

Gold and the dollar
The yen carry trade is having an effect on these two markets as today we saw gold close at $692.65 while the Euro reached for all time highs while closing at 1.3589 to the dollar. We read frequently that high interest rates create demand for a currency but with Euro rates much lower than those in the US it is obvious that interest rates take a back seat to perceived strength of the underlying economy. With a very high correlation between a weak dollar and strong gold it’s been another “free” ride for those borrowing yen, buying euros and buying gold. This will end one day with a monstrous crash but the winners are yelling and adding to their winning positions while many sit on the sidelines wondering how the US can allow a dollar depreciation. The answer of course is that a weak dollar will surely soften the blow to business from a US consumer that has clearly spent all of its income and now must resort to credit card borrowing or stock market profits.

The key to the US economy: The stock market
I am asked daily about the US economy, interest rates and when the Fed will change the current level of the Fed Funds rate (5.25%). Public opinion about the health of the economy primarily comes from recent trends in the stock market. With the powerful advance of the past four years and especially the last four weeks the consensus now feels that the housing market problems are a blip on an otherwise healthy economy. The most frequent comment I read (27 papers a day) and hear (600+ e-mails received each day) is that if the economy can weather this housing storm just imagine how well it will do in a year after the house market stabilizes. Clearly the Fed can NOT ease short-term rates when the stock market is hitting new highs as it must hold its ammunition (lower rates) for a time when there is pain in the marketplace. The only perceived pain today is in the residential real estate market and the Fed must view the entire economy and not change monetary policy on the basis of one small part. Until the stock market stumbles and public confidence falls the Fed will remain on hold with the Funds rate at 5.25%.

Next week
The bond market and US interest rates have taken a back seat to almost every other global market. Economic news is passed over and attention is focused on the Chinese stock market (why?), the value of the yen vs. the dollar, gold, oil anything that might affect the yen carry trade. The only economic event that might garner press next week occurs on Friday (4/27) when the 1st quarter GDP, price index and employment cost index numbers are released at 5:30am. There are times to be an active player and other times when it is best to sit and watch (or sleep) and US interest rate action reminds me of the late 1960’s when we could go days without moving and no one even cared…we are not there yet, but coming close…the Fed actually likes this sort of non-action…maybe we really are returning to the 60’s…I do know that in a few more years I will be there.

Will a falling dollar slow the housing decline?

Be careful of what you ask for…

This morning’s trade report showing a slightly lower deficit of of $58.4 billion ($58.8 last month) managed to only slow down the recent rapid decline of the dollar. The dollar’s recent depreciation might be the only item the Fed/Treasury has left in its bag of tricks that could possibly prevent the dark storm clouds on the economic horizon from becoming a storm that many will remember for many years. I have often written that those who wish for a trade surplus are not focused on the fact that it is caused by weak domestic demand. Most countries that have a hot export (oil) find that a trade surplus is a poor substitute for strong domestic demand from consumers. The current dollar/euro at 1.353 is trading near its all time high and lessening the price of goods to our foreign customers. In the 1980’s we saw strong real estate demand from Japanese investors in part due to a weak dollar which appeared to create bargains for foreigners seeking entry into the US market. Unfortunately many prices became cheaper when the bottom fell out of the commercial market a few years later.

With the Fed clearly on hold and showing no clear sense of direction, Treasury Secretary Paulson is not standing in the way of those that wish to push the dollar to new lows. Today’s PPI (wholesale inflation) release showing that prices rose 1.0% last month was somewhat tempered by an unchanged core (ex food and oil) number but many aren’t buying into the theory that inflation is only a concern when rising across the board. Food is rising due to commodity shortages caused by the demand for ethanol which is in its beginning stages of a major boom. Oil prices are rising due to political concerns and a limited number of US refineries (nothing built in the last 25 years). It will be very difficult for these price increases not to filter through to the retail level. With the housing crisis that will soon spread across the country the ability of the consumer to absorb these price increases is very questionable and highly unlikely. We continue to see a decrease in the amount of real estate loans but an increase in credit card debt at much higher interest rates.

The government cares about the health of the housing industry

A sad but true story from today’s San Francisco Chronicle that profiles just how easy it WAS to obtain a home loan over the past few years and how difficult it will be to for many to stay in their homes. This is a MUST read article for everyone because it details why the crisis is not short-term and why there may not be a solution. The key quotes: “Many of my clients can’t afford their homes in any circumstance” and “they can’t afford the interest-only payments.” This is at a minimum a 5-7 year process and those that believe that it is a great time to jump in the water will soon find that the sea is full of sharks not goldfish. As usual many state governments are arriving at a sure fire loser for a quick solution: a freeze on foreclosures. In yesterday’s Philadelphia Business Journal, a New Jersey lawmaker has asked for a moratorium on foreclosures which will not give homeowners more income to make their payments and surely drive lenders from New Jersey.

An interesting article from the Orange County Register, it appears that the amount of county’s tax payments are running at an 11-year high due in part to lenders NOT forwarding the impounded property taxes from their borrowers. If your taxes are currently impounded you might wish to reconsider making them from your own bank account. This is another story where the ending is months if not years away.

When property values are rising and home sales soaring, state coffers are always bulging with tax receipts giving everyone a sense of calm. State lotteries were born in the days when many states couldn’t balance their budgets and legislators could not go to the electorate and raise tax rates. We could soon see a return to increased gambling (tax wagers on offshore casino bets in return for legalization?) as state tax revenues are falling fast in many of the states that saw the highest property values of 2005-2006. A New York Times article shows that New Jersey could have a $2.5 billion shortfall in 2008 with California right behind at $2 billion.

It’s not only governments that are suffering as many condo associations are learning that when homeowners struggle with mortgage payments it is the association dues that frequently go unpaid for many months or worse. A Washington Post article highlights a Silver Springs, Maryland building where 10% of the homeowners are more than 30 days behind on their monthly dues.

There is one sure fire way to create demand for a house…..lower the price. A Sacramento developer has been deluged with interested buyers due to his offer of a free home to anyone willing to haul the house off of his construction site. There is a correct price that is always sure to create demand and in this case….it is zero dollars and zero cents.

Interest Rates

Another tough week for long-term interest rates and that is why we continue to have the yellow caution flag in front of the green flag. The US bond market is confused by the Fed’s lack of direction and afraid of the inflation that appears to be on the horizon. This action is nothing unusual as I have written for months the first half of this year would see rising long-term rates before declining in the second half of the year. Inflation will stay at the worry stage as the Fed will NEVER create money to bail out the homeowners that need lower rates and higher home values. The bear market for housing and real estate has begun and it will not end until the vast majority has given up all hope that there will be a return to the “good ol days”. This was a once in a lifetime ride for many and the faster they leave the train the better they will be before its final destination in 2012-2014.

Next week we have a few important economic statistics headlined by the important CPI on Tuesday morning. If you are waiting (or needing) lower interest rates the second half of 2007 will have much sunnier skies for borrowers but not much relief for homeowners as property values continue their slow, painful march to much lower levels.

Higher and higher, step by step, one by one…….

The words from one of my favorite Huey Lewis and the News songs “Jacob’s Ladder” apply to the US interest rate market as another week closes with 10-year Treasury rates climbing towards the 2007 high of 4.89% seen on January 29th. This morning’s jobs report showing an increase of 180,000 sent sleepy bond traders (all other markets were closed for the Good Friday holiday) into a selling frenzy pushing long-term rates to 4.74%. Since March 13th (low rate for 2007) the 10-year has moved up 25 basis points with 14 coming from an increase in inflationary expectations and 11 bp from an increase in the real yield. I gave my readers ample warning that April is usually an ugly (up) month for interest rates and so far the seasonal pattern has held to form. I continue to believe that we will not see a significant drop until the 2nd half of 2007.

Where are the jobs?

Today was the sixth time in the last 22 years that the jobs report fell on Good Friday and for the fifth time we saw jobs increase by more than expected by the experts. Not only was this morning’s report 45,000 higher than expected but the last two months reports were revised up by 16,000 each. The category that showed the most growth last month was construction which increased by 56,000. With revisions certain to come it becomes an educated guess that these jobs were playing catch up due to a cold February (-5 degrees) and a warmer March (+7.5 degrees). The two most important parts of the report continue to show that the economy is in the initial stages of a slowdown. Temporary help services fell 1,000 in March after a 6,000 decline in February. If corporations were ready to expand they would be hiring temporary workers and there is almost no sign of this from any industry other than oil services. The diffusion index shows that only 56.7% of industries are expanding their payrolls which of course means that 43.3% are decreasing their payrolls. Employment numbers have always been a lagging indicator and should never be used to forecast future economic trends. The numbers make good headlines for the economists and politicians but because of massive and frequent revisions their credibility has been diminished over the years.

Mr. Greenspan has completely left the building

As most of my readers are aware, I watch, read and review all Fed speeches and most importantly question and answer sessions that occur after many Fed speeches. Monday (4/02) St. Louis Fed President Poole spoke about the current Fed and amzingly I didn’t find it anywhere in press recaps of the event. “Chairman Greenspan often wrote with the expectation that people would read between the lines, but Chairman Bernanke is trying very hard to have people read the lines and not draw implication from reading between the lines.” In one sentence Dr. Poole gave us the key to the lock box at the Fed, the rules of the interest rate game have changed dramatically and many will soon be left behind. Last week I wrote about Chairman Bernanke’s remarks that we should not expect any more forward guidance from the Fed. This week, Dr. Poole made sure everyone who missed the Congressional testimony had another chance and the bond market has followed with higher long-term interest rates.

If the Fed is going to react to economic events as they occur then we are about to see an increase in volatility with movements in prices, yields, commodities, stocks, etc. that we haven’t seen for over 25 years. Chairman Greenspan helped reduce volatility by giving the markets a “heads up” about future Fed policy direction and this enabled the markets to digest the change of direction months ahead of the actual event. It was also calming to know that the Fed head was firmly in control and the Fed’s crystal ball was clearly showing the future in an easy to travel road ahead. Mr. Bernanke is telling the world that he really doesn’t know what to expect from the future and that Fed policy will react to the economic gyrations after they occur and the market will adjust over time. We saw that in the 1970’s and the results were not pretty. Inflationary premiums increased due to the uncertainty and it took a powerful new Chairman (Volcker) to put an end to the record interest rates (20%+).

This is one reason that we have seen gold prices rally over the past few weeks (current price $675). What is most impressive is that gold has risen above the key $665 level despite the selling of 29.2 tonnes of gold by two European Central Banks over the past two weeks. Gold loves uncertainty and a weak dollar (Euro close to all time highs 1.36) and if a confused Fed is added to the mix we could easily see $ 700+ in the next couple of months.

Consumer Credit

Today’s consumer credit report showed revolving credit (credit cards) growing at an increasing rate of 7.0% (yearly gain) versus only 3.0% in March 2006. One of my key tenants for 2007 is that the consumer/homeowner will be shut out of the ATM/Heloc market and will be forced to obtain credit through credit cards. Because the interest rate is so much higher on this form of borrowing it will put a dagger in the ability of consumers to continue to spend at the same pace of the past few years when credit was easy to obtain using houses as collateral. We are very early in this process but by the end of 2007 this will have a major impact on the US economy.

Loan demand

Interest rates are determined by the demand for credit and by the supply created by lenders. Each Friday the Federal Reserve releases its h.8 report at 1:15pm detailing the amount of commercial & industrial, real estate and consumer loans. The Fed pays close attention to these weekly stats in determining the course of monetary policy and the level of the Fed Funds rate. Two weeks ago the amount of the real estate loans took a sharp drop and I commented that it was probably something similar to when Wachovia completed its acquisition of Golden West Financial in October 2006. After a little bit of research it was discovered that Countrywide’s conversion to a federal thrift was approved on March 5th. This effectively reduced the loans tracked by the Fed in the real estate category by over $80 billion. This is why it is so important to analyze these stats on a monthly basis and not be caught by weekly fluctuations. After adjusting for Countrywide we continue to see real estate loans growing at a 6%+ annual growth rate but the trend is clearly headed lower and will be negative within the next six months.

Summary

Long-term interest rates are rising as they usually do in April. The economy continues to be in the early stages of a significant slow down led by a housing market that should stabilize for the next few months before beginning another leg down in the winter months. This will bring a dose of panic to homebuyers and grave dancers (foreclosure buyers) as the first sign that “this isn’t what I expected” takes over in the real estate market. The recent stock market rally continues to be fueled by an every Monday takeover frenzy that reduces the overall supply of shares. Expectations of an easing of Fed policy are creating buyers of stock at a time when supply is decreasing thus the result is higher prices. For those that are watching my 2007 best bet of sugar (currently trading around 9.7 cents) I offer the words written by John Maynard Keynes in 1931: “The market can stay irrational longer than you can stay solvent.” The sugar bull market is coming but patience and deep pockets are needed before its arrival.

Finally for the many mortgage brokers and real estate professionals that read this letter, the lock number at the top (updated daily) is now at 24.7 which translates into an upcoming short-term decline in interest rates. Using an 80% level for absolute locks and a 20% level for no locks we are very close to a point where long-term rates will begin to edge lower creating better opportunities for mortgage pros to lock loans. I will discuss this indicator in my next class on Wednesday April 18th.