The World waits on the Fed

Only three weeks (May 14th) until my next interest rate class. Attendance is limited to 20 people and I will give a detailed forecast for interest rates, real estate prices and where I see the best opportunities for investment in the next 12 months.

Tuesday morning begins a two day Fed meeting that will conclude with another interest rate announcement at 11:17am on Wednesday. The consensus form the experts is another 25 basis point cut in the overnight Fed Funds rate but it is becoming clear that lower interest rates are not as important as the availability of credit. With only a few bullets remaining in their holster the Fed will announce a pause in its interest rate policy with a focus on clearing the credit pipeline of the residue from the mortgage mess of the past two years.

Another inflation scare?

Inflation concerns are growing as oil reaches the $120 level and rice soars to painful levels for many around the world. Long term interest rates are rising along with US stock prices as our predicted counter trend rally picks up steam. Inflation expectations have economists worried but digging inside the US Treasury 10 year note (3.83%) finds actual bond traders driving rates higher because of an expectation of economic growth NOT future inflation worries. The chart shows the yellow line (inflation expectations) in a very steady range over the past four years and at today’s 2.32% level over 40 basis points away from their high of 2.72% (2005). The blue line is the actual 10 year rate and the pink line represents the expected growth rate of the economy (1.51%). If inflation were a real worry the yellow line would be rising quickly to new highs above 3%, bond players don’t wait for CPI stats they sell first and ask questions later. Why have long rates risen in the past two months? It’s about changing expectations of US growth. In the spring of 2007 when long rates reached 5.30% I warned that it was a fake out as inflationary expectations were not rising with nominal rates. Early this year when the 10 year reached 3.32% on January 22nd I sent an urgent e-mail to my daily subscribers that rates had seen their lows for this year as inflation expectations were NOT falling with nominal rates. We are currently in a trading range for interest rates with rallies driven by an increase in economic growth expectations and declines led by fears of an accelerating recession. The bulk of the $$$ has been made in this bond bull market but it is way too early to even consider a substantial bet on higher long term rates. This week’s Barron’s polled 120 large money managers for their opinions on the performance over the next 6-12 months for different asset classes. 3.3% felt long rates would decline while 62.2% forecast higher rates. Too much money is being wagered on higher rates and as usual the majority will be wrong as rates will remain in a trading range for the remainder of the year.

Credit = oxygen for the US economy

Every Friday afternoon the Fed releases its report on the assets and liabilities of commercial US banks. When reviewing last week’s report you will see that real estate loans have clearly peaked and represent over 50% of all loans in the US. Commercial and Industrial loans continue to rise but due to a fear that credit will become unavailable soon and thus it is better to borrow today than be shut out tomorrow. Fed head Bernanke has told Congress and anyone else listening that credit is the life blood of the economy and without growth we are sure to see negative GDP numbers and a very severe recession. I have written all year that you can’t lend what you don’t have and the Fed’s biggest problem today is not the cost of money but finding a way to force the banks to lend $$$ they don’t have…..A positively sloped yield curve will increase profits as banks borrow short and lend long but that takes time and the Fed is painfully aware of the short fuse remaining on our credit structure. Many are asking the Fed to raise short term interest rates to defend the dollar and help cap rising inflation. Doesn’t anyone remember the results in the late 20’s and 1987 when Fed policy was focused on our currency to the exclusion of everything else? It is often said that history repeats itself but in this case I hope our leaders realize that following the herd is not the answer to resolving our most serious economic problem in over 70 years.

The yield curve

Rarely does a bull market give investors a 2nd chance to enter at attractive prices but the recent pullback in the 2yr-10yr. Treasury spread to the 140-150 level offers an attractive risk/reward ratio for those that did not enter earlier this year. Unless the Fed completely changes course and begins to increase short term rates the yield curve should widen to the 250+ level over the next 12 months. The best way for the Fed to assist increase capital is through a positively sloped yield curve and that continues to be my #1 best bet for the remainder of 2008.

Follow the yen

If you have only one minute per day to follow the financial markets then make sure you know the value of the Japanese yen. This has been the best predictor of almost all financial trends for every day this year. If the yen is falling in value stocks and long term interest rates are rising and if it is rising in value then stocks and long term rates are falling. Yes it really has been that simple and as they often say “the trend is your friend until broken.” With the yen resting comfortably at the 104.5 level and appearing to be ready for an assault over the key 105 level stocks and rates should continue to rise over the intermediate term.

Jobs and the economy

The focus has been entirely on the Fed and lack of liquidity in the financial system but Friday’s (5/02) monthly jobs report will have market’s attention as this lagging indicator shows more weakness. It’s an election year and the rising unemployment rate will cause concern but it’s a sure bet that a 6-7% rate will be seen in the next 12-18 months. We do have 50 states and recent stats from Louisiana and Texas show a rising employment trend which should soften the blow from the overall US economy.

The mortgage market continues to shrink

History shows that increased regulation always follows a market that innovates faster than the economy can tolerate and I fully expect the wholesale residential mortgage market to disappear by the end of 2009. It’s too easy for the government to blame the brokers and with the Fed needing to have better control over lenders the “retail” model for lending will be back in the forefront sooner than later.

Summer has begun

The last six months have seen extreme volatility from stocks, rates, currencies and commodities. Markets tend to go in cycles with a relative calmness following a period of hyper activity and I expect the next six months to be marked by a lessening of the fear we saw this past winter. Oil will soon slow its rate of advance (seasonally April is the 2nd strongest month of the year) as the economy begins an adjustment to a much slower rate of growth. Home prices will begin to bottom before the next leg down and everyone will look back upon this year as the last chance to exit many investments and build cash for opportunities that will be present in 2010 and beyond but NOT in the real estate arena. Remember the financial gods owe us nothing and frequently penalize those who stay too long and expect history to always repeat…it does but not when we expect it.

The Economic see-saw: Credit deterioration versus Capital infusion

It seems every day we read about a major bank (and some not so major) reporting millions (and billions) of losses from the growing mortgage mess that is spreading around the globe. It brings back memories of the 1968 hit song “Ride my See-Saw” by the Moody Blues. The words ring true today: “My world is spinning around, everything is lost that I found. People run, come ride with me, let’s find another place that’s free.” FREE is the key word for banks that desperately need to raise capital and are finding they have to give shares away to pique the interest of buyers. Since you can’t lend what you don’t have banks are lowering the price of stock to levels that dramatically dilute the equity of existing shareholders. Today we saw National City (Cleveland bank) raise $7 billion of capital by selling shares to a private equity fund and a few existing institutional shareholders at $5 per share after closing at $8 per share on Friday. They also cut their dividend to .01 from .21 per share thus avoiding the total disgrace of having to completely eliminate any payout to shareholders. The most amazing piece of news comes from the press release where the CEO stated; “We are pleased with the confidence that our investors have expressed in the value underlying National City’s franchise and the fundamental strengths of our business model that will help drive a return to profitability.” He must be relieved the bank found an investor at any price because it appeared they would be taken over and he might lose his job. The bank managed to lose only $171 million in the first quarter of this year versus a loss of $333 million in the last quarter of 2007. Their business model previously mentioned is what drove the losses as this bank was literally giving away home equity loans to anyone with a dollar of equity in their house. The institutional shareholders are adding to a losing position which violates the #1 rule of investing: NEVER add to a losing position or average down as it always seems to result in bigger losses. Have you ever wondered why the CEO that is responsible for leading a company into massive losses does NOT lose his job? When the average worker makes a mistake they are fired quickly, but the CEO of a big bank is rewarded by existing shareholders with a $7 billion infusion of new capital. Amazing!

Rice riots are growing….

News that corn, wheat and soybean prices have been climbing are now beginning to be seen in higher prices for bread, pizza and other food stuffs but the real story is rice. Rising demand from India and China and sharp price rises to over $24 per hundredweight have caused many producing nations to curtail exports. A story from Mountain View, California shows that Costco is limiting each customer to one bag of rice. More importantly we are witnessing recent riots in Haiti, Indonesia, Egypt and many African countries where the average person can not afford to purchase their main food staple. Economics 101 tells us that price rises are always followed by increases in supply but growers won’t be able to switch crops to rice until next year. This morning’s UK Independent newspaper makes an important point that cutting exports does nothing except drive prices higher. . Finally good news from a speech given by Energy Secretary Bodman on Friday (4/18) on the future of biofuels. The key quote that might show a change in administration policy: “This means moving away gradually from ethanol produced from food stocks like corn.” If the government lowers its subsidy to ethanol producers it could have a dramatic effect on the price of corn, wheat and other food stuffs. Food price inflation is painful in the short run but in the long run it will cause massive DEFLATION as consumers are spending more on food & gasoline and less on other items.

The pound is getting heavy

My second best bet of the year (01/08) was a major decline in the value of the British Pound (versus the dollar) to the $1.80 level. With oil reaching record highs ($117 today) the pound has held above its critical 1.95 level. This morning the Bank of England announced a special liquidity scheme (why did they use that word?) that will provide almost a $100 billion in funds for the now frozen British mortgage market. Similar to the plan announced by the Fed a few weeks ago, the BOE will swap UK Treasury Bills for mortgages held by lenders and banks. Very little attention has been given to the rapidly deteriorating British economy but much like early last year when the experts told us the mortgage mess was confined to “subprime” we will soon be hearing that the British economy is sinking like the US.

The Fed is slowing running out of Treasury collateral

Every Thursday the Fed releases its H.4.1 report which shows the amount of Treasury holdings has declined to $548 billion. Yes, that is a lot of Treasuries but this amount was over $800 billion a couple of months ago. The Fed is hoping the financial system recovers before its Treasury holdings reach zero as a worldwide panic would be created if the Fed asked the US Treasury to issue new securities for the purpose of loaning them to banks in need of liquidity and capital.

Counter trend rally underway

On January 22nd I sent a special e-mail to my daily subscribers alerting them to the fact that mortgage rates had reached their low for the year. Since then we have been building a base for a strong counter trend rally in the economy, stock market and interest rates. The yen continues to be the #1 best indicator for the direction of US stocks and Friday’s breakout move by stocks was led by a move from 102.5 to 104.6 in the Japanese Yen. Trends stay in motion much longer than anyone realizes and many who have tried to guess the end of this yen/stock trend have learned painful lessons. IRS refund checks will begin to arrive in May and consumers will spend, save or pay down debt and give a much needed boost to our economy. We are not even close to the end of this sad chapter in US economic history as 2009 and 2010 will bring much higher unemployment and misery to the average worker. Enjoy the remainder of 2008 as it may be the best we see for a long time.

You can’t lend won’t you don’t have

Wachovia’s announcement early this morning of more losses and write-offs continues the credit contraction that began last year. Banks can only lend when they have adequate capital and reserves, losses or write-downs make capital infusions a requirement for continued lending. The problem becomes how to obtain the capital and at what cost. Wachovia decided to raise $7 billion through a stock sale at a discounted price. The best time to sell stock is usually not when your share price is at a 10-year low but the alternative would be worse as credit contractions are hard to stop once in motion. Many banks used precious capital to buy back shares at much higher prices in the past couple of years and then were blindsided by the mortgage meltdown. Today the availability of credit is more important than the actual cost (interest rate) and is shown in the following chart of commercial and industrial loan demand reported by the Fed each Friday in its H.8 report. The pink line represents the overnight Fed Funds rate and the blue line shows the yearly growth rate in loan demand. We have seen an increase in loan demand as borrowers take down credit lines despite not needing them at this time. Normally the Fed doesn’t begin to lower short-term rates until it sees a lessening of loan demand but Ben and his friends were wise to see the real reason behind the increase in loans.

In the past year we have witnessed over $215 billion in bank write-downs from anticipated loan losses but only $30 billion from actual losses and the next 1-2 years will bring up to an estimated $1 trillion from both areas (combined). Capital becomes very expensive when shares are issued at lower and lower prices as existing shareholders suffer from massive dilution of their ownership interest. Sovereign wealth funds (mostly overseas) and newly issued shares represent only about $135 billion in replacement capital and it is very doubtful that banks will be able to replace lost capital with enough new buyers to make up much of their losses. Profits are always a good idea for increasing capital growth and the Fed will do everything in its power to maintain a positively sloped yield curve (short rates less than long rates). Although many seem to fear a coming inflationary storm due to excess money growth I would be very surprised if the Fed changed its current policy (easing) until banks had restocked their capital bases. With Fed Funds currently at 2.25% it is a better bet that the overnight rate will hit 0.00% than an equal uptick to 4.50% in the next few years.

The counter trend bounce

Markets tend to discount the future (many times more than once) and the stock market action over the past two months has shown a resiliency against bad news that wasn’t seen late last year and early this year. Friday’s announcement by GE that it would miss its earnings estimate was followed by a sharp sell-off on Wall Street but without the same follow through seen in previous months. This morning’s news from Wachovia sent its shares lower but most market averages closed the day near the unchanged mark. Markets that don’t decline on bad news are likely to rise on the first good news and the soon to be delivered government rebate checks will increase consumer spending and decrease debt by at least $135 billion. The major economic trend remains firmly lower BUT we will soon begin a countertrend rally in stocks, the economy, the dollar and interest rates. This uptrend will remain for most of the summer and fall and give hope (false) to everyone that we have hit the bottom of this economic cycle. Credit contractions don’t end until asset prices stabilize for more than a few months and must be accompanied by an increase in bank lending. Everything is relative and to those that have suffered the most over the past year it will seem like a breath of fresh air. The smart money will again be liquidating real estate and other assets on this bounce knowing that having cash to fight another day is the only way to long-term profits. This rally like all of its predecessors will climb a wall of worry with surging unemployment and official recognition that we have entered a recession. Do you remember a few years ago when the experts said home prices would hold up because the job market was strong? As usual they were seeing life through their own experiences and forgetting that history does repeat but not when you are expecting. Job growth is a lagging indicator. Credit contractions are rare but extremely dangerous because as Fed head Bernanke told us last month they are the “oxygen” for the economy. Last week Ben told a financial conference the Fed was acutely aware of the economy’s need for credit as “individual firms contract their credit availability.” (I tape every speech and question and answer session and then analyze later that day). The Fed is going to err on the side of ease and has allowed its holdings of Treasury securities to fall over $230 billion in the last 2 months as it trades government securities for mortgages that are less liquid. It has only $570 billion but of course the Treasury can issue billions more of paper with very little effort. Inflation worries? Credit contraction almost prohibits inflation, the real worry that keeps Ben up at night is DEFLATION which will certainly occur if banks are not recapitalized quickly and then find individuals and corporations that wish to borrow. The remainder of this year is going to be easy compared with what this country is facing in 2009-2010. Liquidate debt and increase your savings because they will be needed soon.

The counter trend bounce is on its way

A market that won’t decline on bad news is sure to rise on good news is one of my keys to good forecasting. Friday’s job number (-80,000) saw an initial stock market decline but a late day rebound put the market in the plus column. Long-term interest rates fell but today reversed almost all of the bond market gains and the 10-year has been unable to pierce the 3.50% level for more than a few days. The seasonal adjustment number (birth/death model) created by the Bureau of Labor Statistics added 140,000 jobs in March thus covering up what would have been a horrific employment report. The few remaining “always bullish” economists threw in the towel late Friday and now the clear consensus is that we entered a recession a few months ago. It doesn’t matter what the designation is for official records we are ending the first leg of this economic bear market and beginning a counter trend rally where the economy and stock market will rally along with long-term interest rates. Rebate checks will soon be in the mail and consumers will spend, pay down or save the gift from the IRS and give a quick jolt of stimulus to many industries (including home prices). Unfortunately this will lead to a more severe next leg down as many will be riding the train of hope right off the tracks in 2009. The lifeblood of the US economy is credit and the fact that banks are undercapitalized will make it difficult if not impossible for many lenders to increase their loan portfolios. For those that only see the world from the upside (realtors, etc.) it will represent a breath of fresh air and present an excellent selling opportunity for those that did NOT liquidate their holdings in the last couple of years.

The sun is always shining?

A story from Sunday’s Washington Post is a good illustration of why we haven’t even come close to hitting the bottom in the real estate market. The Mortgage Bankers Association will soon close on a 160,000 square foot building in Washington D.C. with a purchase price of close to $100 million. Do they need 160,000 square feet for their own operations? Of course not as they only require 33% of the space BUT were sure they would be able to lease the remaining 67%. The quote of the year goes to the Chairman of the association: “Anytime is the best time to buy (real estate)” and I’m quite sure he will be reminded of that remark by his 2,500 members over the next few years. Not only are they facing higher interest costs on their loan (the CMBS market is frozen) but they haven’t been able to find ANY tenants for the 100,000+ sq. ft. they have available. Much like a sports team that receives motivation from an opposing team’s flashy quotes this is a sure sign the end is nowhere in sight.

From San Diego comes the story of increasing office vacancies due to an increase in construction from those that believe the past will soon be repeated with higher prices later this year. Wealthy real estate investors have memories fresh from the past where every dip in prices over the past 30 years was followed by a boom in demand creating big profits for those that took advantage of easy credit and high leverage. Carlsbad leads San Diego County with a 26.4% vacancy and we are only at the beginning of my forecasted decline in commercial real estate values. On a national level it was reported today that the vacancy rate for U.S. strip malls has risen to the highest level since 1996. Rents are beginning to fall, supply of available space is increasing and actual space occupied is falling…the perfect storm for a market that saw its oxygen supply (credit) cut off over six months ago.

The dollar….it’s all relative

Last night 60 Minutes broadcast an interview with the head of a Chinese Sovereign Wealth Fund and brought up a point I last saw in the 1970’s during the oil crises. What if the Chinese decide to sell their hundreds of billions of US Treasury securities? Of course anything is possible but I wonder where else in the world one can invest almost a trillion dollars and not cause a major market disturbance. Much has been written about the US economic contraction/recession and mortgage mess and the dollar has been hit hard over the past few months as a consensus has developed that much of Europe will not suffer from our slowdown. I disagree and look for much lower short-term interest rates in Britain and eventually Europe as lower US demand negatively impacts these economies exports. In Spain we see the beginning of a mortgage meltdown similar to what the US has experienced but on a somewhat smaller scale. The prices of many mortgage securities have begun to fall sharply with warnings that prices could fall 20-25% from their lofty 2007 levels. I expect a dollar rally to begin soon led by a sharp decline in the British Pound.

Banks can’t lend without capital

Washington Mutual was thrown a life line in the form of a $5 billion capital injection from a group of private investors. This will cause dilution for current shareholders but the stock rose almost 30% today on relief that they wouldn’t be taken under similar to Bear Stearns. With the Fed Funds rate at 2.25% and sure to be reduced again at the April 30th FOMC meeting we should see a continued widening of the yield curve with the 2year -10year treasury spread rising to 250+ basis points later this year. This will enable banks to replenish their capital base by allowing them to borrow at the low Fed Funds rate and lend at the higher Prime Rate or similar short-term rate. Today I propose the Fed give serious consideration to lowering the Fed Funds rate to 0.00%. This will drive money market funds out of business as consumers will not pay a management fee to earn 0.00% and thus banks would pick up these funds in the form of new deposits with a cost of 0.00%. Banks can’t loan what they don’t have and it will take many years of profits to build their capital base which will then enable them to extend more credit but billions of dollars in money market funds could be used to make very profitable short-term loans to businesses that need to borrow for seasonal purposes. I am not forecasting an imminent move by the Fed to 0.00% but it will be something for them to consider next year when the economy turns down again and government officials become very concerned that the recession is about to become a depression (high unemployment).

It’s spring and the weather is turning with the economy

The economic news is gloomy but the markets always discount the future (many times incorrectly) and that should lead to better times for many (everything is relative). The residential mortgage market has been crushed and we are on our way to a retail model where wholesale represents a smaller and smaller part of the market. The problem baton will soon be passed from residential to commercial as the lack of liquidity and increased spreads drive cap rates higher and prices lower to the dismay of many leveraged investors. We have begun a MAJOR de-leveraging in this country where credit becomes a precious commodity and increased savings drives consumer spending lower. The days of living beyond your means have ended and the high-speed train (US economy) is slowing down to a much safer speed as it prepares to endure the most difficult economic period in over 75 years.