The Deflation monster will be visiting the US in 2008

Treasury rates fell this week but other short-term rates rose and this is causing a major problem in the credit markets. The Fed is faced with its biggest problem in over 80 years. My daily subscribers have the answers every night. Would you like this kind of up to the minute information delivered five nights a week (Sun-Thurs) at 10pm? The cost for this daily e-mail is only $251 and you will receive every update through 12/31/08. Just complete this form and fax or mail to my office.

Interest rates fell slightly this week with the 2-year and 10-year falling six basis points. A normal week for the bond market? Not even close as beneath the surface problems are growing rapidly and they are centered around the three month Libor rate which has risen for 13 consecutive days and closed today at 5.13%. One month ago (10/30) the Fed Funds rate was 4.75%, the 2-year at 3.81% and the 10-year at 4.38%. The Funds rate was reduced on 10/31 to 4.50% and surely will be lowered by the Fed at its next FOMC meeting (12/11) by at least 25 bp. In the last 30 days the 2-year has fallen 80bp and the 10-year 44bp but the most important rate for borrowers (Libor) has risen 22bp. Corporations and individuals don’t borrow at the Treasury rate as these rates are reserved for obligations issued by the US government. Everyone else borrows at rates that are tied to other indices with the vast majority ($150 trillion) linked to the Libor rate. When the Fed lowered the Funds rate on 10/31 it was done with the intention of lowering other lending rates including Libor. It does NOT control market rates so at best it can hope and pray other markets follow but if they don’t…….BIG trouble follows.

The Fed is aware of the problem but…

The actual level of interest rates doesn’t matter if lenders won’t or can’t lend and this is what the Fed has now begun to realize as we saw in three important speeches this week. Wednesday Fed Vice Chairman Kohn said, “Term interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rate-like libor-and the expected path of the federal funds rate…..The spread is one development we have factored into our easing actions.”

More importantly Mr. Kohn addresses the commercial finance market with: “The key question for the Fed is what is happening to credit for other uses, and how much restraint are financial market developments likely to exert on demands outside the housing sector?”

Mr. Kohn told us the Fed is aware of the Libor problems but added a significant new twist to the Fed’s dilemma….commercial finance. The economy can grow with a stagnant real estate sector but credit is the oxygen that allows business to grow and when a company can’t find financing for its everyday needs we are looking at a very serious economic setback.

Thursday afternoon Fed Chairman Bernanke told the world “The fresh wave of investor concern has contributed in recent weeks to a decline in equity values, a widening of risk spreads for many credit products (not only those related to housing) and increased short-term funding pressures.”
He added that “the Fed is following the evolution of financial conditions carefully, with particular attention to the question of how strains in financial markets might affect the broader economy.”

Mr. Bernanke confirms Kohn’s remarks and alerts us to current Fed thinking two weeks from the next Fed meeting. The only tool they have is the Fed Funds rate which now stands at 4.50%; they don’t control fiscal policy (taxes and spending) and they can’t loan money to banks without sufficient collateral. Unfortunately what worked for the past 80+ years doesn’t seem to working anymore as the interest rate markets are moving without the Fed.

Today the St. Louis Fed President gave a speech titled “Market Bailouts and the Fed Put” which addressed many of the issues this letter has brought to your attention over the past few months. The best quote of the speech and probably the month for the Fed was: “Whether further cuts in the Fed Funds rate target will alleviate financial turmoil, or risk adding to it, is always an appropriate topic for the FOMC to discuss.”
Please take a few minutes tonight to read Mr. Poole’s speech and you will have a much deeper understanding of the economic storm that is in front of the Fed.

I have written extensively that the Fed often uses the stock market as a barometer for the perceived health of the economy. Mr. Poole disagreed with my theory with the following quote: “It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.” I believe this is ideally what the Fed would like to accomplish but in reality the last 20 years have shown the opposite mainly due to former Greenspan’s tendency to ease before the economy’s decent reached high speeds.

These three speeches clearly show the Fed is faced with a most difficult decision. If they continue to lower the Funds rate and Libor does NOT follow, the market’s will panic upon realization that the most powerful central bank in the world has lost its ability to influence money markets. If the Fed keeps the Funds rate at its current level (4.50%) it risks a complete collapse in the lending market and we are already on our way…Heads they lose and tails they lose so the answer is the government must assist the efforts through loan guarantees to banks and creation of an entity that will purchase these commercial loans because the banks don’t have the room on their balance sheets to retain them. The Fed needs help as it lowers the Funds rate and without it the U.S. economy will suffer the worst economic contraction since 1932.

Upcoming news

Normally the Fed would be focused on economic indicators that are released weekly by various government agencies. Friday, December 7th at 5:30am we have the very unstable and often revised jobs report. The consensus is a 75,000 gain but it is a lagging indicator and tells us what happened in the past and should almost never be used as a leading indicator. We will hear from more Fed governors and presidents next week but Bernanke and his fellow FOMC members have set the tone and alerted the world that there is a serious problem and they may not be able to help. The stock market rallied this week on the fact that past Fed easings have led to economic turnarounds but I’m not sure the past is a good indication of what we will see in 2008.

Interest rates

Early Monday morning (11/26) the 10-year reached 3.80% which is only 10bp away from my long quoted target of 3.70%. The yen continues to lead the stock market and the bond market moves almost perfectly with every move from stocks. This relationship has been solid for many weeks and should not be dismissed until it actually breaks down. The Fed will continue to ease (it has no choice) and we will have a very nice relief rally in the real estate market after January 1st as many give up all hope and sell before the end of this year. The small uptick in property prices will convince many that a bottom has been reached and the worst is over for this cycle. 2008 will prove to be a ledge not a base for those buyers who of course only see the future from their own past experiences. For those that did not sell or liquidate their holdings in the past year it will be another opportunity to turn assets into cash which will be the big winner next year.

Conclusion

Conditions have worsened in credit markets as borrowers scurry around trying desperately to find a lender that has funds it is willing to lend. Credit contractions are DEFLATIONARY and 2008 will bring a drop in prices and asset values accompanied by a strengthening dollar. This is exactly the opposite of what we read in the press but you could also say the same thing about everything I wrote early this year….lower interest rates, slowing economy and the beginning of a long, slow painful bear market for real estate owners, borrowers and lenders.

99.9% of people would rather lose in company than win alone and hopefully my readers represent the 0.1% who are brave enough to follow my forecasts and avoid the carnage in the US economy next year.

Buddy, can you spare a loan?

It’s Thanksgiving Week and financial markets are anything but quiet as interest rates are falling and the Fed seems to be confused. My daily subscribers have been in front of the markets with my special nightly analysis. Would you like this kind of up to the minute information delivered every night (Mon-Thurs) at 10pm? The cost for this daily e-mail is only $251 and you will receive every update through 12/31/08. Just complete this form and fax or mail to my office.

Credit is the lifeblood of the US economy. The ability to borrow funds quickly and at a reasonable interest rate is often the difference between a profitable business venture and one that never gets off the ground. A company that sees its sales increase in the fourth quarter of every year needs funds to survive the other three quarters. When we think of debt we normally assume it is a mortgage that is securing a home and that is what has driven the first part of our economic crisis this year. But in 2008 we will enter a much more dangerous phase of this cycle, an actual credit contraction in commercial finance. The past four months have been difficult for the residential housing market as lenders have tightened underwriting guidelines and increased spreads over Treasury rates with the net effect being that borrowers have NOT been able to benefit from the drop in Treasury yields. This has been disturbing to homeowners as they find it nearly impossible to refinance their loans and this debt contraction is causing housing prices to decline in most areas of the country. Unfortunately this is only the beginning of the worst credit cycle we have seen since 1932 as the Fed is caught in a box where every move it contemplates will create more problems for borrowers and a realization that there is only one solution and the sooner the better. The US government must guarantee the banks that any properly underwritten commercial loan will not be allowed to default. Yes this is probably a bail out but I am not sure the economy is capable of sorting out this ever growing debt mess. This is NOT about sub-prime residential mortgages but a much more important part of the economy that deals with the every day needs of businesses: commercial finance.

Every day we see headlines about deals that are NOT mortgage related failing to close due to the credit contraction. This morning we see that Cerberus Capital can not find a home for $4 billion of loans tied to its purchase of Chrysler and this has nothing to do with mortgages. This debt will stay on the balance sheets of banks until a final resting place is found and that makes it more difficult for banks to lend on other more profitable and safer collateral. The virus is clearly spreading to other parts of the economy which is something the “experts” told us earlier this year would not occur and why the economy was not headed for a recession. I have studied the history of economies that date back a few hundred years and have never seen a recession that was predicted ahead of time, they always occur when the experts tell us the chances are slim. We have already entered a recession and the only question is the severity of the contraction and my guess is that we are looking at something we have not seen since 1932. Since we only see life through our own experiences it is not a surprise that the forecasters are comparing today to 1987 and 1998 as these are the only similar events they have experienced in their lifetime.

The twins are in trouble

Fannie Mae and Freddie Mac need help from their big uncle Sam as Freddie Mac announced today that it lost $2 billion ($3.29 per share) last quarter and marked down the value of its assets by $3.6 billion. Analysts had estimated a loss of only 22 cents a share and as a result these same analysts probably helped drive the stock lower by 28% in today’s trading. This is the same government sponsored agency that everyone in the mortgage business believes should be allowed to purchase more mortgages and guarantee loans. It is doubtful the US government would ever allow this agency to go under but its stockholders must be looking out the window today hoping Washington is going to come to the rescue soon. Fannie Mae’s stock declined 25% today as it suffers from the uncertainty that is increasing in the marketplace. Finally Countrywide’s stock fell 15% this morning as investors worry about their ability to down-size faster than their decreasing loan volume. The answer for Countrywide is probably a buy out from BofA? (They own options at $18 per share) but Fannie and Freddie are going to require a massive government injection of guarantees and probably capital.

Libor is more important than Treasury rates

Earlier this year (see the archives) I wrote that Treasury rates would decline but mortgage spreads would widen thus negating the positive impact of lowering borrowing rates. My long standing objective of 3.70% in the 10-year is within range but I’m not sure it’s really going to matter as lenders become more unwilling to lend at spreads tied to Treasury rates. This summer (before the market realized what the EWW saw over a year ago) the 3-month Libor rate was trading at 5.35%, the Fed Funds rate at 5.25% and three month T-bills at 4.85%. The Fed then lowered the Funds rate by 50 basis points in September and another 25 bp in October but the 3-month Libor rate has fallen only 35bp and trades today at 5.00%. $150 trillion of loans, mortgages, securities and derivatives are priced off Libor so the Fed’s recent moves have done little to lower borrowing costs to anyone other than banks that trade in the Fed Funds market. In the past two weeks the two-year has fallen 48bp, the 10-year had dropped 28bp but the “key” 3-month Libor has risen 14bp which means that for most borrowers interest rates have gone up instead of what the Fed hoped would happen. If the Fed continues to ease (which they must) will Libor follow? And if it doesn’t what does the Fed do next? (Panic).

Hold onto your job, it might be hard to find another

One of the keys to “expert” predictions comes from those who see continued increases in the number of people holding a job. The Labor Department announced that October jobs increased by 166,000 but most of that came from the birth/death model which seasonally adjusts each month’s numbers and has accounted for 70% of the job growth this year. A better measurement that is not seasonally adjusted is the monthly calculation from all 50 states and comparing that to the national figure as all data comes from the same monthly survey. Last month we found that these numbers showed a DECLINE of 41,000 in jobs not the gain the BLS created from its “seasonal adjustments” and that is more in line with what I believe is actually occurring in the overall country. We will soon see the unemployment rate jump over the 5% barrier and monthly job growth will turn negative. Job numbers are a coincident to lagging indicator of economic activity and should never be used to forecast the future as it is no different than driving and using your rear view mirror for directions.

The Fed

The US central bank and its leader Ben Bernanke are thoroughly confused about the direction of future monetary policy. In an attempt to create more transparency it has created an environment of confusion and lack of leadership as the economy begins its worst contraction since 1932. Earlier this year the Fed head told the world the economy was fine and the mortgage problem was limited to a very small part of the real estate market. In the spring the Fed told us it was more worried about inflation than a spreading of the mortgage mess. In the summer we learned that the Fed was focused on the wrong pieces of the puzzle and got caught by a meltdown in the value of mortgage securities so it lowered the discount rate (banks borrow directly from the Fed). In September we received a 50 bp decrease in the Funds rate with a statement that we’re now ahead of the problem. In October the Funds rate was reduced another 25 bp and the message was “that’s enough for now” and Fed policy is at neutral. Just last week a Fed governor told the world that there really was no need for any additional Fed easing unless something changed dramatically…and it has…..just look at the stock market which has become the official barometer of economic stress for the Fed and the world. The Fed could lower rates today to 3%, 2% 1% or even zero and I’m not sure it would make a difference in lending rates or increase the availability of loans for businesses, consumers or homeowners. Every time the Fed lowers the Funds rate and Libor doesn’t follow it loses another bullet in a gun that has lost most of its power over the past couple of years. We only see life as we experience it and every time over the past 30+ years the Fed has lowered rates the economy and lending have responded so how could we come to any other conclusion that it will happen again? This time is different and it is going to be more painful than you can imagine.

The stock market

We entered a very favorable seasonal trend today that ends with the close of trading on Friday. Early weakness and the bad news from housing weren’t enough to push the market lower and we ended the day in positive territory. I am a big fan of seasonal trends but pay close attention to the times they don’t work as that can cause violent moves in the other direction as it did when the late October/early November positive stock market seasonal failed for the first time in 13 years. This was followed by a sharp sell-off in the stock market and my daily subscribers were alerted before, during and after the fact. The Fed is using the stock market as a primary indicator of when to move on the Funds rate and its interest rate decision on December 11th (next FOMC meeting) will be heavily influenced by further declines in the stock market. The best predictor for the stock market remains the yen/dollar relationship and the yen saw the false rally in stocks in October and would have kept you away from November stock declines.

Conclusion

All year I have written about interest rates going lower (3.70% on the ten-year) and the economy getting much weaker and real estate prices beginning a long bear market. The good news is that I have been right on rates, real estate and the economy. The really bad news is that it’s going to get much worse after a “dead cat” bounce that will begin in January. This will be a false “all clear” signal for many speculators and investors who have learned from past experience that buying every dip in real estate was the way to create big profits and wealth. It “was” correct but now that road is closed and many are about to learn a painful lesson that history does repeat but not when needed for profits. We are nearing the end of the first phase of what history will see as the demolition of hundreds of billions of dollars of real estate and mortgage equity in the US economy. A true bear market is not something we have seen for over 80 years and it is long-lasting, painful and doesn’t end until the masses have left the scene of the massacre.

The good news for those still reading is that the government’s tool box is full with tax cuts, spending and loan guarantees available to be used as soon as Congress understands the severity of the situation. The inflationary implications of all or a few of these tools will only be an issue if the Fed fails to sterilize any excess monetary injections but I would urge all of my readers to go back and study the history of the Japanese economic slump that began in 1989. Early in 1990 “world experts” warned of the inflationary consequences of a massive (80%+) increase in the money supply but forgot that velocity (actual usage of the money) is just as important and without it there can be no inflation. Rising prices are not inflationary IF they are accompanied by a decrease in demand. Oil closed today at $98 a barrel and will soon be followed by an increase in the price of gasoline but the typical consumer will soon cut back on other non-discretionary items thus neutralizing the inflationary effect.

One more item: Every year many investors purchase stocks that have been down all year and are sold to take advantage of losses for tax purposes. For those that must buy a house (family, space, etc.) I would suggest that the best buys may occur for contracts signed by December 31st. Taxes are probably not a consideration but psychology is a major player as many homeowners who have been trying to sell will be more willing to “throw in the towel” and reduce the price so they don’t start a new year with an unsold house creating tension and more financial difficulties. I am NOT suggesting house purchases for anyone who is expecting appreciation in the next 3-5 years but if you must buy and are able to put down at least 20% then you might want to take advantage of opportunities in the next 45 days.

The next letter will be sent on Friday, November 30th and I wish everyone a safe, healthy and happy Thanksgiving. I will spend the day serving dinner to over 300 homeless and poor in Hollywood. Their worries are far away from the economy and centered on their next meal and where they will sleep every night. When you are homeless everyone has a key to your front door!

I will have some great investment ideas tonight in my daily e-mail which is sent Sunday through Thursday evenings at 10pm.

Another week of frantic activity

Another week of frantic activity in the financial and mortgage markets as treasury rates and stocks fell but lending spreads widened. My daily subscribers knew what to expect based upon my interpretation of events as they occurred. Would you like this kind of up to the minute information delivered every night (Mon-Thurs) between 10-11pm? The cost for this daily e-mail is only $251 and you will receive every update through 12/31/08. Just complete this form and fax or mail to my office.

My last interest rate class for this year (next class – February 2008) will take place on Wednesday, November 14th at 6pm.This two-hour class is an excellent addition to my newsletter. I will review the current interest rate environment and unveil my 2008 forecast. Each attendee will receive a 50-page book of charts and we have an unlimited question and answer session. This class is excellent for real estate owners, agents, mortgage brokers and investors who need to know the future direction and levels of interest rates. Advance registration is required.

The best place to begin is often where we left off in life so let’s start with the last week’s conclusion: The green flag (lower rates) continues to fly as confusion reigns in financial markets around the world. The credit bubble is deflating and deflation is good for only one market (interest rates). We are on our way to at least 3.70% in the 10-year but it will be an ugly scene as credit contracts and the Fed is powerless to help. Strap on your seat belt, the ending is nothing you have ever seen in your lifetime.

Uncertainty = Lower prices

This week we saw the beginning of a meltdown that will only end with strong intervention from the federal government. In the past few weeks the jumbo (non government guaranteed) mortgage market has seen liquidity shrink dramatically due to tighter underwriting guidelines and much wider spreads to Treasury rates. The conforming market (417M and under) continues to operate smoothly due to the fact that Fannie Mae and Freddie Mac are there to purchase mortgages and that has kept spreads relatively tight to Treasuries. Up until now the commercial mortgage (asset backed) market has been able to weather the storm with slightly higher lending spreads. This week we saw a dramatic change as spreads widened and then disappeared as lenders who initially book the loans and then sell into mortgage pools lost complete confidence in their ability to distribute the loans. Buyers of these mortgages are afraid and because they don’t know their true value have retreated to the sidelines. Markets that don’t function are bad for everyone but especially when they involve commercial finance because the effect on the economy (jobs, consumer spending, etc.) is devastating. I have often written that uncertainty of any kind is much worse for a market than bad news that is certain. Lenders and borrowers can plan accordingly when all of the news is out but not knowing if things will worsen makes it difficult to price an appropriate interest rate for a loan.

The extreme uncertainty in the loan markets this week drove funds that would normally be invested in mortgages into the only safe haven……Treasuries and specifically the 2-year treasury note which fell 26 basis points to 3.42%. With Fed Funds at 4.50% and the next Fed meeting December 11th the market is clearly sending a message to the Fed that it has fallen further behind the curve with monetary policy and it will need to catch up with multiple Fed Funds cuts over the next few months. We have entered a new era for Fed policy and if conditions continue to deteriorate as they have this week the Fed will be forced to cut short-term rates in between meetings. What makes this so different is that we are not suffering from high interest rates but a lack of liquidity due to mispricing of risk that has not been resolved. Normally when you reduce the price of a good or service demand rises but when lenders are afraid to loan the rate really doesn’t matter. The other end of the uncertainty curve is the stock market which fell over 4% this week (S&P 500) and those that have made a great living buying every dip for the past 5 years are learning a painful lesson that history doesn’t always repeat.

Now that I have explained what is occurring I must take you to the next stop on this train of destruction and why we are headed for a crash landing that only the government can make better. In the past banks have originated the majority of loans and of course kept them on their books so if there was a problem they could help the borrower quickly and efficiently as they knew the situation closely as relationship meant more than it does today. In today’s world the originating bank probably has initiated the loan but then sold it either in a package of loans to Wall Street or to another bank that may also sell to another bank, etc. This enabled banks to earn fees and at the same time keep their capital high and their reserves (required by the Fed) low. It was a win for everyone as long as nothing went wrong in terms of value of collateral and monthly payments. As usual something did go wrong and in a BIG way and it began with the residential mortgages both from the borrower (delinquency) and lender (value of packaged securities) level. All year the “experts” have told us that the mortgage mess was contained to a small part of the economy and that with a weaker dollar our exports would more than make up the difference and keep the economy humming. That has proven to be incorrect as the word “contagion” is now front and center and about to send the economy into the worst tailspin since 1932.

The economy needs credit soon

Credit, and its availability, is the fuel that allows an economy to grow. The Fed creates the money that is used to spend, lend and invest through the money supply (M2) but it is sent to banks who then must lend it to corporations, etc. and this is called velocity. We saw a massive increase in the money supply in Japan in the late 80’s/early 90’s which created a fear of inflation that never arrived due to banks not lending the money sent to them by the BOJ (Bank of Japan). If lenders and borrowers are afraid to consummate a loan does it really matter if interest rates are 0.1% or 9.9%? Japan has proven to be a text book case of lower rates that did NOT bring about inflation or increased borrowing. This is called deflation and once started is very hard to end.

The Fed has told us this year that it is very worried about future inflation due to rising commodity prices (oil, grains, metals) and has been reluctant until recently to lower the Funds rate. Rising commodity prices have a poor history of converting to higher consumer prices. Rising prices don’t create immediate inflation if consumers pull back and purchase less of a commodity at higher prices. Isn’t that how economics is supposed to work? The Fed should be much more worried about deflation than inflation as the credit contraction is going to stop the economy quickly as the oxygen (credit) becomes more difficult to obtain for anyone but the US government.

The Fed is caught in a box and has a very short time period before action becomes a necessity. This fear of inflation will soon be banished as prices come down due to a lack of credit and demand from a consumer that has run out of places to borrow and real estate investors that are learning prices don’t rise every year. To those that can’t wait to buy the first dip I must warn that this “dead cat” bounce we will see next year is only a ledge that when broken leads to much lower levels. Unfortunately the Fed will soon learn that decreases in the Funds rate don’t increase the demand for money or the willingness of those that normally lend to borrowers. With today’s 3-month T-bill at 3.27% and the 3-month Libor rate at 4.88% the spread of 161 basis points clearly shows the market understands that lending to the US government has a much higher probability of repayment than lending between banks , corporations or hedge funds.

The Fed is confused

The next 12 months will have Ben Bernanke wondering why he ever signed up for this most difficult job. The words from an old Moody Blues song called “Ride my see-saw” come to mind when analyzing the impossible situation the Fed is faced with next year. “Ride, take a free ride, take my place, have a seat, it’s for free.” The world is about to learn that the Fed cannot fix every problem by lowering short-term interest rates and they really have no other weapons to use when being attacked by a credit contraction. The federal government MUST come in and offer hard guarantees to lenders similar to the SBA program now in place for small businesses. Yesterday Ben Bernanke told Senator Schumer that the government could guarantee residential mortgages of up to 1MM so that Fannie Mae and Freddie Mac would be able to purchase these securities and at spreads that would be narrower than seen in the last few weeks. We need to see the same guarantee for the commercial asset-backed market which would allow normally functioning again.

Next Week

The economic news is not as important as how the markets react to the credit contraction. Continued stock market declines accompanied by lower short-term rates will place pressure on the Fed to lower the Funds rate but the long end is the key as we watch the inflation component of the 10-year Treasury which stubbornly holds at 2.42%. When this does break we will see a fast decline in the overall 10 yr. rate now at 4.22%. Wednesday (11-14) we have retail sales and it should tell us the US consumer is pulling back as we enter the Christmas shopping season. Thursday (11-15) the CPI (retail inflation) will show a 0.2% rise in the core rate (ex food and energy) and an annual rate of 2.4%. We have yet to see the coming benefit from lower rental prices for homes that can’t be sold but are being leased by owners who are struggling to make monthly mortgage payments.

Conclusion

I continue to be very concerned with a credit contraction that seems to be picking up momentum and when realized by borrowers will create a panic in the financial markets. 3.70% continues as my target for the 10-year but if I am wrong it will be because rates go even lower than my projections. These rate declines will not be of much benefit to borrowers as lending spreads will widen except for those loans guaranteed by a Government Sponsored Entity (GSE). This is not a time to be a hero, stay liquid and on the sidelines as there will be much better profit opportunities next year. I look forward to seeing many of you at next week’s interest rate class.

Interest rates see the economic future and it’s not pretty

This past week saw the dollar, oil, gold and interest rates move in both directions as they reacted to rapidly changing economy and the Fed. My daily subscribers knew what to expect based upon my interpretations of events as they occurred. Would you like this kind of up to the minute information delivered every night (Mon-Thurs) between 10-11pm? The cost for this daily e-mail is only $251 and you will receive every update through 12/31/08. Just complete this form and fax or mail to my office.

My last interest rate class for this year (next class – February 2008) will take place on Wednesday, November 14th at 6pm.This two-hour class is an excellent addition to my newsletter. I will review the current interest rate environment and unveil my 2008 forecast. Each attendee will receive a 50-page book of charts and we have an unlimited question and answer session. This class is excellent for real estate owners, agents, mortgage brokers and investors who need to know the future direction and levels of interest rates. Advance registration is required.

A wild week for those that closely follow the economy, fed and interest rates. It was a roller coaster ride that had bumps, curves, big dips and a final resting place to catch your breath. The 10-year ended the week at its low for the year of 4.32% which was down 8 basis points from last Friday but included a move early Thursday morning to 4.50%. Volatility in any market is often a sign of confusion and it is clear that the leader of the pack (the Fed) has no idea what or when its next move will take place. Although many would determine that gold rising to $809 today is a message about future inflation fears I would counter that it is about the uncertainty facing world financial markets. When asked last month (at his NY Economic Club speech) the information he needed to make better monetary policy decisions, Bernanke answered with “I wish I knew what those damn things (mortgage securities) were worth.” When the Fed head is confused market players react by changing their positions frequently and hedging their bets through the purchase of gold. The beneficiary of these recent events has been the bond market as cash has entered the “safe haven” until the sky clears (2008) and that is one of the reasons I see continued Fed easing and an ultimate target on the 10-year of 3.70%.

Job growth?

This morning’s report showed a gain of 166,000 jobs but we must remember this is a guess on the part of the BLS (Labor stats) and that 103,000 of these gains were from the mythical birth/death model that has been the source of 69% of new jobs in the past 12 months. Both the stock and bond markets are beginning to realize the jobs numbers are not reliable and often revised many months later and are at best a lagging indicator of economic activity. The unemployment rate was unchanged at 4.7% which is a function of a smaller labor force not job growth. The Labor Department is now releasing a new report called Labor status flows with the jobs number and it showed that many workers are finding it difficult to become re-employed. Last month 465,000 additional workers were unemployed for the second consecutive month and this metric has grown 1,839,000 in the last twelve months. These numbers tell us of an impending rise in the unemployment rate over the 5.0% level. In the previous 12 months (October 2006 – October 2005) we saw only 666,000 workers unemployed for two consecutive months. These numbers are very important and sowing the seeds of my forecasted 2008 recession. The bad news is that the Fed could lower the Funds rate to zero and I am confident it would make no difference in the job and unemployment picture. This ship has left the dock and is not coming back for a few years.

The Fed

The news of a 25 basis point cut in the Fed Funds rate on Wednesday garnered most of the headlines but the accompanying statement caught my close attention. These two or three paragraphs that follow the announcement of any rate change at each FOMC meeting are watched by world traders for clues as to the direction of future interest rate decisions. This is another example of seeing the world only through our own experiences and after 19 years of Fed leadership by Alan Greenspan there is no other logical conclusion. BUT this is not the Greenspan Fed and each Fed chairman in the past 80 years has put his own signature on the Fed’s communication of its policies. When Greenspan took office in 1987 the world concluded that he would be just like his predecessor Paul Volcker. No sane person would have ever believed that Paul Volcker would have the same management style as G. William Miller, who was perhaps the worst chairman in Fed history (there have been a total of 14). The longest tenure of any chairman besides Greenspan was William McChesney Martin who served from 4-02-51 to 2-01-70 and his replacement Arthur Burns found it difficult for markets to accept his management style.

In this week’s FOMC statement the Fed noted recent increases in energy and commodity prices might put upward pressure on inflation. They also told us that the risks of inflation roughly balance the downside risks to growth of the economy. In the Greenspan era the markets would react knowing the Fed was on hold and maybe even tighten in the near future to combat future inflation. Wednesday the first reaction from the bond market was a hard sell off which sent the 10-year rate soaring 12 basis points within 12 hours. But this isn’t the Greenspan Fed and the markets quickly reversed on news the stock market was falling led by the problems at Citibank and other financial institutions. In less than two days the interest rate market changed its focus from Fed leadership to Fed reaction and it is never good for anyone when the Fed is making policy decisions using its rear view mirror. At its September 18th meeting the FOMC told the world that it was lowering the funds rate by 50bp to “help forestall some of the adverse effects on the broader economy from the disruptions in the financial markets.” A month later the Fed is changing from a 50 basis point ease to a hold? What happened? The answer is obviously “nothing” but the Fed is confused because the stock market is rising and oil and gold are soaring to all time high prices. If the stock market was falling and oil and gold were following would the Fed have used the same verbage? Probably not and that is a BIG problem, their credibility is being questioned by the markets and they will keep pressing on the Fed like a shark that smells blood knowing its prey is near.

On August 7th the Fed announced that the economy was “likely to continue the economic expansion at a moderate pace over the coming quarters.” Within a few days we had a major meltdown in the mortgage and financial markets due to the inability to price and trade mortgage securities. The Fed swung and missed as they lowered the discount rate just a few days later.

Due you remember what the FOMC said after its January 31, 2007 meeting? “The economy seems likely to expand at a moderate pace over coming quarters and there are signs of stabilization in the housing market.” The thread that connects these Fed meetings is that they have been consistently behind the curve this year and show no signs of catching up and getting ahead which is what the world needs and wants from the most powerful central bank in the world. The sad truth is that 30 years ago the Fed had access to information that the average investor could only dream of obtaining and today the world is much more connected and information flows freely in just minutes. The Fed’s team of researchers today is no better and probably a little less informed than many hedge funds and other investment professionals. Yet the public continues to believe that the Fed leads through its interest rate actions. Thursday’s newspapers and media told us about the Fed easing and the average person thought that ALL interest rates had fallen on Wednesday because of the Fed move and it was exactly the opposite. I’m sure if the Fed could influence long-term rates they would prefer they move in the same direction as short rates controlled by the Fed. One of Mr. Greenspan’s greatest frustrations was seeing the Fed raise the Funds rate from 1.00% to 4.50% and not being followed by a move upward in long rates. He tried and tried through speeches and Congressional testimony to blow the house of low long rates down but found that market forces were too big for the little Fed that couldn’t…

To forecast the future of interest rates one must fully understand and be comfortable with the past and although history does often repeat, it never does when we most expect it. The current Fed has no more idea of its next move than anyone else and once you incorporate this into your thinking it will be easier to see the world financial landscape unfold in the next 12-24 months.

Next Week

The main event will take place on Thursday (11/08) at 7am as Big Ben testifies before the Joint Economic Committee of Congress. Unfortunately the questions will be coming from politicians, many of whom are up for election next year, so we may not see any serious discussion of monetary policy but it will be heavy on the housing problems. There is very little the Fed can do to help homeowners as further reductions in the Funds rate may not be followed by a similar drop in the Libor rate which is tied to many mortgage rates. When the 10-year breaks the 4.00% level and begins to trade in the 3%+ range it will from the realization that the economy has not been shielded from the mortgage mess and is spreading to Europe and beyond. The Fed’s only weapon is the Funds rate and that used to be a very powerful sword but we will soon learn it has been reduced to nothing more than a toothpick.

Mr. Bernanke will also speak to a micro finance conference on Tuesday at 10:40am but it is doubtful he will touch on any sensitive subjects due to his Congressional testimony on Thursday.

Stock Market

I rarely write about the US stock market as this is NOT an investment letter. I do watch seasonal trends closely and believe they are extremely important when they fail to repeat their normal patterns. One of the most powerful trends over the past 12 years has come from the S&P 500 index in the last three trading days of October and the first three trading days of November which has resulted in an average return of 3.3% in just six days with a 100% track record (no losing trades). I am writing about this today because with one day remaining in this six day period the S&P 500 is down 1.7%. Monday’s (11/05) performance may erase this deficit but if it does not occur I would be very careful for the next few weeks as a failed seasonal is a powerful message that the market is not working as usual and might be setting up for a trend in the opposite direction. Anyone who has used their negative economic forecast to trade the stock market has been run over multiple times this year and is probably hiding in a cave with other bears but one day the stock market will realize that this round of Fed easing will NOT help the economy rebound as it has every time over the past 25 years. Be careful of what you wish for as the results may not be what you are expecting…

Conclusion

The green flag (lower rates) continues to fly as confusion reigns in financial markets around the world. The credit bubble is deflating and deflation is good for only one market (interest rates). We are on our way to at least 3.70% in the 10-year but it will be an ugly scene as credit contracts and the Fed is powerless to help. Strap on your seat belt, the ending is nothing you have ever seen in your lifetime.