The engine is humming and the green flag will be raised soon

The INDY 500 race begins every year with the green flag being waved to the 33 drivers who will attempt to complete the race under what are frequently harsh conditions (this year’s race was cut short by bad weather). In interest rate land we use the green flag to indicate an all clear signal to our readers that rates are headed lower. The yellow flag is used in conjunction with our forecast when we are in a cautious mode while waiting for rates to peak. On March 23rd of this year we raised the yellow flag with the 10-year at a level of 4.61% and that has saved our readers 42 basis points as the 10-year closed today at 5.03%. With the end of 1st half of the year we wave good bye to the strong seasonal pressures for rates to rise and welcome the seasonal trend to lower rates in the 2nd half of the year. Although we are not quite ready to move the green flag in front of the yellow flag, the stage is set for another drop in long-term rates as we enter the July/August period. In the last 41 years we have seen long-term rates drop 31 times for an average move down of 141 basis points. Whether we see a drop to 3.62% this year will be determined by the economic landscape but we enter this period with the odds in favor of a drop to at least the 4.50% level.

The tote board

Much like the odds at a race track that flash the chances (determined by the bettors) of a horse winning each race, the interest rate forecasting business is made up of the millions of borrowers and lenders who come to an agreement each day on an interest rate for the 10-year Treasury note (5.03%). Most forecasts today are for a continuation of the current Fed Funds rate at 5.25%. After early year forecasts of lower rates most experts have now thrown in the towel and feel that the Fed will stay on hold for the remainder of 2007 and 2008. History is often used to forecast the future and in reviewing the past 17 years of Fed policy (somewhat similar economic environment) we see that the average number of months between a Fed policy change is 12 months with a range of 5 (1995) to 17 (1994). The Fed went on hold in 6/06 and now has gone 12 months without any change and might set a new record if recent forecasts prove accurate. BUT we must remember that most of this history comes from the Greenspan era and each chairman has placed his own signature on the Fed so history may not be a good barometer this cycle.

The Fed

Thursday’s FOMC meeting produced nothing unexpected as Chairman Bernanke led his team in another chorus of “the song remains the same” with a Funds rate at 5.25%. The Fed continues to focus on an inflation rate of 2% or slightly under and is concerned about oil over $70 and food prices that have been rising all year. Corn is down 20% in the last two weeks, but soybeans and wheat rose to yearly highs as acreage was switched to corn. The key ingredients for a change in Fed policy revolve around the stock market, unemployment rate and loan demand. Unfortunately none of these have moved much in the past few weeks but that could easily change depending upon the continued meltdown of the mortgage market. Over the past 40 years I have witnessed the Fed make a 180 degree change in policy in reaction to a significant economic event that impaired liquidity in the marketplace. If we are to see that event this year it would certainly come from the forced “market to market” of sub-prime debt owned by funds that operate on very high leverage. The best I see from this sector over the next six months is a “muddle through” but the most likely is more of the same where debt owners are forced to liquidate and that brings up the age old question: “Sell to whom?”

The economy is growing but very slowly

There has been much written about inflation fears by the Fed and price increases being passed through to the consumer. Real rates of interest have risen in the past few weeks as expectations of a strong 2nd quarter GDP have created worries in the bond market that inflation may reappear later this year. If inflation were a real threat would we have seen the recent 54 bp increase (March 13 until today) in the 10-year be dominated by the inflation component and that has risen only 4bp. If inflation was threatening wouldn’t we see someone on strike from our 135 million work force? (Not one labor strike in the US in June.) If the economy was growing would we see Southwest Airlines announce a cutback in capital spending for 2008 by several hundred million dollars? If inflation was growing wouldn’t it be easier for gas stations to pass on cost increases to the buyer, especially for a product that is inelastic like gasoline? (Inelastic is when demand does not fall when prices rise.) Quote of the week (thanks DC) comes from Maine where the owner of a gas station told us: “Last year, credit card companies made more on a gallon of gas than the retailers.” Prices are increasing but margins are dwindling to nothing for many businesses as consumers spend more on one item at the expense of foregoing another item. Inflation stats will continue to decline for the next six months especially since rental rates are dropping due to homeowners that have come to the conclusion that a rental payment is better than a foreclosure. Finally we saw this week that the American Trucking Association reported another decline (1.3%) in truck tonnage in May after April’s decline of 2.2%. 75% of goods sold to consumers in the US are transported by truck and we expect this to have an negative impact on retail sales later this year as retailers order smaller deliveries as their customers cut back on spending.

House prices are falling and office space is available

This week we saw that house prices fell again last month but what the stats don’t show are the sales at high prices with huge sales incentives for the buyer. In Loretto Bay (near Las Vegas) we see a home builder offering zero payments for either 12 or 18 months and zero money down. This is a great incentive but an overpriced house is still overpriced unless you are planning on moving within the first couple of years and have a guaranteed buyer when you are ready to leave. From the Sacramento area comes news that we haven’t seen for many years, a glut of office space. The one branch everyone was hanging on was that the commercial area was holding up well and many of the displaced residential workers could find jobs in commercial construction. It appears that a few branches are about to break and the tree will have a few hard years ahead.

China laying off risk to its citizens?

A very important story in the June 27th Xinhua News (China) tells us that the Ministry of Finance has authorized a bond issue to be offered to Chinese citizens. The proceeds ($200 billion) will be used to purchase US dollars that are currently stored for a rainy day by the Chinese National Bank. The world has watched as “hot” money has been used to sell dollars and buy the undervalued Chinese currency (Yuan). The Chinese central bank has accumulated 1.2 trillion dollars of foreign exchange reserves and has decided to spread the risk of a declining dollar to its citizens. The State Council will suspend the interest tax on personal savings to give everyone an incentive to purchase these bonds. The Chinese government is attempting to slow down the heavy rush of funds into its stock market and probably allowing the government to purchase more dollars as it continues to keep the Yuan from appreciating at a more rapid pace.

Scoreboard and predictions

In my initial 2007 EWW (see archives) I forecast three surprises for the year and the first was one of the worst calls I have made in many years. Sugar not only did NOT rise 40% in the first six months but actually fell 15% to its current level. “Never buy something that is given away for free” became the battle cry for sugar bears as supply from Brazil overwhelmed the market every month of this year. The stock market did take a sharp fall in late February/early March but came right back in June to reach new highs. Finally I said that the housing debacle would be much worse than everyone had predicted and that has turned out correct with more to come. Overall grade a “C” so let’s try for a better grade in the last half of this year.

Scorpios are stubborn and I am no exception so I will go back to Sugar for my first call. If oil continues to stay near the $70 level the demand for sugar used for ethanol will increase and that should send the price back up at least 25%. The stock market is being held up by stock buybacks, takeovers and the powerful “yen carry” trade so it will probably take a rise in the yen for the stock market to see any meaningful depreciation. My forecast of a long, slow, painful bear market for residential real estate is intact and I see a short period of strength over the summer for values but back to the slow decline during the fall and winter months.

Interest rates

Most of my day is spent studying and reviewing events that could effect future interest rate movements. For the next six months I have the following probabilities: 65% – the most probable path is for long-term rates (currently 5.03%) to drop to at least the 4.50% level but only after a retest of the 5.32% area we saw three weeks ago. A slowing economy led by a drop in consumer spending and low inflation will ignite demand for US bonds but due to problems in the mortgage area we may not see the same drop in residential borrowing rates. I would only punt on this forecast if we saw the 10-year rise to the 5.50% level for at least two weeks. 25% – a replay of the 1987 story where the stock market melts down due to a shortage of liquidity in the mortgage market and its bleeds through to the economy and forces the Fed to intervene by increasing reserves to banks. This is probably the reason we have seen a move to a positive yield curve in the past few weeks as someone is making a large bet that history is about to repeat. The key to this occurrence will come from the action in the long end of the yield curve. If the 30-year interest rate drops more than the 2-year we are more likely to have scenario #1 but if the short end leads the long end down scenario #2 will take the market for the next few months. 10% or less – I am completely wrong and inflation picks up without the Fed showing any concern and the 10-year rises to 5.50% and stays there or above. I actually have a hard time putting a 10% probability on this but you never know in this business and stranger things have happened over the last 40 years.

Conclusion

We have arrived at the starting line for the most favorable interest period of the year. Although loan demand has stayed strong and the stock market is near its recent highs we should be in a position for long rates to begin a sharp drop to much lower levels. Inflationary expectations are contained and the most recent run up in Treasury yields came from a fear that growth in the economy would translate into future inflation and I just don’t see that in 2007. We will know sooner than later and hopefully my 40-year old crystal ball has a few good years remaining. Remember that “fear” stands for “false expectations about reality” and my forecast is that the interest rate market will soon reconcile reality and recent false expectations with lower rates.

This is NOT an investment newsletter and I advise all readers to consult with a professional investment adviser before entering any markets with their hard earned dollars.

Is the housing foundation cracking?

Although buyers and sellers are an important part of the pricing mechanism in house prices, lenders may hold the keys to the front door of many sales in the near future. This week we witnessed what may be a turning point in the very leveraged world of home lending. A few short years ago the typical home lender was your local bank who would write a mortgage and then keep the loan on its books or “portfolio.” In 2007 the odds of your initial lender holding the mortgage for more than a few weeks are low and the actual end lender may well be overseas (Far East, Middle East, etc.). When mortgages are held by banks, the amount of reserves that must be held by the lender are regulated by the Federal Reserve or state banking authorities. By managing these reserves banks are able to leverage their balance sheet and control their risks that are closely overseen by government agencies.

With the sub-prime lending problems bubbling up through the lending landscape we may be seeing the beginning of a trend that will continue for at least a few years. This morning’s Orange County Register wins the award for best quote of the week: “It wasn’t a problem with securities, it was a problem with margins.” Irvine mortgage lender Brookstreet saw its capital shrink from $16 million last Friday (6/15) to -$3 million (yes, negative net worth) today as the value of the mortgages it held (lender) dropped in value. Some of the loans were valued at only 18 cents per dollar of loan as the firm shut its doors yesterday. The obvious question after reading this article is: “what happened this week in the mortgage market” and the answer appears to be the most important three words in the mortgage market: “mark to market.” This term refers to how a lender values its mortgages when interest rates are rising and credit quality falling. It appears that many of the sub-prime lenders that built billion dollar portfolios on huge leverage have nothing to fear unless they are marked to the market. The Bear Stearns High Yield Mortgage funds have been in the press all week due to a threat of margin calls. What has the “street” worried is that most of these lenders do NOT have their loans marked to market and hope they don’t have to any time soon as the marks will all result in a giant margin call for those on big leverage (almost everyone).

This is very complicated and probably more than most of my readers wish to know but will be a big story on Wall Street soon if these lenders are not saved by other lenders who will allow time to work out the problems. The most interesting story of the week about this ticking bomb was the reason the first bear bail out failed: the borrowers wanted a one year moratorium on any margin calls. Sorry, no one would ever loan money and not require more equity to be added to position that was rapidly falling in value.

Sub-prime borrowers paying credit cards before mortgage payments

Today’s Business Week magazine has a fascinating article (sorry no link) about a study from Experian (credit bureau) that shows sub-prime borrowers making credit card payments BEFORE their mortgage payments as they realize the new bankruptcy laws make it more difficult to expunge those debts. They may also realize their home equity is so little that they need to have active credit cards to keep buying gas, food, etc. Homeowners also may believe that house prices will rise over the next year and bail them out. A story this morning from the Associated Press details a poll by the Boston Consulting Group that shows 55% of Americans feel the price of their house will rise over the next 12 months. We see life from our own experiences and every person that has made money in real estate over the past 25 years knows that buying dips/pull backs has proven to be profitable within a few years, so why shouldn’t this occur again? This is the reason why construction is still growing….build it and they will eventually arrive…and it’s better to be a year or two early than be late and miss the next big move up. This is the fuel that feeds long, slow, painful bear markets when everyone buys the first few dips in an attempt to ride the next wave up in profits only to find out the next wave is down in prices.

Housewives make the best foreign currency traders

The Japanese yen closed today at 123.89 to the dollar (2007 low) and shows no sign of topping as the Bank of Japan seems to be happy with a record amount of yen leaving the country (all yen eventually come home?). A story from Tokyo early this week shows how Japanese individuals are borrowing $11 billion every day and investing these funds (after converting to another currency) in the hottest markets around the globe (New Zealand, Euros, US stock market, etc.). Individuals have opened 600,000 margin accounts this year as the urge to borrow at 0.5% (Japanese borrowing rate) and lend at 8% (NZ) is growing daily as profits to the average worker/housewife become more than a year’s salary in no more than a couple of weeks. This certainly reminds me of 1929 (I wasn’t born yet) when Joseph Kennedy told everyone that when the shoe shine boys are giving profitable stock tips it’s time to make a hasty exit.

House/condo rental rates declining

I have written for over a year that the US inflation rate would be held down due to declining rental rates for homes. From Ft. Myers, Florida comes the story of condo rental rates that have fallen over 10% in the last year due to so many owners not being able to sell and choosing to rent to help make monthly mortgage payments. The second best quote of the week comes from a renter paying $1350 a month (barely enough to pay the owners taxes and condo association fees): “It’s like living in the Ritz-Carlton, it’s got great amenities, it’s clean, it’s safe and has a beautiful view.” From Raleigh, North Carolina we see that a condo developer of 179 units is now renting all of the units due to soft demand for purchases. Last quote of the week comes from Mark Keisel who manages bond funds for Pimco (Bill Gross), when asked about the US housing market: “It’s a bloodbath”, “We’re talking about a two to three year downturn that will take a whole host of character with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit.” Rarely do you see quotes like that from main stream money managers.

Interest rates go up and down and all around

It’s almost five o’clock and I could write for another two hours…..we are very close (five trading days) from the end of the most negative cycle period for interest rates, mid-May to the end of June. The Fed/FOMC meets next week and will announce at 11:15am on Thursday (6/28) that they will hold the Fed Funds rate at 5.25% and that inflation is under control but still lurking and the housing market has problems. In other words nothing new BUT this will have a calming affect on the interest rate market. I wrote a couple of weeks ago that we would test the important 5.25% and probably go thru for a couple of days (5.32%) and then come back down to the 5.10-5.12% before making another move back to the 5.25% level. This backing and filling and scaring the you know what out of everyone will form a solid foundation for the drop I am expecting in the second half of 2007. The Fed absolutely does NOT want to tighten monetary policy through an increase in the Fed Funds rate and can’t ease until the 10-year US Treasury note falls below 4.50% or the stock market falls sharply accompanied by an increase in the unemployment rate. With the yen reaching new highs it may be difficult for the stock market to drop but the unemployment rate seems poised to rise over the next few months and the housing problems will continue to grow and grow…….long term rates are coming down and the party to celebrate will begin in July……it’s going to a bumpy ride on the rate roller coaster but the direction is down.

The blue troops (lower rates) defend the key 5.25% level after an attack from the red troops (higher rates) earlier this week

Last Friday I spent quite a bit of space detailing what I expected over the next few weeks. “The key will be the important 5.25% level on the 10-year and as long as we don’t see this rate breached for a two week period the Fed will again have successfully defended its current position.” Last Friday the 10-year closed at 5.11% and by Wednesday morning (2:30am) we traded at 5.32% but just as I suspected mysterious buyers appeared and by today we were back down at the 5.16% level. With another two weeks in the weak seasonal period (May 15th-June 30th) ahead of us I fully expect more testing of the 5.25% level with short spikes above 5.30% which will shake many late comers to the party out of their long positions (lenders). Nothing that has occurred this month is unusual (see my past newsletters) and this week’s action has actually been very healthy as we begin to sow the seeds of the next move down in long-term interest rates.

Stocks higher and higher

The U.S. stock market soared to new highs today and anyone who has followed the movement of the yen (down, down, down) has been able to ride the stock market wave to big profits. The chart of the yen versus the S&P 500 shows almost a perfect correlation this year and with borrowing rates in Japan remaining at 0.5% (the BOJ this morning decided to hold rates steady) every big and small speculator has heeded the call of “everyone into the pool of profits.” The most amazing news from this party is that the size of the pool continues to grow as the Bank of Japan increases the monetary base at a higher rate thus creating a heavy supply of yen which is then borrowed by spec’s and immediately converted to other currencies and investments that are soaring in value. Normally when enough investors short something (a bet on a price decline) the limited supply creates a “squeeze” and the price rises as the shorts run to cover. In currency land the supply is not fixed and the Japanese government is happy to supply more and more yen in an ill advised attempt to stimulate spending in their economy. In reality the yen is borrowed and sold driving the price lower thus creating the opposite effect for the Japanese economy. No one ever said that governments were smart but they are powerful and eventually this rocket ship will crash and create a very painful accident for those on high leverage and small reserves. In the meantime it’s very similar to the 1978 movie “Animal House” where the inevitable eviction was coming but in the meantime it was party hard, party fast and hopefully be the first one out the exit door when the whistle blows.

Strong economy but low inflation

This weeks economic statistics reinforced the bears (higher rates) belief that a rebound in the U.S. economy is underway and inflation will soon follow with higher levels. Wednesday’s report of a 1.4% increase in retail sales should have sent the 10-year to 5.40% but it didn’t and the past two days PPI and CPI reports show headline inflation running at very high levels but again the bond market found the path of least resistance is higher prices and lower rates. The “mortgage lenders” have clearly hedged their positions and probably overhedged any new loans they are planning on funding in late June/early July which will prove to be painful if these shorts are not covered on our next trip to the 5.25-5.30% level.

Housing sector – no signs of a rebound

Tuesday morning (6/26) we will see the most recent housing starts and permits numbers and we must remember that these stats are very volatile. They are expected to fall and should fall but anything is possible on a month to month basis. It should be clear to everyone (except the new economist at the NAR) that this part of the economy has not bottomed and with so many grave dancers (thanks Sam Zell) lurking around each neighborhood the bottom will many years away. Bear markets don’t end with a bell ringing for everyone to enter and the big money on the sidelines will have to enter and not exit (lower prices) before we will see the sun shine again on the residential house market. Remember that just because you made $$ over the past few years by buying real estate and selling for a quick profit does NOT have any correlation with future investment results. The key question for everyone should always be: Did I make money due to luck (a rising tide floats all boats) or actual skill (add value) that can be repeated at a later date.

The Fed is coming

The next FOMC meeting will take place on June 27th and June 28th with an announcement at 11:17am on the 28th. Much like last year’s June meeting which sent a message that the Fed was done raising the Fed Funds rate I expect this month’s meeting to be the most important of the year. It is clear that the Fed does not want to raise the funds rate above its current level of 5.25% and to insure this stability it must do everything possible to keep the 10-year close to the 5.25% mark. The Fed knows this is a market rate and thus cannot control the rate but it can make its intentions clear to market participants thru Fed governors/FOMC members speeches that are routinely given each week around the country. I expect the next FOMC statement to very carefully send a message to the market that its fear of inflation is waning and that current policy is enough to keep the economy growing and inflation tolerable. This would set off a strong rally in bond prices and lower long-term rates. It’s been a long first half of 2007 for many borrowers who have been waiting for lower long-term rates but with a few more moves to the 5.25-5.30% level on the 10-year and an increase in short/hedged positions by mortgage lenders we should have enough seeds in the ground to see a much better landscape appear in the late summer/early fall. For those with a shorter outlook next week’s bounce to the 5.10-5.12% level should provide an opportunity to lock loans that are closing in late June.

Do you know what happened at 3:10am this morning?

Hopefully most of you were asleep at that hour but after leaving the office last night at 11:45pm with US treasury yields moving higher in Far East trading I had a feeling that we might see significant volatility in Europe. Around 2am selling pressures intensified and by 3:10am the 10-year Treasury was trading at the magic level of 5.25%. By the close of trading this afternoon the 10-year was back at 5.11% as sellers regrouped before another attempt at what will prove to be formidable resistance for the remainder of this year.

The wall at 5.25%

To understand the importance of the 5.25% level we must go back to March of this year when the 10-year was trading around its other key level of 4.50%. The low rate for this year was set on March 13th at 4.49% but intraday we did see levels below this but each time the market found sellers and quickly bounced back above the key marker. I wrote for weeks in the spring that the Fed did NOT want to ease (lower Fed Funds rate) unless forced by at least two weeks of 10-year rates under 4.50%. Fed Chairman Bernanke’s forecast of US economic strength later in 2007 and an underlying fear of higher inflation made it clear that the Fed wanted long-term rates higher than March levels of a slightly inverted yield curve (short rates above long rates). The Fed can’t directly effect long rates but it can send the troops (Fed governors and FOMC members) out into the field to let worldwide investors peek into their crystal ball and most importantly what they fear the most, inflation.

Does it really matter what caused yesterday’s rate rise?

From the low yield of 4.49% on March 13th we have seen a rise in the 10-year of 62 basis points to its current level of 5.11%. Yesterday’s meltdown in bond prices was described by the media as selling by mortgage lenders (true) and fears that the Fed will raise short rates in a similar fashion as the Central Bank of New Zealand which increased its overnight rate to 8% on Thursday (false). New Zealand’s economy is much smaller than the US with a currently rising inflation rate of 3.80% and a currency that is on fire from hedge funds that are borrowing in Japan at 0.5% and investing in the kiwi (currency). On the surface it seems like a riskless investment as the currency is at a 20 year high and an 8% return on cash but sooner than later these hedgies will find that the exit door isn’t wide enough for everyone to leave the party at the same time. Raising interest rates only brings in more investors (China, etc.) and the central bank needs to sterilize the fund inflow so that the inflation rate remains low.

22 days until seasonals change

Seasonally we are in the middle of the weakest part of the year for interest rates. I wrote a month ago about the fact that in the last 11 years we have seen a very consistent trend for rates to rise between the middle of May and the end of June and we are seeing the pattern repeat itself just as it did last year when the 10-year saw its 2006 high of 5.24% on June 28. Although yesterday’s move up in rates brought headlines in the press it was nothing unusual for this time frame and I would expect more testing of the key 5.25% level. I expect the Fed to march out its warriors if the 10-year spends more than a day or two above this level in an effort to make sure that this rate does NOT go much higher which might force the Fed to tighten (raise the Funds rate) as this would surely place the housing market in intensive care. The is almost the exact opposite situation we saw in March and I would expect the 5.25% level to be well defended (as it was at 3:10am this morning) for the remainder of June.

History repeats?

This week’s action is very similar to that of June 2003 which saw the 10-year reach a cycle low of 3.13% on June 13th. This dramatic drop in rates occurred at a time when a fear of deflation (lower consumer prices) consumed lenders and Fed Chairman Ben Bernanke gave a famous speech stating that the Fed should be willing to drop money from helicopters if needed to prevent massive deflation. The government choppers were never needed as rates rose in the summer of 2003 and reached 4.60% on September 3rd. The important part of this piece of history is that during the 87 basis point decline from 4-11-03 to 6-13-03 we saw the inflation component decline only 15bp while the real rate of interest fell 72bp. Interest rates had declined during this two month period but NOT from a decline in inflationary expectations but rather a perception that the economy was about to enter a recession which of course never happened. It took only 2.5 months for the markets to realize their error and rates rose quickly to their 2003 high in September.

Inflation?

Fast forward to 2007 and we see that the 10-year has risen 62 basis points from March 13th (4.49%) to its current level of 5.11%. BUT rather than coming from an increase in future inflation expectations we see that the real rate has risen 54bp and the inflation part only 8bp. I feel that when it becomes obvious in a couple of months that the economy is not on fire (with no increase in inflation) we will see an unwinding of this rate rise and long rates will again test the 4.50% level. This appears to be an exact repeat of the 2003 experience except that this year rates rose before the expected decline. The key will be the important 5.25% level on the 10-year and as long as we don’t see this rate breached for a two week period the Fed will again have successfully defended its current position. For those seeking a good period to lock loans it will soon become apparent that the late summer will offer much better opportunities at much lower rates.

Real estate news from around the world

Many believe that the US housing market is experiencing the results of a bubble bursting but it appears that its a tiny bubble compared with growing problems in Spain. Spanish builders constructed 750,000 houses last year which is more than France and Germany combined. The best quote of the week comes from a property website that tracks Spanish home prices: “Bankers have said to me, why do you care if the appraisal is fake? It will be true in the future.”

From Edmonton, Canada we see that the average house has jumped over 50% in the past year from $282,208 to $426,028 last month. With the Canadian dollar head for par (current 94 cents) and oil revenues soaring the real estate market for our northern neighbor definitely qualifies as a “bubble”.

On a local level it appears that rental rates in San Diego are declining as apartment vacancies increase due to unsold condo’s becoming available to those looking for shelter without the risk of principal loss. Rental rates are a key component in the calculation of the monthly CPI (inflation) and will surely help in keeping the inflation rate under the Fed’s key 2.0% level for the remainder of 2007. With the home real estate market in the beginning of its bear market I would expect many more units to be converted to rentals in the next 2-3 years.

Lastly I actually found someone whose views are more bearish than mine concerning house prices. A San Bernardino appraiser is quoted in this article from the Modesto Bee with a prediction that home values will drop 25-50 percent and I believe that is a very low probability except in rare areas where neighborhoods have been abandoned. The next 3-5 years will be characterized by a slow decline in prices accompanied by brief spurts of buyers trying to pick a bottom only to be frustrated by the realization that the bottom is another cliff that leads to next level down.

Summary

Nothing has changed with my forecast of lower rates once we pass the July 4th holiday. Pessimism is building in the press with Pimco chief Bill Gross writing on his website yesterday that long rates will reach 6.50% in the a few years. Interest rate speculators are increasing their bets on higher rates and the best way to create higher prices is for shorts to be set at lower prices and yesterday’s heavy volume shows that many lenders threw in the towel and hedged their positions at what will be seen soon as too late. The next few weeks should see testing of the key 5.25% level but I expect this to be defended by the Fed much like they did at the 4.50% level in March. Patience by borrowers will be rewarded later this summer as long rates begin their awaited decline to 2007 lows.

Are we there yet?

Much like a cross country ride with children who become frustrated with the current scenery, the interest rate market has many who would benefit from lower rates wondering if they will ever arrive. My long time readers are well aware of the strong emphasis I place on seasonal tendencies and the 75% historical pattern for rates to rise the first half of each year. Last week I wrote about the strong seasonal move over the past 11 years from Mid-May to the end of June where rates have risen an average of 28 basis points. This afternoon with the US 10-year Treasury at 4.95% we have moved 32 basis points but with 20 more trading days before the end of June we could easily move past 5.00% but surely not reach last year’s seasonal high of 5.24% reached on June 28, 2006. Everyone patiently waiting for the change in seasons may see more pain (higher rates) but with short positions building with negative sentiment (a mortgage lender bought 100,000 ten year puts on Thursday) the seeds of the next move down in rates are being sown now for a late summer, early fall harvest.

Jobs increase?

This morning’s jobs number appears to show that 157,000 new workers were added to payrolls in May. Remembering that the BLS (Bureau of Labor Statistics) has the worst track record of any government agency in the distribution of accurate stats we will surely see massive revisions from the initial announcement of strong job numbers. The biggest culprit in this monthly circus show is something called the birth/death model which in English is equivalent to seasonally adjusting data to conform with the calendar year (students finding summer jobs,etc.) For May the BLS plugged in an additional 203,000 jobs that it assumed would be created in May so without this extra edge jobs really fell 46,000. The most glaring error appears to be in the construction area where it is obvious builders are trying to unload homes NOT hire new workers to build more of what they can’t sell. But the BLS uses adjustment numbers that show May is a seasonally strong month for construction so they added 40,000 jobs to May’s number and the net result is a loss of only 15,000 construction workers. The diffusion index shows that only 54.9% of industries showed job growth last month so 45.1% of employment groups fell and temporary help fell another 9,000 in May after a 3,000 decline in April. If business was picking up wouldn’t employers hire temps for a few months before adding permanent employees? In the last 12 months temp workers have declined by 36,000. Finally I find it very interesting that the household survey which is used to calculate the unemployment rate (4.5%) shows a gain of only 17,000 for the first five months of 2007.When final revisions are released later this year and early next year there is a high probability that we will see job growth was nowhere near what was initially broadcast by the BLS.

Being right doesn’t always convert to profits

For those in the mortgage business you will be fascinated by an article in yesterday’s Financial Times of London. It appears that some very sharp hedge funds made sizeable bets early this year on an increase in mortgage defaults from the sub-prime sector. Celebrations have cooled in the last few weeks as these fast and loose players have learned that many lenders are attempting to modify the terms of delinquent home loans by lowering the interest rate or extending the repayment term in an effort to keep the loan current. The lenders of course are acting in the best interest of the borrower and themselves but not it appears for those that have big bets that only pay off on defaults.

Homeowners that can’t sell turn to renting

One of the reasons I look for the US inflation rate to stay under 2.0% for the remainder of 2007 comes from the fact that home rental rates are sure to fall as homeowners turn to renting to create funds to make ever rising mortgage payments. According to an article in the Miami Herald, rental inventories are up 40% this year for South Beach condos and up 400% for South Florida vacation rentals. Economics 101 teaches us that when supply increases prices decline and condo rentals in California, Nevada, Florida and other hot spots from the past few years will be coming onto the market in bulk over the next few months.

How to stop a runaway freight train

China’s stock market (A shares only open to locals) clearly meets the definition of a runaway freight train with a 60% advance this year and 130% increase in 2006. With hundreds of thousands of new accounts opened each month by new Chinese investors the government is clearly concerned about the wreckage that is sure to come when the train crashes. In an effort to slow down the market’s rise the Ministry of Finance on Tuesday increased the stamp tax (equivalent to sales tax) to 0.3% from 0.1%. According to recent history (the Chinese stock market is only 17 years old) this should curtail speculation as it did in 1991 and 1997 when the stock market declined after similar moves in the stamp tax. I would be surprised if this was the last move by the Chinese given the massive flows of money from around the world into the severely underpriced Yuan (Chinese currency).

Want to buy a bank house repo?

It’s been more than a few years since we have seen bank liquidation of homes in bulk but Sacramento will soon see an auction of 242 homes. The curious part of the article from today’s Sacramento Bee is that the selling banks seem to be happy about the auction actually believing that they will make a lot of money due to heavy publicity and many investors waiting on the sidelines. Rarely do the sellers and buyers come away from a transaction believing they got the better deal. Something has to give soon and my feeling is that recent buyers will find that they are too early in this process (5-7 year bear market) and will soon be attempting to sell at even lower prices.

When the initial cut is not enough

Pulte Homes, the fourth largest homebuilder in the US said this week it will lay off 16% of its work force. This comes after a 25% job cut in 2006 and early 2007. Obviously those that thought the downturn would be quick have had to revise their forecasts and I look for more cuts later in 2007-08. The chief economist for the National Association of Home Builders now believes there will be no rebound until 2011 stating that “the upswing will be relatively slow, unlike earlier cycles.” The key words are unlike earlier cycles as everyone sees the world from their own experiences and every real estate investor who has bought the first dip in the past twenty years as been rewarded with huge profits so they stand ready to buy again. The train wreck only occurs when the conductor is sure that the tracks are free of debris just like all the other times in the past. I strongly urge patience for those seeking to buy a house in the next few months.

FOMC minutes

Wednesday’s release of the FOMC minutes from the May 9th meeting brought little reaction from financial markets with interest rates continuing their daily advance and the stock market using it as another reason to set records. Page 5 of these minutes is an important read for all those who wish a little more insight into current Fed policy. Chairman Bernanke and his staff pay close attention to the bond market’s reaction of each FOMC decision and short statement after every meeting. It is clear from the minutes that Mr. Bernanke was not happy that the market’s reaction to the March FOMC statement was interpreted by the markets in a way that drove rates lower so he made sure that future FOMC communications emphasized the Fed’s concern over future inflation and this drove Treasury yields higher which then pleased the Fed. As I have written all year the Fed does NOT want to ease at this time and won’t lower short rates until it sees a much lower stock market, an unemployment rate at 5.0% or higher and a 10-year US Treasury note rate of under 4.5% for at least two weeks.

Home loan originations to continue to decline

Last week John Dugan, Comptroller of the Currency gave a speech about residential mortgage underwriting standards with a focus on “stated income loans.” There is no doubt that the federal government is finally becoming involved with tightening controls as it seeks to prevent more damage in the already reeling mortgage area. On June 14th the Federal Reserve will hold public hearings on the adequacy of existing home mortgage regulations bringing much publicity to an area that is no where near done with its problems. Short of a federal bailout (very doubtful) or a massive increase in the money supply in a misguided way to create higher real estate prices it will be at least 3-5 years before we see home prices reach the levels of 2005-2006.

Borrowing drives interest rates

It may just be a statistical error but according to the h8 report released by the Fed today at 1:15pm showed that commercial and industrial loans fell by $13.4 billion in the last week. We will know more over the next two weeks but if this most watched Fed stat remains at this level or declines it could be the beginning of a drop in credit demand. Many of these current numbers are later revised to account for missing data so no need to jump to any conclusions.

Summary

It’s June and interest rates almost always rise this month and that is exactly what they have done for the past few weeks. Today the Japanese yen fell to 122 to the dollar keeping alive and well the “yen carry” trade which continues to fuel the runaway freight trains (stock markets) around the world with a special emphasis on the US market which has been closely correlated with the yen since the beginning of 2007. Until the yen rises to the 118 level or below the US stock should have clear tracks to travel and faster and faster speeds until its ultimate hard correction similar to its February 27th pit stop.