Up, up and away we go where we land nobody knows…

Would you like my comments every night (Sunday -Thursday) for only
$1 per day? Up to the minute market news and forecasts every night around 10pm.

Up, up and away we go where we land nobody knows…

The theme for 2008 is a counter trend rally for rates, stocks and interest rates propelled by the “carry trade” where many have predicted its demise but this week showed it is very much alive. The carry trade dominated last year and will continue to lead markets
until hedge funds that borrow at a rate of under 1.00% in Japan stop making $$$ every month. Borrowing at a low rate in a weak currency and investing the funds in oil, corn, rubber, or other recent winners creates a frenzy among hedgies to increase their positions and speed of advance in prices. The most important chart of the year continues to show the tight relationship between the yen and the US stock market. With the yen breaking the 105 level it should again lead to higher stock prices and rising long-term interest rates. It is amazing the amount of investors that have tried to predict the end of this trend and most have gone into hiding licking their wounds and plotting a strategy to fight another day. One of the old lessons we all learn is that a trend stays in motion much longer than anyone can ever predict and this is certainly a great example from the investor textbook “Trading 101″.

Does the carry trade determine the long-term trend of markets? No, but it does influence short and intermediate term trends and rice is an excellent example. From a price of under $10 per hundredweight to over $25 in a few months and riots in many countries the carry trade ran into economics 101 where supply increases as prices rise.
Unfortunately oil has not seen an increase in supply as prices have soared but demand from miles driven is seeing the sharpest decline since stats began in 1942. Unless the US finds a way to build refineries overseas demand will continue to be a major influence on fuel prices.

Another rising chart pattern comes from the job arena where the Conference Board’s consumer monthly sentiment figures should lead to a much higher unemployment rate. The yellow line represents the widening differential between plentiful jobs and those that are hard to land versus the purple line which shows a rising unemployment rate. The yellow line has tended to lead the purple line by a few months in the 41 years I have been compiling the data.

Rising interest rates and a slowing economy?

Frequently a slowing economy is associated with declining long-term interest rates but this year it appears the normal relationship is not working. Expectations are major component of interest rates as investors place bets based on their view of future economic strength and inflation. It is extremely important to always break down every recent rate move into two components: the real rate and the part that represents inflationary expectations. In May 2007 long-term rates rose with the 10-year reaching a peak of 5.30% but the vast majority of the upward move came from expectations that the economy was improving and that the mortgage mess was contained in the sub-prime sector. I warned all readers of the impending sharp drop in rates that would begin in July using anchored inflation expectations by bond buyers as one of many reasons the experts would again be wrong. This year we must again dig deep into the core of recent interest rate movements to determine the next course of direction for both the long and short-term trends.

Thursday’s report that first quarter GDP showed a 0.9% growth rate increased expectations of an economic rebound in the next few months and drove the real rate on the 10-year from 1.27% (May 20) to 1.58% today or 31 basis points. During this same period the inflation component of the 10-year has remained at the 2.50% level. This is a very short-term snapshot but is important because the media has told us rates are increasing due to rising inflationary expectations. On a longer term basis long-term rates will continue to rise gently for the remainder of this year before resuming the downward move in 2009. Credit availability was the force behind the real estate and mortgage boom and credit contraction is now having the opposite effect on an economy that uses credit as oxygen. With a positively sloped yield curve (short rates lower than long rates) each push higher in long rates will bring in leveraged buyers who can earn a much higher return as the Fed keeps the repo (borrowing rate) lower as banks (and hedge funds) replenish their balance sheets. The futures market is predicting a Fed tightening later this year and this is the same market that believed the Funds rate would be 1.50% by June. Its track record has not been good recently and I believe they will be wrong again as the Fed stays on hold much longer than anyone expects.

The Fed’s balance sheet

Individuals, corporations and governments have balance sheets that measure assets and liabilities. Most entities don’t last long when liabilities exceed assets but the quality of the assets is an important part of the economic health of every entity. Today the Fed
released its H.4.1 report which shows its holdings of different securities.  Again this week the Fed’s holdings of Treasury securities fell by over $11 billion and now has fallen almost $300 billion this year and totals only $491 billion compared to over $800 billion last year. The Fed has not lost the $300 billion but swapped these gilt edged securities for other debt that is backed by mortgages and credit cards. This is not a short-term issue but may become a major issue for our trading partners and the dollar in a couple of years.

The yield curve

With the 2yr.-10yr. spread on US treasuries at 140 basis points the risk to 125 bp seems definable while the upside could see a spread of 250+ bp sometime in 2009 when investors realize the economy has not hit bottom but inflation has peaked for this cycle. In England the BOE tells us inflation is the problem and because markets believe the Bank of England knows the future better than anyone else investors have the opportunity to bet on a widening yield curve with the 2yr.-10 yr. spread now at a negative 10 basis points (2yr = 5.13%, 10 yr. = 5.03%). You do have currency risk but the pound should weaken as the BOE is forced to lower short-term rates later this year. The best
opportunities always occur when credit is tight and investors are looking the wrong way on future central bank policy (similar to 2007).

Summary

On January 22nd I sent an e-mail to all daily subscribers that rates had bottomed for 2008 and a counter trend rally in rates, stocks and the economy would begin in a couple of months. This forecast is right on target and as long as the yen holds above 102.50 the rally will continue. The Fed is on hold for now as the $100 billion in stimulus checks continues to hit bank accounts of most US consumers. Whether the $$ is used to pay down debt or is spent on oil it is arriving at the intended destination. For now it is a band aid but by next year the bleeding will begin again as investors realize credit creation is the key to a growing economy and the Fed is forced to again come to the aid of banks that have learned again the hard lesson of “you can’t lend what you don’t have.”

Oil hits $132, inflation expectations rising BUT…

The oil market continues on its historic run with many predicting $150 by July 4th. Tuesday’s release of wholesale inflation (PPI) showed a 6.5% gain in the last 12 months. Last week’s University of Michigan consumer sentiment survey reported one year inflation expectations of 5.1% up from 3.1% 7 months earlier. And yet the ultimate interest rate scoreboard reacts with indifference. The US 10-year Treasury note remains in its recent trading range of 3.60-4.00% with today’s rate at 3.82%. The inflation component remains anchored at 2.50% under its March 11th high of 2.56%. If investors were truly concerned about future inflation wouldn’t they be demanding higher yields on their loans to the US government? Are they waiting for the actual rate of inflation to rise above its current levels? Aren’t they listening to the “experts” who are forecasting much higher inflation next year? Don’t they see the rising price of oil and gasoline they are paying each week to fill their cars? Last week I wrote about the reduction in car traffic on US highways according to new Federal Highway Administration data. Today I present a chart showing the increasing amount of retail sales dollars going towards the purchase of gasoline each month by consumers. Yes, rising prices do create inflation but only if demand stays the same can it lead to permanent price increases. Without rising incomes the average consumer must cut back on the purchases of other items as the amount spent on gasoline increases and that is not inflation but a redistribution of spending patterns. Normally when the price of a commodity rises sharply we see an increase in supply (wheat, sugar, etc.) but oil has been a temporary exception as demand from China and India has made up for the drop from the US. Unfortunately the supply of oil from US refiners has not increased due to a lack of capacity as it is almost impossible to gain the necessary permits to build new facilities. The end result is much higher prices and massive economic dislocation of consumer spending patterns which will result in another setback to the US economy in 2009 & 2010.

The Fed speaks, are you listening?

Most of the world hangs on every word spoken by Fed Chairman Bernanke but few understand the importance of listening to his #2 man at the Fed, Vice Chairman Donald Kohn. Tuesday Mr. Kohn addressed a Public Employee Retirement Conference in New Orleans and shed light on current and future Fed policy. He acknowledged that business uncertainty has cut planned spending which would boost the economy at a time when it is desperately needed. For those predicting an uptick in the overnight borrowing rate as the next Fed move he said: “If longer-term inflation expectations were to become unmoored-whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought—then I believe that we would be facing a more serious situation.” That was the longest sentence I have heard from a Fed Governor in many years but the thought was important….the Fed is on hold for the foreseeable future. He added “It is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term.” He reiterated the Fed’s dual mandate but it is clear after their March actions that bailed out Bear Stearns inflation is a secondary concern to the economy and employment. He also touched on a non-monetary issue when he disclosed that 75% of public pension systems are underfunded and one-third are funded at less than 80%. This will be a growing problem in the next few years unless we see a dramatic rise in stock prices where the majority of these assets are held. The entire speech can be read at: http://www.federalreserve.gov/newsevents/speech/kohn20080520a.htm

The end of wholesale residential mortgage brokers?

Normally I stay close to the economy and interest rates for my weekly commentary but Tuesday the Mortgage Bankers Association published a 33 page report that is must reading for anyone in the mortgage business. Fearing (correctly) that Washington is about to increase regulations surrounding the mortgage industry this trade association threw brokers under the bus in an attempt to save their own constituency. They are advocating for the majority of new regulations be implemented at the broker level because banks already have enough oversight. A year from now I expect most residential mortgages to be processed through retail bank channels as wholesale operations shrink to minimal levels.

Are you afraid to miss out on the next rally in real estate prices?

We only see the future from our past experiences is my theme for this economic cycle. Impatience has been rewarded in the past by those investors clamoring to jump on board the profit train through purchases on the first dip in prices. An economist at the National Assoc. of Realtors recently went so far as to encourage a quick drop so we could hit the bottom faster. I would warn him that he should be careful of what he wishes for as there is no guarantee the bottom won’t be a ledge that breaks next year. I am becoming very concerned about the next leg down after the end of the current counter trend rally in the economy, stocks and interest rates. The economic boom that was led by real estate and then burst 2 years ago was created by an increase in credit. The willingness to borrow and the massive availability of credit to anyone breathing drove prices higher and higher due to demand that came from greed more than common sense. We are at the very beginning of a major credit contraction where lenders are under capitalized and underwriting standards have gone from one extreme to the other. The most significant remark Fed head Bernanke said this year was that credit is oxygen to the economy and by next year the Fed will be forced to supply credit intravenously to a patient that can’t survive without it. Will the US economy bounce back? Of course, but not like it has in the past. Patience is NOT one of our best attributes and we have become a society of “must haves”, borrow to make it happen and worry about paying it back at a later date. That worked in the last 20+ years but it will take time not lower interest rates or Fed intervention to ignite us back to the same standard of living we became accustomed over the past decade. Patience, savings and low debt will be rewarded in the next few years because it will be the hardest to accomplish.

The yield curve is calling

In 1985 Mike and the Mechanics (Genesis) had a hit song “Silent Running” whose words remind me of today’s yield curve plays in the US and England. The 2yr-10 yr. spread in the US is currently 146 basis points and appears to offer tremendous opportunity for a move to 250bp in the next year. The UK yield curve is completely flat with the next move upward to +100bp on any easing by the Bank of England. In both cases an investor’s risk is an imminent tightening (higher) of overnight lending rates. Both central banks fear inflation but neither would be able to raise rates for fear of major economic contraction led by massive unemployment. For those with patience these two yield curve plays offer an opportunity to profit from future central bank easing and/or a continued increase in inflationary expectations.

You Can’t Lend What You Don’t Have

Only 10 more days until my next interest rate class on Wednesday, May 21st at 6pm. We have 6 seats remaining. I have many new charts and will unveil a couple of exciting new investment ideas that offer outstanding potential returns for the remainder of this year.

You can’t lend what you don’t have

This morning Fed Chairman Bernanke addressed a Georgia Financial Conference on the topic of credit liquidity. Knowing that the world is listening and watching every word, Ben spent quite a bit of time today telling his audience what has gone into his thought process over the past year of the mortgage and credit crises. He is quite a historian so it was no surprise that he quoted from Walter Bagehot’s treatise “Lombard Street” published in 1873 and giving us page numbers for reference. Many mortgage borrowers have been quite upset at the lack of credit availability this year with the most pain being felt by homeowners with unused helocs (home equity lines) capped or cancelled due to lender’s running out of $$$ to lend. Confidence is the most important word in the world of lending because if depositors fear they won’t be able to withdraw their $$$ the bank will fail quickly. Of course the bank could be bailed out with the government stepping in to guarantee all creditors as we saw earlier this year with Bear Stearns and in England with Northern Rock. Mr. Bernanke clearly points out the risks in these “rescues” as moral hazard increases with institutions becoming reckless as they believe they are too big to be allowed to fail. The Fed is clearly caught in a most unusual and difficult situation as the normal solution to financial problems (lower overnight interest rates) is having very little effect on borrowing patterns. A normally good indicator of lending activity (Commercial & industrial loans) is sending a signal of panic as corporations draw down available credit lines for fear they may not be there when needed (similar to Helocs). The Fed has correctly determined that it must create liquidity for the banks until they are able to build their balance sheets to begin lending again. Normally banks increase lendable funds through profit growth but time is important so they are selling more shares of stock at lower and lower prices but the price of dilution is high and the Fed is trying to help by allowing banks to swap loan collateral (mortgages, credit card debt, etc.) for Treasuries which the banks can then borrow against easily at low rates. The Fed has reduced its Treasury holdings almost $300 billion this year and is on track to deplete all of its holdings by 2009. It really has no choice but as Ben said this morning “the Fed has to use methods it does not usually employ to address liquidity pressures across a number of markets and institutions. The Fed has had to innovate in large part to achieve what other central banks have been able to effect through existing tools.” He added that financial markets are far from normal and the Fed stands ready to increase the liquidity if conditions warrant.

U.S. money markets have begun to discount a Fed tightening (increase in rates) in 2009 with the 2-year Treasury climbing to 2.47%. Some of this worry is coming from an increase in inflation fears as the price of oil soars past $126. I might be the only one on the planet that believes the rising price of gasoline is deflationary as consumers spend more of their income on their autos and less on discretionary items. For the first time in 25 years the Federal Highway Administration reported that Americans drove less miles than the same month in the previous year (stats from February 2008). Economics 101 is finally kicking in as high prices cut into demand but the second half of the economics lesson will take much longer as supply will be slow to increase due to massive government red tape for new refineries.

The bottom line for investors to understand is that the most important fear for the Fed is NOT a rising inflation rate but a growing credit contraction. Two months ago Ben told members of the Joint Economic Committee that credit was the equivalent of oxygen for the economy and that his focus was to make sure borrowers had available credit. It is very doubtful the Fed will be raising overnight interest rates anytime soon.

The yen leads the way

All signs for rising markets come from the direction of the Japanese yen. The “carry trade” is far from dead and has been leading the US stock market higher led by Transports and the Nasdaq. As long as the yen holds the 102.50 level stocks should continue their recent advance. (For daily analysis see my nightly newsletter.) The British Pound has broken the key 1.95 level and should accelerate its decline once below the 1.94 support area.

Buy one, get one free

At 11pm each night one of my Televisions (tuned to CNBC) switches to infomercials hawking “deals of the century” household items. From San Diego comes the story of a desperate home builder offering a free 2nd home in Escondido if someone buys a home in San Pasqual. 

The yield curve

With many market players betting on higher short term rates a 2nd opportunity exists for those willing to bet on a steeper yield curve. The 2-year is at 2.47% and the 10-year at 3.92% giving us a spread of 145 basis points. Unless the Fed does tighten soon or long rates plunge (neither is a high probability) we should see a move back to the 200+ level later this year. This is a very interesting trade because if long rates rise due to an increase in inflationary expectations the spread will widen and if the Fed doesn’t tighten the spread will widen. If either scenario is realized you have a home run in a year where there is very little profit potential from betting on the direction of rates.

Ben and the Fed

Fed chief Bernanke will speak in Chicago on Thursday at 6:30am on the topic of bank risk management. He is sending an important message to world financial markets that the Fed has its eye on the big problem: credit contraction. Next time you are turned down by your bank for a loan please understand the reason has more to do with their lack of capital than your credit history.

Notes from my Scorecard

My next interest rate class will be held on Wednesday May 21st at 6pm, registration details can be found here.

One of my favorite expressions has always been: “if you don’t know where you are going, any road will get you there.” This week I want to give a brief overview of the economic landscape and most importantly where we are headed for the remainder of 2008 and into 2009.

The US economy

My forecasted counter-trend rally remains on track as over 7 million economic stimulus checks totaling $7 billion were mailed last week with the remaining $120+ billion to be sent over the next 2 months. With recent GDP growth showing 0.6% I expect the stimulus checks to propel economic growth to the 1-2% level over the next six months. With the price of oil over $120 and gasoline near $4, much of the money will not be saved but used for the added cost of fuel and food as these items are more of a necessity than a luxury for most consumers. An article from today’s Sacramento Bee shows gambling in Nevada to be turning down as a normally counter cyclical industry is showing signs of fatigue. Two Lake Tahoe casinos filed for Chapter 11 bankruptcy on Monday. I always thought a casino couldn’t lose….

Friday’s (5/02) jobs number created more confusion for economic forecasters. The monthly seasonal adjustment (Birth/Death model) added 267,000 jobs in April and lowered the reportable number to an overall loss of only 20,000. The average workweek and earnings were weak and give no indication that we are anywhere near the point of consistent job creation. I expect the unemployment rate (5.0%) to reach the 6.0-7.0% level before government support is able to stabilize the economy.

Government regulation

I have a new #1 best bet for the next 3-5 years but investors and business people will not be happy as government intervention and regulation have entered a long bull market. The mortgage mess and credit contraction have pulled Washington into an arena that will save the economy from ruin and make it difficult for many industries to grow and thus create jobs. The twins (Fannie and Freddie) are now the only substantial lenders for homes and apartment buildings but will need billions of support from the US government and shareholders to continue their needed funding levels. This morning Fannie Mae announced a net loss of only $2.2 billion in the quarter ending March 2008. (They lost $3.6 billion in the fourth quarter of 2007). They also announced a plan to raise $6 billion in new capital through public offerings of common and preferred stock. As a result of the capital raising OFHEO (Office of Federal Housing Enterprise Oversight) lifted its consent order with Fannie Mae. With all of this good news FNMA’s stock price rose 4% this morning in early trading. Can you imagine if FNMA would have shown a profit? It is obvious the government will soon have to completely take over these GSE’s (Government sponsored entities) but at whose expense? The cost of insuring against defaults for the twins has fallen by more than 60% in the past few months. Their stock prices appear to have bottomed and yet the shareholders that ultimately will pay through massive dilution. Could the typical business borrow $$ from a bank or issue stock when it showed massive losses every year? Of course not but when you have the backing of the US government and its ability to fund forever your ability to stay in business changes…or as Alfred E. Newman would say…..what me worry?

States are in no better fiscal shape than the federal government. A report from the Rockefeller Institute shows 21 states had sales tax declines in the first quarter of this year (compared to the first quarter of 2007). With gambling no longer a quick solution (see above) and running a deficit not an option, states will soon be forced to raise taxes (not a good idea) or cut spending (difficult in an election year). The other solution is paying a higher interest rate on debt. From Sacramento we see a headline this morning that the State of California may run out of cash by August. The key quote comes from state Controller John Chiang who states: “It’s like taking a subprime loan for the state, and it comes with greater costs.” The real estate boom masked budget problems for many states and now with the massive revenue loss because of falling real estate values (lower property & sales taxes) these legislatures are faced with painful choices. It’s not only California that is feeling the pain but states that house some of the wealthiest hedge fund managers in the world. Connecticut projects a $67 million deficit for the fiscal year ending June 30th. I look for a massive migration of workers from states showing declining tax and job revenues to states that have an abundance of natural resources (Texas, Oklahoma and Louisiana). With oil setting record highs almost daily these states could be the leaders in job growth over the next 5 years. I will be monitoring apartment trends in these three states as new workers will need places to live.

The Federal Reserve

Like a football coach that stays in his office each night watching game film of his next opponent, I tape and review each and every speech by Chairman Ben Bernanke. Last night at a Columbia Business School dinner in a speech on mortgage delinquencies and foreclosures he gave us a nugget that helps us determine the current focus of the Fed. “When the source of the problem is a decline of the value of the home well below the mortgage’s principal balance, the best solution may be a write-down of principal or other permanent modification of the loan by the servicer, perhaps combined with a refinancing by the Federal Housing Administration or another lender.” The key words are decline in the value of the home. Last year we were told the problem was about rising interest rate re-sets on home loans but of course we now know that homeowners were walking away by the thousands as mortgage amounts exceeded the value of their homes. Declining asset values are leading the credit contraction and Fed head Bernanke has realized a lower Fed Funds rate (currently 2%) is meaningless if borrowing is unavailable. Banks can’t lend what they don’t have and the Fed’s main objective for the next few years will be to solidify the capital structure and profitability of its member banks.

The Fed has a long journey ahead as yesterday’s Senior Loan Survey shows 55% of domestic banks reported tighter lending standards as of April and the majority of these banks increased their lending margins in an attempt to boost profits. 80% of domestic banks tightened their underwriting of commercial real estate loans and it’s important to remember there is no Fannie or Freddie in the commercial area except for apartments. The end of this severe liquidity crises will NOT come quickly and after the summer rush from government stimulus 2009 will see another set-back for markets that need liquidity to grow.

Stocks, interest rates, commodities and the dollar

The Japanese yen continues to lead the way for almost all world markets. Hedge funds ability to borrow in Japan at 0.5% and invest in oil, rice and other markets has made market volatility the big winner this year. With almost a perfect correlation between the yen and US stocks we should continue to see a counter trend rally in stocks (led by Transports and NASDAQ) that could easily reach new highs and confuse the majority of experts that sold at panic lows in March. The Fed has finished its first round of easing with the Funds rate of 2.00%. Long-term rates have risen and could easily pierce the 4.00% level on the US Treasury 10-year note but will not be a concern to the Fed unless the inflation component breaks above its 2008 high of 2.57% reached on March 5th. Most of the increase in the 10-year has come from a bounce in the real rate of interest which has rallied from 0.91% on March 10th to its current 1.49%. We saw a similar rise in May 2007 and with the stimulus checks soon to be spent this rate could reach 2.00% or more. With the Fed on hold for at least a few months and domestic demand slowing for many of our major trading partners the dollar should stabilize soon and offers the most upside against the British Pound which has been supported by the recent rise in the price of oil.
Although we have seen a dramatic increase in many food items (rice) economics 101 will kick in soon and farmers will focus new plantings on those commodities that have risen the most in the past year. We have already begun to see this with wheat and rice is next.

As long as the yen continues to depreciate against the dollar, US stocks will offer the most potential for appreciation this summer with the low in rates solidly behind us as I wrote on January 22nd. With oil at $120+ inflation will not be the problem everyone expects but rather a growing credit contraction that makes it difficult for consumers to continue recent spending patterns. Home prices will stabilize for the remainder of this year with many forecasting a permanent bottom. The next leg down for this economic and credit cycle will begin next year with another government stimulus package to follow. Patience will be rewarded to those that don’t chase the first bounce off a temporary bottom. Those with debt should liquidate into strength and build savings for the opportunities that lie ahead in 2010 and beyond.