2007 – The year in review

This will be the last issue for 2007 and we will return on Monday January 7th with our 2008 forecast letter. Daily subscribers will continue to receive an e-mail each night at 10pm. If you wish to subscribe to this service please complete this form and e-mail or fax to my office. Best wishes for a happy and healthy new year!

January

January 2007 began with my three surprises for the year and one was a complete strike out, the other was a double and third was a home run. I began the year by holding on to an old prediction from the year before and sugar was anything but sweet as it began the year around 11cents per pound and ended the year at approximately the same level. Most of the year was spent below the 10 cent level and I learned my lesson that I shouldn’t predict the price level of a commodity that is given away free at every restaurant and coffee shop.

My next surprise was much closer when I wrote that the stock market would have a major decline in the first half of the year. I correctly said that when the hedge funds liquidated their short yen positions it would result in a sharp stock market correction. The yen strengthened in late February/early March from 122 to the dollar to the 115 level and US stocks quickly fell over 10%.

The best surprise was the most devastating to many market players as I wrote in early January “the housing market will NOT bottom in 2007 but long-term interest rates will decline to new lows (below the 2006 low of 4.34%). The US 10-year Treasury rate peaked at 5.26% on June 12th and reached its low of 3.84% on November 26th. In the January 12th letter I wrote “much lower long-term rates and a move to under 4% in the 10-year later in 2007.

February

The second month of the year brought expectations from the Fed and other experts that the housing problem was isolated to the “sub-prime” area and would not spread to the general economy. This was more hope than reality as it became obvious that house prices had peaked and mortgage securities were not worth what many “needed” for borrowing purposes. I warned in my 2-09 letter that due to poor seasonals, interest rates were not ready to make their way to significantly lower levels.

March

The 3-02 letter found this nugget, “I continue to believe that we are at the beginning of a long “bear” market in house values and that there will not be a crash but a slow torture that will force many to leave a business that appeared to be full of gold for everyone.” The realization phase began to hit in the spring and by the end of the year we saw many lenders drop out of real estate mortgage market.

April

For those looking to buy a house I offered the suggestion that they seek a rental with an option to buy. I also warned that “long-term interest rates should have a very tough April before seeing my long awaited decline to new lows in the 2nd half of 2007.”

May

We saw a sharp move higher in long rates as fears of a strong economy drove many players to sell bonds and buy stocks. I warned “we are coming to the end of a strong seasonal up pattern for long-term rates and the 2nd half of the year should see much lower rates” The fact that the real rate of return was the main ingredient in the rate increase and NOT the inflation component made me comfortable with my very “lonely” forecast of lower rates.

June

The June 15th EWW may be the highlight quote of the year: “I expect the next FOMC statement (6-28) 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. With a few more moves to the 5.25-30% level on the 10-year and an increase in the short/hedged positions by mortgage lenders we should have enough seeds in the
ground to see a much better landscape appear for rates in the late summer/early fall.” The 10-year hit 5.34% for one hour in mid-June and then it was straight down for the remainder of the year. I couldn’t have been more clear and hope that my readers were able to take advantage of lower rates.

July

The summer brought the beginning of our long awaited decline in rates but the press was filled with reports of job growth but again I warned that job numbers are coincident not leading indicators. I spent a good deal of space writing about the increase in credit card debt as the US consumer found the housing ATM shut and was forced to borrow at much higher rates using credit cards not houses for collateral. On July 27th I wrote that the 10-year was trading at 4.78% but was headed to a first stop of 4.50% and it did a few weeks later.

August

The 8-03 issue begged the Fed to begin lowering the overnight Fed Funds rate with a warning that Fed easing wouldn’t have any effect on mortgage rates. I highly suggest readers review this issue and it is listed in the archives as are all of the 2007 issues. This same issue saw the problems ahead in the mortgage markets and the widening spread between conforming and jumbo loans. This was many weeks before anyone read or heard about the impending liquidity issues in the money market. August 17th brought this quote: “We only see life from our own experiences and for 99.99% of Americans they are about to witness something they have never seen in their lifetimes.” I urged readers to think outside the normal box and not to be afraid to win alone because the vast majority will be losing in company.

September

In the 9-21 issue I boldly began with “How often do we get a 2nd chance to back up the truck?” and urged readers to load up on bonds (10-year at 4.61%) to take advantage of the impending drop in long-term rates. Over the next two months the 10-year rate fell 77 basis points to 3.84%. The profits from this trade would be enough to move any portfolio manger to the top of the list and be followed by a big year-end bonus. The 9-28 issue focused on the problems with the Libor rate which was not following the Fed Funds market lower. This was weeks before it was mentioned in the press.

October

The 10-19 issue forecast a move to the 3.70% level on the 10-year before the end of the year. (We bottomed at 3.84% on November 26th.) The 10-26 report mentioned gold’s rise was more about a hedge against uncertainty than future inflation.

November

The real estate and mortgage problems became common knowledge so I began to write about the growing credit contraction. The Fed can inject an unlimited amount of $$$ into money markets but can’t force banks to lend and this is a growing problem in many part of the country. The Fed has to be very careful that its focus on inflation doesn’t shield it from seeing the inability of corporate borrowers to access badly needed funds for working capital.

December

On December 7th I declared that the first leg of the interest rate bull market had ended with the low of 3.84% reached on November 26thand raised the yellow caution flag. I made it clear that rates will rise over the next few weeks/months as we enter a seasonal period of stronger credit demand in the first half of 2008. The 10-year closed today at 4.21% in a shortened session before the holiday.

Summary

It has been an amazing year for EWW prediction and one in which I hope to match next year. My 2008 forecast issue will have a few surprises when published on Monday, January 7th.
This weekly newsletter tries hard to catch the long-term major trends in the economy, interest rates and real estate markets. For those that have a shorter time horizon I urge you to subscribe to my nightly e-mail which is sent by e-mail every Sunday thru Thursday nights at 10pm.

Best wishes for a happy and healthy new year and holiday season.

Interest rates and roller coasters

This was a “wild” week in the interest rate market and the only way to prepare for the festivities would have been to spend a few days on the rides at Magic Mountain Park. Three very significant events occurred and the market’s reaction was unpredictable in each case, but gives us clues that shape our expectations for the next few weeks.

FOMC meeting

Tuesday’s Fed meeting resulted in an unchanged Fed Funds rate of 5.25%, but the accompanying statement told us more about the current focus of Chairman Bernanke. With the addition of the word “substantial” to the phrase “cooling of the housing market” the Fed acknowledged the recent softening in house prices and sales. The phrase “recent indicators have been mixed” sends a message that the Fed is on track with its forecast of a slowing growth rate (GDP) for the economy in 2007. The bond market’s reaction to the press release was a brief rally that drove long (10 yr.) rates back to the 4.50%+ level that is the key dividing line between an easing Fed and one that is on hold for the next few months. Tuesday was clearly the best day of the week for those betting on lower rates.

Retail Sales

Wednesday morning saw a dramatic turn in how one “feels” the interest rate market as the report that retail sales rose a very surprising 1.0% (+0.2% expected) sent those long the market looking for a quick exit at any price and drove rates higher throughout the day. The important point that came from this action was that the market’s focus changed from inflation watching to a fear that economic growth was the new elephant in the room. When a market receives bad news pay close attention to the reaction, and in this case, it was all negative and clearly showed that too many had hopped aboard the lower rate/Fed easing train and were caught long. Retail sales are frequently revised at a later date (see jobs numbers) and we may learn in early 2007 that the consumer is not nearly as strong as these numbers indicate.

CPI

I have written many times that when you are yellin’ you should be sellin’ and when you are crying you should be buying and today’s interest rate action was a perfect example of this behavior. 5:30 this morning brought “excellent” inflation news that the CPI (retail inflation) and core CPI (ex food or energy) was unchanged for last month at 0.0% (no inflation) versus expectations of a 0.2% increase for both regular and core CPI. Two tenths of a percent may not seem much to you and I but to the bond market it can be the difference between a move up or down of at least 10 basis points. Obviously this morning’s good news brought an immediate rally in US Treasury prices and a drop in the 10-year down to that “magic” 4.50% level but then something occurred that needs our attention. The market did NOT stay at the 4.50% level as would have been expected, but instead spent the remainder of the day rising and ended the day at 4.59%. Whenever a market receives better than expected news and does NOT react as it should by rallying it is sending a very loud message that something is wrong on a short term basis (days or weeks not months). One has to wonder what would have been the markets reaction had the CPI risen 0.2% as expected and the answer isn’t very pleasant. Sure the stock market rose to another new high for 2006 but is extended on a sentiment basis to near record levels and might find that 2007 brings a nasty pullback once we enter January.

Bottom Line

My long term forecast of much lower long-term rates has NOT changed as the fall out from the housing bubble has just begun and will surely permeate into many other parts of the US economy in 2007-08. Many of my readers are in the real estate industry and need help with the timing of “locks” for their mortgage clients and today’s reaction to the CPI news tells me that rates have further to go on the upside for the next few weeks before we begin another leg down. The yellow flag remains in front of the green flag as the roller coaster ride of the past few days will continue until the market’s reaction to good news is a lowering of rates which is not what we saw today.

Next week

Two Fed Presidents (Fisher & Lacker) will speak next week and Housing starts on Tuesday and GDP on Thursday may give us quick reactions in what should be thin market conditions as traders close down for the year. On Friday I will review my 2006 good and bad calls and look into my crystal ball for 2007 forecasts. As always I welcome any comments or questions. Happy Holidays to everyone!

The Fed is fighting two wars but only one is real

The next issue of the EWW will be posted on Monday, December 24th followed by our 2008 forecast issue on Monday, January 7th. Daily subscribers will continue to receive their e-mail each night at 10pm.

Tuesday (12/11) the Fed lowered the funds rate by 25 basis points to 4.25% and stunned world financial markets with no apparent answer to current money market liquidity problems. My nightly subscribers received the following just hours after the Fed announcement: “I am going to step way out tonight and state the consensus is wrong (again) and the Fed has not shown all of its cards and is surely going to act in a way that will surprise the markets. It’s too obvious to come to the conclusion that the Fed is unaware of the problems in the money markets led by the 3 mo Libor hanging at 5.14%. If I am correct we will look back upon today with the description of a fake out day.” On Wednesday morning at 6am the Fed announced a new $40 billion auction facility for banks to be able to obtain funds beginning Monday, December 17th. The stock market rose 200+ points within minutes before falling again and long-term interest rates rose quickly.

In the same Tuesday night e-mail I said: “I continue to believe we have seen the lows for the year in long-term rates and have entered a badly needed “pause to refresh” period before beginning the next leg down in rates next year.” The 10-year closed at 3.97% on Tuesday and then rose 27 basis points to the 4.24% level it traded today.

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This was a wild week for financial markets that saw rates rise, fall and then climb to levels not seen in over 4 weeks. But the past five months have brought back levels of volatility I haven’t witnessed since 1980. (I have been watching interest rate markets for over 40 years.) The week began with the 10-year Treasury note rising to 4.16% as uncertainty over Fed actions on Tuesday dominated trading decisions. Tuesday’s announcement of “only” a 25 basis point decrease in both the Fed Funds and Discount rate sent money into Treasuries and out of stocks. The stock/bond relationship has been strong the last few months as long rates have plummeted lower in a flight to quality rally driven by a liquidation of the yen carry trade and US stocks. As noted above something didn’t feel right after the Fed announcement and much like a doctor who sees hundreds of patients each month one develops a feel for the normal rhythm of markets after many years of daily observations. Tuesday afternoon players were clearly confused and upset with the Fed for apparently paying no attention to the rising Libor rate and its consequences for tightened liquidity in the lending market.

Wednesday begins with a bang!

The Fed let the other shoe drop on Wednesday with its announcement of an auction facility where banks will pledge collateral and pay very close to Fed Funds (4.25%) rates for borrowing up to 4 weeks. The ability to borrow outside of the Libor market will allow rates on money market instruments to narrow their spread over Treasuries. The NY Fed announced this week they would allow current holdings of T-bills to mature and not reinvest the proceeds thus freeing up money to be used in this new program. The Fed is NOT creating new money for this new project but rather rearranging its assets from Treasury holdings to lesser quality collateral. Although initially projected to be $40 billion it could easily be increased and maturities extended if the response from banks is positive. The markets initial reaction was so negative that positive results from the first auction on Monday (12/17) could easily be met with short covering (stock market). Long rates rose 12 basis points on Wednesday as fears of inflation from a perceived increase in Fed money would surely cause consumer prices to rise.

Thursday shows the US consumer is alive????

Yesterday at 5:30am the bond market was hit by two body blows that appeared to show retail sales growing by an astounding 1.2% in November and PPI (wholesale inflation) increasing at a 3.4% rate for last month. If the interest rate market was focused on these “old” economic numbers and believed these numbers would not be revised we would have seen a 50 basis point increase in the 10-year instead of 11bp that occurred. Over 50% of the increase in retail sales came from gasoline sales and a faulty seasonal adjustment that will have next month’s number showing a reversal. My quote of the week comes from CFO.com report: “In the last four or five months we have seen an absolute onslaught of people trying do hardship withdrawals and loans out of 401 (k)s.” Gasoline sales at record high prices are being funded from borrowings and credit cards and won’t last many more months. A surge in bankruptcy filings is a sure bet for 2008 and is a good place to seek employment for the tens of thousands that will leave the mortgage and real estate business next year.

Friday breaks the link

2007 has seen a solid link between the Japanese stock market, US stock market and recently US long-term interest rates. The yen fell most of the year (until August) and that enabled a yen carry trade where hedge funds could borrow in Japan at less than 1% and invest the proceeds in rising asset markets like the US stock market. Long-term interest rates began a sharp decline in July (as predicted early this year by the EWW) and became a safe haven for those that liquidated their stock and short yen holdings. Each day one could watch the stock market and almost predict with certainty the direction of US long-term interest rates. Today for the first time we saw stocks fall and interest rates rise and this could represent the beginning of a new trend where the world begins to understand the US recession is not an isolated incident and could very well spread to our major trading partners around the world. Up until now, the consensus has been the US economy was suffering from an isolated case of “sub-prime” problems but it is obvious that a huge mortgage mess is affecting the entire credit market and causing a major contraction of available credit at any price. The Fed’s number #1 objective must be to slow the descent of the fall and find a way to incentivize the banks to lend money. A year from now the residential market will not be the topic of discussion but rather the commercial finance market will take center stage as businesses desperately search for banks that have room on their balance sheet to lend.

Summary

Last Friday (12/7) I raised the yellow flag (caution) in front of the green flag to signify that long-term rates had bottomed for the year. The news continues to be bleak but one must understand the relationship between markets that discount the future and the reality of today. This is a most difficult point to understand and it takes years of observations before your “gut feel” becomes an accurate guide to the future. We only see life as we experience it is my creed when analyzing markets and 99.9% of the population has never experienced what we are about to see in the next few years. Every day I hear “I remember in 1980, 1987, 1998 so I am ready for what is next” but history has shown the biggest losses are borne by those unaware that history doesn’t always repeat when expected. The first part of 2008 will bring a relief rally for most financial assets and the dollar will be the star performer as foreign institutions realize they must invest in the US, it’s most important buyer of its goods and services. Leg two of this most vicious bear market will not begin for many months but it will leave those not in cash struggling for financial survival. Those that are not afraid to win alone instead of losing in company will reap the rewards of a very volatile new year.

The tug of war continues between the Fed and the bond market

The Fed & Ben Bernanke breathed a sigh of relief this morning when the Labor Department announced that 132,000 new jobs were created in November. The 10-year US Treasury note held just under the key 4.50% level for a couple of hours but it was all sellers soon thereafter as the experts again flipped their forecasts back to an unchanged Fed for 2007. The recent pronouncements by these economists remind me of the roller coaster ride at Magic Mountain, up and down and all around. The employment situation has not changed much in the last few months other than the sad fact that the Bureau of Labor Statistics (BLS) continues to have a problem counting each month and is badly in need of an abacus after again revising the last two months numbers up 42,000 (September +55M, October – 13M). One important point from today’s report was that we saw a drop in both residential and non-residential (commercial) construction and I expect that to continue throughout 2007.

As written last week, the Fed does NOT want to lower the Fed Funds rate from its current lofty level of 5.25% until it is forced by the market (long rates below 4.50%) or weak economic conditions such as a rising unemployment rate or a sharp stock market decline. Mr. Bernanke is fearful that any Fed easing (next FOMC meeting 12/12) would bring an increase in speculation and loan demand. With the 10 year at today’s closing rate of 4.55% the Fed has a little more room than last week to hold the line on monetary easing. This will not prevent long rates from declining to much lower levels in 2007 (10-year at 4% or lower) and that will certainly force the Fed to lower the funds rate to sub 5% levels.

On another sad note, it is not only the BLS that has counting problems but even the mighty Federal Reserve. Credibility is important to markets and when data is adjusted month after month it sends a message that the initial reports can NOT be trusted. Thursday the Fed announced that borrowing by US households declined by the greatest amount since 1992 which is the exact same headline we saw last month. How could this occur two months in a row? It didn’t, last months consumer debt was REVISED from a decline of $1.2 billion to an increase of $3.99 billion. The bond market is becoming very frustrated with the lack of accuracy in the government agencies that compile and then release monthly data. The last three jobs reports have seen an increase of 9, 12 and today 7 basis points in the 10-year and much of this sell-off is because of the credibility problem that is growing from the massive monthly revisions in these statistics. The next jobs report is Friday January 6th and I expect interest rates to rise in the days before this release simply because of the “fear” that if it has occurred three months in a row it could easily happen a fourth time.

Inflation and rents

One of the major components of the CPI comes from rental rates (apartment and houses) and with the high cost of homes over the past year we have seen an increase in rents. This may be changing soon as a story in today’s San Antonio Express News points to an increase in the supply of rental homes. Last year I wrote about the coming glut in condos and the fact that many buyers would be forced to rent their recent purchases rather than sell and take a big loss. In San Antonio, the average house rental has dropped from $1301 to $1099 a month in the past year due to an increase in the supply of homes looking for a tenant. According to the article 10,650 homes have been placed on the rental market this year, an increase of 22%. This is a trend that will soon spread across many other areas of the US.

One of the stories I always hear from those that are always bullish on real estate is that as long as the population continues to grow there will always be a shortage of housing. Yesterday’s Arkansas Times points to Northwest Arkansas population growth of 1,100 a month but in what is sure to be a record – there is now 112.9 months of inventory (over 9 years) in Benton County. Somehow the thought “if I build it, they will come” seems to have been the mantra of every builder in Arkansas and surely there is going to be a lot of pain felt soon in this state.

The dollar

The last few weeks we have seen the dollar plummet against the Euro from 1.28 to 1.33 and the financial press is again running with the story that confidence in the US is declining and foreign countries are liquidating US bonds. This sounds good but reality tells us a different story according to a release this morning by the Federal Reserve Bank of New York (somehow this stat is rarely revised). In the week ended Wednesday December 6th holdings of US government securities (bonds) in custody for foreign official and international accounts rose $16.8 billion. Even if we adjust for redemptions of treasury bills and bids in the recently completed 2 & 5 year note auctions, the results show that foreign central banks were BUYERS of our government debt in a week the dollar fell sharply against major currencies. This leads me to the conclusion that the dollar selling was initiated by hedge funds and that the recent dollar decline could easily be reversed if these fast-paced funds decide to take profits at the same time. Despite what we read every day that foreign central banks are diversifying out of the dollar the actual reports show that they are not acting in the same way in which they are talking. It will be interesting to see what happens next week when Treasury Secretary Paulson and Fed Chairman Bernanke visit with Chinese monetary authorities.

Housing – the beat goes on……

Despite the best efforts of regulators, the residential mortgage market continues on with many of the same loans being advertised that will soon trigger the worst part of the housing bear market in 2007. An article from today’s San Francisco Chronicle discusses a mailing that was sent to many Northern California homeowners from a Southern California mortgage company. The most interesting part of the article comes from an interview with the head of the company that sent the mailing which was promoting negative amortization loans. The owner of the company admits that it probably was NOT a very good decision to send the mailer but I doubt he will turn down the leads that were created by the mailer. The good news is that the article has quotes from others that clearly state a “neg-am” loan is not for the average home owner.

Earlier this week the Federal Reserve reported that the average homeowner had only 53.6% equity in his/her house down from 54.6% a year ago. With home prices dropping for the next 3-5 years and so many having to refi out of neg-am loans I look for this percentage to drop below 50% by 2008. America is the country where everyone strives to own a home, but if the goal is achieved it will be with much less equity than anytime in the last 30 years (1983 = 70%, 1993 = 60%, 2003 = 58%).

Next week

It will be a busy week for interest rate watchers with the key event on Tuesday (12-12) as the FOMC statement at 11:15am may offer a few clues to future changes in Fed policy. No change in the Fed Funds rate is expected but a change to a neutral stance with an emphasis on current economic conditions would put the market at ease and focus attention on a weakening consumer (housing) and lower inflation. Wednesday (12-13) retail sales should show a slow down in store sales and Friday (12-15) CPI will give us an unchanged inflation rate of 2.4%.

Has anything changed?

One day’s rise in the US 10-year brought many e-mails to my desk with a worry about higher rates around the corner. I continue to believe that we will see much lower long-term rates in 2007 but with sentiment figures at an extreme (I mentioned last week we needed a pullback) it would not be surprising or alarming if the 10-year went back into its recent September-November trading range of 4.55-4.75%. The next Fed move is to lower rates and the 10-year will move back below the key 4.50% level which will push the Fed (accompanied by weak economic stats) towards easing in early 2007.

The seasons are changing and so are rates

The US 10-year note rate on Monday was 3.85% and today closed at 4.11% a 27 basis point rise in five days. My daily subscribers were prepared for higher rates from Tuesday evening (12/04) when I wrote: “We saw bond sellers waiting for buyers on the two minute rally after the news that Fannie Mae had cut their dividend by 30%.” On Wednesday evening I wrote: “From a short-term point of view I am becoming very cautious about the bond market.” On Thursday evening I wrote: “Tomorrow could be a bloody day for bonds…” and today rates rose 10 basis points. Would you like these insights 5 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.

The yellow flag is flying again for the first time since August 3rd when the US 10-year note was trading at 4.68%. We have reached the end of a strong second half seasonal down trend in rates. At today’s rate of 4.11% that represents a profit of 57 basis points for those able to take advantage of this fall in long-term interest rates. The green flag remains in 2nd position behind the yellow flag as my long-term view of much lower rates has not changed. I expect to see a seasonal up-tick in rates as we enter 2008 and then another leg down later in the year. The low of 3.84% that we reached on November 26th and then again this past Monday should hold well into the New Year.

True bear markets are painful and long drawn out events that can take years to end. The US economy has entered a very serious period of credit contraction but for the next few months we will see a “relief rally” in many asset classes as the markets simply went too far, too fast and now must rest and build ammunition for the next attack on lower rate levels. When the bottom is finally reached many businesses will have gone under and a record number of bankruptcies will offer the only alternative for individuals that were blind-sided by the credit storm. While many will hope that next year’s rally signals the end of the mortgage and real estate problems it will only serve as an opportunity for those that didn’t sell last year to have a second chance. The big winner in 2008 will be cash as leveraged asset plays will find interest costs exceed any possible appreciation.

Jobs are increasing?

This morning’s labor report showed November payrolls increasing by 94,000 but as usual the government’s seasonal adjustment numbers destroy all credibility. 51,000 of today’s total came from a government guess as to what is normal for November growth in jobs. Over the past 12 months there has been an increase of 1,216,000 in private payrolls but 1,128,000 have come from the birth/death model (93%) the government uses as its estimate of what should occur but usually does not. The BLS should announce figures annually and not even try to announce a number that is almost always incorrect and frequently changed within weeks of its original announcement. September’s increase of 93,000 was lowered this morning to 44,000 and I’m sure today’s report will be “adjusted” many times in the next few months. November’s diffusion index (the % of industries showing job growth) fell to 49.8% down from 53% last month and the lowest in over 4 years. The unemployment rate was unchanged at 4.7% but will rise above 5% in early 2008.

Consumer borrowing increases again

The Fed reported its monthly consumer credit report today and revolving debt (credit card) rose by $6.3 billion following a $4.6 billion increase last month. In the last 12 months, credit card debt has grown 7.5% which represents the fastest rate since August 2001 (recession).

A Fed report that is MUST reading

Each day I read 27 newspapers, watch CNBC, Bloomberg and now the Fox Business Channel and then review at least 50 blogs. One of my top 5 reports each week comes from the Fed and is almost never written about by any media member. The H.8 report is posted on the Fed’s website each Friday at 1:15pm.

This report shows the weekly change in assets and liabilities of commercial banks in the US. I closely watch commercial and industrial loans, real estate loans and consumer loans. For most readers page 1 will give you the most important info about banks willingness to lend to borrowers that are willing to complete a transaction at today’s higher than normal lending rates.

This report also measures the levels of bank holdings in Treasury securities as banks frequently purchase these bonds and notes with excess capital that is not needed for lending. Pay close attention to lines 3 & 4 on page 1 and you will see a most disturbing development in regards to bank balance sheets. In the last three months, US banks have liquidated over $71 billion of their “safe” Treasury securities and purchased over $210 billion of “other securities”. These other securities can be mortgages, asset backed pools, securitized loans, etc. and these purchases have NOT been voluntary. Banks have been forced to repurchase securities that they may have originated or guaranteed for a fee and now don’t have the capital to make new loans to businesses that need working capital. The Fed is very concerned as they see credit contraction picking up steam and know that the result is always DEFLATION.

December 11th Fed meeting

Tuesday’s FOMC meeting is being watched closely by world financial markets as this week we saw a drop in the overnight borrowing rate by the central banks of Canada and England. The Fed will certainly reduce the Fed Funds rate by 25 basis points to 4.25% but that may not have the normal effect on money markets as the 3-month Libor rate traded at 5.14% and there are many more transactions where the borrowing rate is tied to Libor than the Funds rate. The Fed is stuck and its normal tool to fix the economy is not working and probably wouldn’t work even if the Funds rate were lowered to 1.00%. The Fed must find a way to make banks lend $$$ and take away the fear of credit quality or increase the profit on each loan which will give banks an incentive to lend. It’s time for Fed Chairman Bernanke to reduce reserve requirements for banks which will free up capital that can be lent to the business sector. Every bank is required by the Fed to set aside a set amount of capital for every loan that is made and the exact level of reserves is set by the Fed. The Fed has encouraged banks to borrow directly from the Fed by using collateral that is “stuck” on banks balance sheets but this has not occurred due to bank fears that public knowledge of these borrowings will create anxiety on Wall Street. It’s time for the Fed to step up and acknowledge the “frozen” state of the lending market and then take bold action or risk the most severe economic setback since the early 1930’s.

The housing market continues to slide

Many buyers are sitting on the sidelines waiting for the best time to buy and we will see a bounce early next year but without the ability to acquire a mortgage (lenders continue to close up daily) it is almost impossible for the market to hit bottom. Yesterday Fannie Mae announced that they were implementing a new upfront charge of .25% that will apply to mortgages purchased or originated after March 1, 2008. They will now finance 5% less than before in markets that are experiencing price declines and finally will not allow cash back on purchases. The effect of these three changes will increase the rates on conforming loans ($417,000) and that is not what the Fed or US government wants in an economy that has fallen into a recession.

For those that would like to purchase a house with no mortgage Countrywide is offering six houses on their website for $1 each. For the cost of a six-pack of beer you can be the proud owner of six homes in Detroit, Michigan. I have no idea how much money would need to be spent before the houses are livable but you can be assured of no price depreciation.

I have very few comments about the government plan for a freeze on sub-prime loans and many of the daily newspapers ran detailed question and answer sessions today. Treasury Secretary Paulson held an online Q&A this morning with readers to an “Ask the White House” website. I am sure we will be seeing many revisions to this plan in 2008 and many of them will not benefit borrowers or lenders.

Conclusion

The first leg of the BIG bull market in bonds and fall in rates ended this past Monday with the 10-year reaching 3.85%. After a few weeks/months rest, the bull will again roar as rates drop to levels not seen since 2003 and it will be accompanied by rising unemployment and much lower real estate prices. Enjoy the “relief rally” as it will shake out many of the late comers who have entered the market at the wrong time and must be forced out (with big losses) before the next leg can begin. The dollar will rally (a surprise to many), inflation will roll over and become deflation and cash will be the king for 2008. Opportunities will be many next year but only those in cash will be able to take advantage because leverage will be difficult to obtain for all except the highest of credits.