Don’t Lose Sight of the Big Picture

The next few months will bring a bounce to the US economy and stock market; it will NOT represent the end of the credit contraction and lower real estate values. The recently passed Washington stimulus plan will soon kick in with $100 billion+ in checks from the IRS to hit bank accounts and mailboxes across the US in a few weeks. Whether consumers pay down debt, use for savings or spend on new items the end result will be a temporary boost for the economy and GDP. Hurricane Katrina (2005) brought a much smaller spike in consumer spending to the South and I am expecting something similar in duration but greater in its affect on the US economy. Recent stock market activity shows a growing resilience to bad news and soon the market will rally as those betting on further declines will learn that being early can be very painful. Counter trend rallies are always difficult as they trap those hoping and wishing for a return to the good old days.

If the current rules cause too much pain……change the rules

Last Friday the Securities and Exchange Commission sent an interesting memo to certain public companies regarding regulations dealing with valuation of assets for financial statements. These companies are required by SFAS 157 to value their securities holdings to fair market value based on the availability of market prices. Level One assets are usually those that have daily or weekly closing prices on an exchange or something similar. Level Two assets are those where the value can be calculated by reviewing the prices of similar traded assets or formulas. Level Three assets require a “guesstimate” because a lack of liquidity can create a distortion in the price of transactions. With billions of dollars of write-downs in the past year required by company auditors these firms have seen their earnings plummet and stock prices have followed to new lows. Of course the old rules did not require companies to “mark to market” any drop in value and assume that each security would be held to maturity when full face value would be realized. With liquidity at a premium for everything except US Treasuries and the cost of raising capital increasing each week, the SEC is giving some companies the option to go back to the old rules. They are now allowing corporations to “use valuation models that allow significant unobservable inputs for some of your assets and liabilities.” The key words in that sentence are “significant unobservable” which can be translated to just about whatever you need if the loss is bigger than you want it to be. It is hard enough understanding a public company’s financials and trust is a HUGE factor in becoming a shareholder. Do you actually believe a company will announce its quarterly earnings with a note that its level three assets have been artificially boosted by millions or cents per share based on someone inside the company changing the value of a company asset? This could set a very dangerous precedent as once the opportunity is available to “certain” public companies the remainder will want to access the same loophole. Yes, the auditors are probably requiring their clients to take conservative marks with their portfolio but if left to the company itself aren’t we inviting a runaway freight train that eventually is certain to crash? Isn’t that what happened to Bear Stearns?

The Fed is focused on liquidity but the real problem is asset deflation

The past six months have seen the beginning of the worst credit contraction this country has seen in over 70 years. The ability to sell or borrow against an asset is an integral part of the US economy and is one of the reasons we have been able to grow rapidly with little inflation over the past 25 years. The Fed has used its main tool of overnight interest rates (Fed Funds) to lower the cost of credit to borrowers this year and hope eventually it will lead to an increase in loan availability. The longer term issue that it will soon be faced with comes from declining asset prices. Currently the consensus is that we are in a temporary pull back in real estate prices with this opinion coming from a hope that past experiences will be repeated in the next few years. Every dip in prices over the past 30 years has been a great buying opportunity for those brave enough to step up at the first sign of distress from sellers. Unfortunately the past is not about to repeat in the same way and after this upcoming bounce we will head lower and cause tremendous “fear” for those that have tried to catch the falling knife of lower prices. A credit contraction is defined by loans being extinguished faster than new ones are created thus giving cash the greatest return each year. Falling prices increase the value of debt (especially Treasuries) and put extreme pressure on those in debt who need values to rise and overcome high interest payments. Credit contractions are almost always accompanied by declining price levels and a rush to deleverage which is what we are seeing in the residential housing market.

The good news is that we have a Fed Chairman who has studied economic history with a focus on the deflationary periods many countries have witnessed over the past 400 years. On November 21, 2002 Mr. Bernanke gave a speech titled: Deflation: Making Sure it doesn’t happen here” and it is MUST reading for all of my readers. Please take the time to read this at least a few times and you will get a sense that the Fed head is as prepared as one can be for the oncoming storm. The medicine needed to survive isn’t easy and takes awhile to execute but you will feel much better after reading this historic speech. He understands that the level of long-term interest rates is one of the keys to stimulating consumer spending and reviews the many alternatives available to the Fed including placing a ceiling on long-term rates and/or the purchase of private (non-government securities). These remedies will only be used if we see negative GDP numbers and rising unemployment (next jobs number 4/04).

Lenders without capital

A credit contraction can only be ended by the creation of new loans. Capital is the key to any lender as it must have reserves for every loan it issues and lenders are very short on capital due to write-downs on real estate loans. This afternoon Lehman Brothers announced a 3 million share offering of convertible preferred stock and it appears that investor demand was very high. What I find interesting is that investors are lining up to purchase a security where the dividend rate, conversion rate and other terms are yet to be determined according to the press release. Would you be a buyer of a security without knowing any of the terms? Very strange and one has to wonder why Lehman rushed to make the announcement without any of the important details.

Bernanke speaks to Congress

Wednesday morning (4/02) the Fed head testifies before the Joint Economic Committee of Congress at 6:30am. He will be asked about Bear Stearns, the economy’s health, the mortgage mess and the future. He should take this opportunity to hit one out of the park (today was opening day for the MLB) and become a confident leader that we need from our Fed Chairman. No one knows economic history (I’m not close) like Ben Bernanke and the country and world need to hear his thoughts and most importantly preparations for what is certain to be the toughest time most of us have ever experienced. Change is difficult for everyone but losing in company rather than having the courage to win alone is not the answer to surviving in 2008-09.

The tug of war between moral hazard and laissez faire

We begin this week with the struggle between two formidable forces with impressive arguments. The past couple of weeks have seen unprecedented moves by the Federal Reserve to insure the safety of the US financial system. Fed Chairman Bernanke brokered a take over of Bear Stearns by JP Morgan at an original price of $2 per share (now $10 per share) and that event sent into motion a string of other Fed moves that could easily last until next year. Last week’s announcement by the Fed that it would begin to accept commercial mortgage backed securities and other private label mortgages (non-FNMA & Freddie Mac) as collateral for badly needed loans has created a lot of controversy in the financial markets. Moral Hazard has suddenly become the buzz word for anyone with any interest in their own finances or of the US. According to an online dictionary moral hazard is defined as: “the lack of any incentive to guard against a risk when you are protected against it (by the government)”. If you enter into an investment where the reward potential is high but the risk is minimal or none the amount invested will be much larger than if one has to prepare for the chance of a substantial loss. When the Fed accepts commercial mortgages as collateral for loans to primary dealers or banks at very favorable interest rates it is encouraging these borrowers to purchase more of these mortgages and then finance them which creates higher prices for underlying securities and lower rates. What is wrong with that? Isn’t the country better off with lower mortgage rates? Doesn’t everyone win? Maybe, but proponents of laissez faire believe that a market system functions best when a price is determined by demand from risk takers and sellers that need liquidity. Using the same dictionary we find a similar definition: “the theory or system of government that upholds the autonomous character of the economic order, believing that government should intervene as little as possible in the direction of economic affairs.” The question is: Can the Federal Reserve manage to support the US financial system from failing but at the same time not give the impression it will stand ready to bail out any institution that is near bankruptcy. Unfortunately we don’t have enough experience as a country to know exactly what to do in this situation but I believe Mr. Bernanke is following the lead of Japan which faced a somewhat similar situation in the early 1990’s. There was an interesting article in the March 20th LA Times where Eisuke Sakakibara (professor at Tokyo’s Waseda University) was interviewed concerning the response by the Japanese government. One of his quotes might be appropriate for today: “You have to overtake the speed of the markets, especially in a crisis when the speed really accelerates. In hindsight, we were always behind the curve.” For most of 2007 and early 2008 it was clear that the Fed was reacting to economic events and not anticipating the obvious reaction that was soon to come from financial markets. It is too early to know whether the Fed’s actions will be the correct medicine and more importantly if any more changes are needed but with my counter trend rally in stocks and the economy upon us the Fed has at least bought a bit of time to watch the health of its primary patient.

The yield curve

On January 8th I forecast a widening of the US Treasury yield curve where the spread between the 2-year and 10-year would increase from 108 basis points and I continue to believe we will see a much higher level. At today’s spread of 173bp we are only half way to a reasonable goal of 250bp.The Fed may be on hold for a few months but the end of Fed easing is far away as the recognition of a bounce in the US economy is far different than a permanent bottom that will lead to a new round of growth and increases in the prices of homes and buildings. This is a good investment for inflation worriers as rates on the long end will soar versus the short end if inflation goes from fantasy to fact. We have a much bigger chance of DEFLATION from a sagging economy than inflation by Fed money creation. This morning the Chicago Fed released its monthly economic index and solidifies the argument that we have already entered a recession.

Today I want to introduce a new player into my forecast arena and one which I believe has even more potential upside than the move higher in the US yield curve. The Fed has been the main world player that has eased monetary policy with lower short-term interest rates. The dollar has been pummeled in the last weeks as the spread between US and foreign interest rates has widened led by the strength in the yen, Euro and pound. The argument has been global decoupling and that these trading partners will not be affected by our mortgage and real estate meltdown. Much of the spread widening has occurred due to the US Libor rate dropping while the foreign central banks stand by and not intervening in their domestic money markets. This will change later this year when the ECB is forced to lower short-term rates and switch its fight against an imaginary inflation monster to an all out battle against the most severe recession seen on the continent in decades. Lower short-term interest rates will shift the German Bund interest rate curve to a much greater steepening and create big profits for those long the 2 year and short the 10 year government bonds.

Today, Tomorrow and next month

Economic news has taken a back seat to panic in the US financial markets. Over the next few weeks I expect long-term interest rates to trend slightly higher with mortgage spreads narrowing due to the massive liquidity injection by the Fed. The key trend continues to be the direction of the yen and with expected weakness it should lead to higher stocks and rates. The major trend toward a much weaker economy and DEFLATION has not changed but a counter trend move has begun in many markets. The deleveraging of the US economy and financial markets is in its first phase and will not end for many years. Increased government regulation and intervention will surely cut the potential growth rate for the US economy. Decrease debt and increase cash/savings will continue to be the biggest winner for 2008.

The USS HOPE springs a leak

The biggest cruise liner in the world has a gaping hole that Captain Bernanke and his Fed crew are desperately attempting to cover and keep the ship from sinking in the stormiest seas we have seen in last 70 years. The events of the past week remind us that hope is not an answer when events cause us to believe recent history will repeat thus giving us certainty for the future. The experts continue to predict the future of our economy from their own experiences in the late 70’s through the 90’s but I almost never hear anyone offer a view from the 30’s or earlier. I am older than most but clearly not old enough to remember the last depression or the big depression of 1837. Yes it is easier to forecast the future from our life experiences but often it doesn’t allow us to see similarities to a previous era. The Fed is clearly in uncharted waters and Captain Ben is trying hard to steer a path to calmer waters but sometimes listening to the views of a crew that has far less experience that leads to direction changes and moves that are always a step too late.

The Fed’s past and future

The buzz word for 2008 has become moral hazard, preventing a party from suffering the risk from a poorly timed investment. Whether it is a child that needs to learn one of life’s important lessons or investors that took too much leverage seeking high returns if the risk of loss disappears the decision making process is irreparably harmed. The Fed is always leery of coming to the rescue of its member banks unless the consequences of no action are too great to the economic system. Sunday we saw the end of Bear Stearns as the Fed injected $30 billion of guarantees into JP Morgan so they could survive with all of Bear’s liabilities. Is this a historic event? Yes, but probably not the end of the extraordinary actions by the Fed and/or the US government. Although memories are short, history has shown our government has always prevented the biggest from failing (Continental Illinois Bank) and thus contained further damage to other banks. Former Fed Chairmen Volcker and Greenspan were quick to take action and built reputations on their “gut instincts” that were translated into mostly positive results. Our current chairman is a brilliant historian but is picking up his hard experiences early in his term and desperately needs to jump out ahead of the crowd instead of reacting to fires that are coming close to burning the building to the ground. Friday’s Fed move that was to allow Bear a financing outlet (JP Morgan) for its mortgage collateral never got off the ground as Bear had an old fashioned run on the bank and by nightfall was ready for bankruptcy or bail out. Obviously Captain Ben was a step behind in realizing the severity of the liquidity crises as Bear couldn’t obtain overnight financing for its mortgage collateral. It appears that Ben is focused on the high seas around his ship instead of the storm that is creating the daily waves. Liquidity is the ability to create cash from the borrowing against or sale of assets. The Fed has created lending facilities for banks and now primary dealers to borrow against mortgage securities. BUT the Fed is not fighting the bigger storm which has long term DEFLATIONARY implications…lower asset values. The prices of homes and commercial properties (soon) are declining and that is creating a spreading fear among lenders and borrowers. A bank will loan money against an asset that is rising or stable in price but falling prices create a domino effect on the value of the underlying loan. The Fed is chasing its tail by focusing on the debt side of the balance sheet and must step up in a major way and inject capital on a permanent basis to the twins (Fannie and Freddie) and through the purchase of mortgages that will be held until maturity or default. If the price of a security is determined by demand and supply, a Fed purchase of mortgages will dramatically reduce the supply thus driving up debt prices and lowering yields. Reducing the overnight Funds rate to 0.00% (Japan) may not translate into lower long-term rates as they are influenced by inflationary expectations and an expected real rate of return. A Fed move before the markets make it a requirement would see a massive stock market rally followed by dramatic increase in the dollar (big short covering). Moral hazard is an important issue in a normal healthy economy but if the Fed continues to worry who caused the accident before deciding whom to help we will soon find us in the third great US depression.

The dollar

Much has been written about the dollar’s slide over the past few months but today is a good example of the media overstating the facts as a worldwide panic out of stocks into US Treasuries this morning appeared to also include dollar selling. But a look under the hood shows us the only currency rising against the dollar was the Japanese yen as the “carry trade” continues to be unwound by those who borrowed yen at low interest rates to buy higher yielding currencies. I often point out that trends tend to stay in motion longer than anyone expects and causes major financial problems for those that try and predict a change in the major trend. The yen has been the #1 best predictor of US stock and bond movements for the past 1+ years and a strong yen has led to lower US stock prices and interest rates. With the yen trading tonight at 97.43 I would expect intervention from the Bank of Japan if the yen reaches the 90 level and would not expect a significant stock market rally unless we see yen weakness back above the 100 level. Why fight a perfect correlation? Until worldwide hedge funds liquidate all of their carry positions the yen trend is a trader’s best friend. For those that believe the US is suffering from a withdrawl of foreign funds I would note stats that were released this morning showing net foreign purchases of $37.6 billion of US Treasuries in January with over $36 billion coming from central banks. Brazil was the largest buyer ($10.3) followed by China ($9.6), Norway ($8.4) and Japan ($6.4). Each one of these countries has seen its currency rise sharply against the dollar in the last few months. Dollars that are being sold to these countries are being re-circulated through purchases of Treasuries neutralizing the effect of a weak US dollar.

The yield curve

In our first issue of the year on January 8th (see archives) we forecast a widening yield curve to be the best bet of the year. With the spread between the 2 year and 10 year Treasury notes now trading at 196 basis points we should see more Fed easing push the spread to the 250bp level. With $140 billion in rebate checks coming in the next 60 days I expect a bounce in economic activity and consumer spending. It will appear to most that we have bottomed and real estate agents will be breathing a sigh of relief that they have weathered the worst storm in history but bear markets don’t end that quickly and another leg down will visit in 2009. The inability to be objective because one can’t short real estate will be the most painful lesson learned this decade for those that sell homes.

Summary

The good news is that the Fed appears to be waking up to the fact the US economy has entered a recession but the bad news is that if they don’t change course we will be entering the deep waters of a great depression similar to 1837 and 1932. The level of interest rates is irrelevant if the banks don’t have the $$$ to lend due to shrunken balance sheets and massive losses from the mortgage mess. Recent temporary solutions of increased lending facilities and lower short term interest rates are band-aids that are keeping the patient alive but its time for a permanent (capital) blood transfusion to put the country back on the right course.

Treasury rates plunge but mortgage rates soar, is this temporary or the new reality?

On Thursday evening (3/06) at 11:17pm I sent the following to my daily subscribers: With demand for treasury bonds soaring at the expense of mortgage securities the Fed must step in and offer a term repo where it will take only mortgage securities as collateral and then sterilize the operation by selling Treasury notes. Less than 6 hours later the Fed announced a term repo where it would loan funds against mortgage securities. Would you like this information on a nightly basis?

My daily e-mail is sent every night (Sunday through Thursday) at 10pm and covers issues that are important for those whose who need my opinions on a daily basis. To order your subscription…

In the past weeks the credit contraction picked up momentum with a perfect storm of a rising yen, falling stock prices, declining long-term Treasury rates and most importantly a growing inability to borrow by anyone except the US government. Unfortunately this bear market has arrived at a time when the country is least prepared and consumers and businesses are reacting as if they have seen this storm before and are waiting for it to blow over as it has done for the past 30+ years. Because we only see the future from our own past experiences the vast majority of real estate agents, mortgage professionals, real estate investors and almost everyone else except farmers (corn, wheat, and soybeans) expect a repeat of the past because it is too scary to believe the world isn’t what they need it to be.

Since the mid 80’s every time the US has suffered an economic contraction the Fed has lowered the overnight Fed Funds rate which has stimulated borrowing and economic activity. The last time down during Chairman Greenspan’s term the funds rate fell to 1.00% and everything rebounded including real estate prices. That memory is the most vivid in everyone’s mind so it becomes the most probable expectation of Fed action this year. It is often said that history does repeat but I often add that not when it is expected. With the current Fed funds rate at 3.00% and a near 100% consensus the next move is to 2.25% it is only a matter of a few short months before the Fed runs out of bullets with a Funds rate at 0.00%. The problem is that people are becoming more aware that the Fed does NOT control the level of long-term interest rates. The US central bank often tells the world of its two mandates: a stable economy and low inflation. The third but unspoken goal is low long-term interest rates. Fed Chairman Bernanke must be suffering from many sleepless nights as he wonders how to fix the widening gap between Treasury and government agency debt (Fannie & Freddie).

Friday (3/10) the Fed attempted another quick fix by announcing a new borrowing facility for primary dealers that would accept mortgage securities for up to 28 days and can be renewed for as long as needed. The credit market’s reaction was a big yawn as the perception of a liquidity problem changes to the reality of declining asset values. Liquidity is important as it allows buyers and sellers of securities the ability to go in and out of positions at any time of the day or night. It is just as important to know you can borrow against these securities (mortgages) when needed and at an interest rate close to the Treasury rate. The BIG problem is that the “experts” are seeing inflation clouds on the horizon as they extrapolate rising commodity prices (grains, metals, oil) into a climbing future inflation rate when the exact opposite is likely to hit in the next 24 months. A 1970’s stagflation where the inflation rate exceeds the annual growth in the economy was caused by an out of control Federal Reserve that expanded the monetary base in a misguided attempt to stabilize the economy.

Today the annual growth rate in the monetary base is less than 2% and sinking fast as loan growth is quickly turning into loan payoff, paydown and contraction. As usual when the world is looking in one direction an unexpected storm comes from the other direction and causes havoc as the majority are completely unprepared and suffer huge losses. With declining home values soon to be followed by falling commercial real estate prices and a melt down in the values of mortgage securities the dreaded DEFLATION monster will soon be arriving for an extended stay in this country.

With short-term rates plunging towards 0.00% the Fed will be faced with the most unusual problem of having no bullets left in its arsenal. Is there an answer from the past that can be used again to solve today’s credit crises? There are many possibilities but they all involve some degree of government support and the one which I will present tonight is something from the 1960’s. There are very few advantages of growing old but memory is one and mine is vivid from the days of President Kennedy. It was declining dollar crises (similar to today) that drove the government to “Operation Twist” where short-term rates were pushed higher to strengthen the currency and long rates were pushed lower. The objective was to balance our balance of trade by creating an incentive for foreigners to buy dollars and invest in the US. I believe it is time the Fed step up to the plate with a bold move that requires just one swing of the bat and if done correctly will surely send the ball over the fence and turn confidence around immediately. Big Ben must use Fed assets to purchase on a one-time basis only mortgages at an above market price thus giving banks and lenders the badly needed capital to remain in business. Mr. Bernanke is trying to use a positively sloped yield curve to accomplish the same thing but it will take too long and banks don’t have excess capital to borrow short and lend long. Raising equity from new shareholders has proven to be a disaster in the last few months as the dilution is devastating to existing owners and with the share price falling ends any hope of additional share sales. Sovereign wealth funds are a partial solution but will only step up in a big way if they partner with the US government. There has been much written about homeowners walking away from their homes because they no longer “have any skin in the game” and the same is true of our trading partners when we ask for additional capital. There is a moral hazard problem of bailing out the risk takers and sending a message that “Big Daddy” will always be there but that will be dealt with soon when the government is forced to take over Fannie and Freddie as they don’t have the capital to help solve much of the current problem.

The media reports that the economy will rebound as it has always done in the past. Friday’s jobs number was another disaster and for sure we have entered a recession but does it matter what we label this environment? Can we afford to allow a continuation of current policies that could easily create a depression with high unemployment and DEFLATION? We are in a major bear market and the counter trend rally this summer will only serve to delay the inevitable credit contraction. The worst news is my theme for 2008 has taken hold in many industries: “People would rather lose in company than win alone”. The smartest investors are de-leveraging and increasing cash reserves but they are few in number. The vast majority are too afraid to step outside the crowd and see the landscape has changed for the future. Warren Buffett’s famous line applies today, ”When the tide goes out we see who is swimming naked.” Many that have made $$$ in the past few years have done so by luck and now the tide is going to expose all but the
few that are not afraid to stand alone.

Bernanke honors his promise to Milton Friedman

At 11:30am on Wednesday, February 20th with the 10-year Treasury rate at 3.89% I sent a special e-mail to my daily subscribers: The treasury is getting ready to rally and we could see a fairly significant drop in the long end of the treasury curve in the next few days. I would NOT lock anything for the remainder of the week but would wait for this 20-30 bp rally. This move does NOT change my overall bearish view of the bond market but we have gone too far, too fast and “carry” traders will soon come into the market with new purchases.

Long-term interest rates have fallen 38 basis points in the last 2 weeks exactly as forecast. Can you afford not to have this information?

My daily e-mail is sent every night (Sunday through Thursday) at 10pm and covers issues that are important for those whose who need short term opinions. For subscription details…

November 8, 2002 Fed Governor Ben Bernanke (Greenspan was Chairman) spoke in Chicago to celebrate the birthday of the economist Milton Friedman. The speech honored Mr. Friedman’s work on monetary policy during the Depression and ended with the following quote: “Milton, regarding the Great Depression, you’re right, we (the Fed) did it. We’re very sorry. But thanks to you, we won’t do it again.”

It has become clear in the last few weeks that the current Fed Chairman remembers these famous words as his remarks last week before the Senate Finance Committee were as honest as I ever heard from a Fed head in the 40+ years I have been following world finance. The speeches given by Fed members each week are almost always posted on one of the Fed’s websites but the questions and answer sessions often reveal the nuggets we need to accurately assess current conditions and future monetary policy. I closely watched last week’s House and Senate sessions as Mr. Bernanke responded to the mostly political questions on Wednesday but surprisingly insightful questions on Thursday. Much like a football coach reviewing his next opponent’s past game films I tape each Bernanke session for playback at night and watch for nervousness while answering certain questions or calmness answering others.

When asked about his biggest concern for the economy he said that he is worried banks don’t have enough capital to make loans and then said credit is the lifeblood of the economy (very true). A senator asked if lower overnight interest rates (Fed Funds) would be enough to stimulate the economy and Ben answered with a succinct…”we hope so.” This was followed up with the question: “Does the Fed have any additional tools other than the Fed Funds rate to control inflation?” The Fed head didn’t hesitate to say they don’t and then followed up with his observation that there are greater risks to the downside in the economy than future inflation risks.

Does Mr. Bernanke know something about future inflation that the markets are not seeing? With out of control commodity prices (gold, wheat, oil, etc.) climbing wildly to daily new highs inflation fears have increased as the US economy slows rapidly. Milton Freidman taught the world that inflation is created by excess money growth above the rate of economic growth. When Japan entered the 90’s the global worry was that inflation was rebounding due to a very high rate of growth in the money supply. Inflation never reappeared as an increased money supply was never used by the banks. Inflation created by money growth needs velocity (turnover) before it can ever be considered a worry. There is another ingredient inside inflation and that involves wage growth. The chart shows 44 years of hourly wage gains and the CPI (consumer price index) and the tight relationship between the two without much divergence in high and low inflation periods. Mr. Bernanke is betting that slow monetary base growth (1-2% currently) will prevent rising wages. The problem he may have to deal with is a severe recession or worse?? High oil prices and commodity prices are driving gasoline, bread, etc. higher almost daily and if wages don’t grow demand for these products is sure to fall and accompanied by a credit contraction that might be the perfect recipe for a 1930’s style economic setback. In the meantime the recently passed stimulus package will be sending checks to everyone to spend and spend and spend and might give the economy a bounce this summer. If the Fed continues to cut the overnight Funds rate and long-term borrowing rates continue to rise 2009 and 2010 will have consumers and businesses fighting for a space in line at the bankruptcy court.

The scoreboard

Our first 2008 issue (1/08) announced our three best bets for the year. A widening of the yield curve (2-10yr.) spread has been a home run with the current curve at 190 basis points. Tonight the 2-year is at 1.66% and the 10-year at 3.56%. I continue to believe we will see this spread reach 250 bp within a few months.

The 2nd best bet was a lower British Pound and tonight the pound trades at 1.9844 and should see a move towards 1.80 by summer or early fall. The Bank of England must begin to ease (lower rates) as the British economy suffers from diminished consumer demand and teetering home prices.

The final best bet was for problems in the commercial real estate market to grow similar to the home mortgage problems. The securitized mortgage security market has seen only one deal priced this year and spreads have continued to widen making borrowers and lenders freeze until someone blinks. Interest rates drive commercial RE prices and most players are hoping for a return to the good old days of the past few years. Unfortunately these participants only see the future from their past experiences and many will be seeking employment in a different industry before the end of the year.

Conclusion

The yellow flag remains as the US 10-year rate drops due to a cut in economic growth expectations NOT a reduction in future inflation. Friday’s jobs number should show an increase in the unemployment rate but may surprise with an increase in payrolls due to the “birth/death” model seasonal adjustment factor. Last year’s February adjustment was +118,000 with the previous three years showing +201,000, +116.000 and +100,000. The jobs numbers are always adjusted many times after the initial release but markets react as if the numbers are leading indicators which is not even close to the truth. Employment is at best a coincident indicator and should be published by the government on a three month lag to improve its accuracy. Tuesday morning at 6am Mr. Bernanke will speak about mortgage foreclosures in Florida. It will be interesting to hear his remarks as the audience is sure to be seeking anything that will give them hope for the future.

The US economy will soon begin a counter trend rebound before its dive next year into the most severe contraction since the 30’s. For those who missed the opportunity to sell real estate last year this will be one last chance to build cash and lower leverage for the opportunities available in 2011 and beyond.