Wet logs don’t create smoke (inflation)

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Notes on a very busy scorecard

$700 billion bailout bill – Congress sees the U.S. stock market as a barometer for the American public. This week’s decline and the need to campaign for the upcoming elections will create enough energy to agree on a bill no later than this weekend. The inflationary consequences of massive government intervention are nil until we begin to witness credit creation instead of the weekly credit contraction that has banks unable to loan money due to their shortage of capital. You can’t lend what you don’t have has been my theme for 2008 and it’s important to remember that the bail out bill will take months if not years to execute and unless banks are forced to lend they will be content to borrow from the Fed and lend to the Treasury (widening yield curve) to slowly grow their capital.

Inflation – To ignite a fire (inflation) you need matches and dry wood and the logs shown above signify an economy (wet) that is in no position to create credit and without it excess money just sits and waits for demand from borrowers. In the early 1990’s there was worldwide fear of rising inflation in Japan due to double digit money supply growth and yet they continued to see a continuation of DE-flation (declining prices). Inflation is created by excess money growth and an increase in velocity (how fast it is loaned or spent) and that is NOT what we see in the U.S. at this time. The inflation component of the U.S. 10-year Treasury remains well contained at its current level of 1.71% and its lowest level in over 5 years. The price of gold has risen dramatically in the past few weeks ($890) but much of the demand is from those seeking insurance in the unlikely event the U.S. defaults on its debt. Oil has also risen in a flight to safety more than a bet on future inflation. Watch carefully the 10 year inflation component (10 year yield less the 10 year TIPS yield) and unless it rises over 2.00% the Fed will be on full speed ahead in its fight against DEFLATION and the most serious economic contraction since the early 1930’s.

U.S. stock market – After being bearish for the first 9 months of this year I am changing today as I believe last night’s final chapter in WAMU history will mark a significant event in economic history and the trigger for a sharp intermediate term rally in stocks. The economic news is gloomy almost every day but it just feels like the sellers have thrown in the towel and we should see rising prices despite much more bad news from the banking sector.

The Fed – The current Fed Funds rate is at 2.00% but with inflation expectations low I believe the Fed will reduce the Funds rate again by the end of the year. It won’t matter if they reduce the rate to 0.00% as the counter party risk is so great that very little lending is taking place except in the Treasury sector. Three month Libor is 3.76% but should fall quickly once we reach October as the rate is being held high due to banks not wanting to have to scramble for funds at year end. The Fed’s balance sheet is a mess with loans against equities, bonds, credit cards and anything else a bank or brokerage firm wants to provide and will take years to stabilize but what else would you expect from the world’s greatest expert on the Great Depression and DEFLATION. Fed head Bernanke has made it clear to the world that he will continue to throw money at the credit problem until the logs dry and credit begins to grow again. Credit is oxygen to any economy and without it there can NOT be any economic growth.

Long term interest rates – Inflation will not be a problem for many years and DE-flation is here now and that is why the Fed is pouring $$$ into the system on a daily basis. As long as the inflation component remains under 2.00% it will be difficult for the 10-year Treasury to rise above 4.00%. Monthly CPI numbers under 0.00% could drive long rates lower later this year but the best bet of the decade continues to be on a wider yield curve where the spread between the 2 year and 10 year increases from its current 182 basis points to 250+ bp or more as banks replenish capital courtesy of the Federal Reserve. This has the best risk/reward potential of any investment I see for the next 12 months.

WAMU – JP Morgan’s purchase last night will go down in history as one of the best of all time. Picking up deposits and retail branches and not having to assume any of the holding company subordinated debt and preferred stock allow them to step in and take under WAMU without any guarantees from the FDIC, Fed or Treasury. The most amazing part of this drama is that WAMU survived until yesterday. Each day the bank offered 12 month CD’s at 5.00% the cost to the FDIC increased as investors rushed to purchase no more than $100,000 in the insured deposits. In fact one of the best investment strategies today is to find banks that are close to the end and buy their CD’s at above market rates and then wait for the FDIC to shut them down. No risk but high returns above U.S. Treasury rates. This comes at a huge cost to the U.S. government and the faster the FDIC takes over these institutions the lower the cost to the taxpayer who is ultimately paying the highest cost for the worst financial mess in 75+ years.

Where to bank, where to put your $$$, where to find a job

2009 will see a flight of deposits and relationships to the biggest U.S. banks. Although the government has shown us they are willing to allow a few institutions to fail they will have a vested interest in making sure the biggest banks have the necessary capital to survive and eventually grow. The Treasury will be forced to inject permanent capital into many U.S. banks through the purchase of preferred stock. It will take many years for bank capital to grow to the levels needed to increase bank lending. The government must create a program similar to the current SBA lending platform that guarantees banks against loan losses. Banks need profit incentives to lend after they have sufficient capital. For depositors it will be a mad dash to the big banks where service will suffer as they try and accommodate thousands of new clients (without being prepared) and become the lender for 95% of all residential mortgages.

Return OF capital rather than return ON capital is the key to financial survival in today’s economy and leverage is being lowered while savings increases for the first time in many years. The biggest impediment is our memories as we only see the future from our past experiences and those are all from higher real estate prices and inflation being used to cover the tracks of poor purchases. In the past few years there have been many instances of profit by investors who succeeded “despite themselves” as a rising tide (inflation) floats all boats. The next 5-10 years will see a return of cash flow investing for real estate as appreciation becomes something for short-term traders not long-term investors. If you are willing to change your mindset and believe that this is a new era you will profit handsomely but I continue to see the majority willing to lose in company rather than have the courage to win alone.

The unemployment rate in California is headed for 10% and the U.S. rate will near 8% or more. Texas continues to offer the best opportunities for growth but the most job openings will come from the federal government as it will need tens of thousands to oversee the many new regulatory operations that will begin in the next year. These jobs will offer safety and job security but advancement might be limited. In 2009 any job will be better than no job and it’s not too early to be researching what areas the government will be expanding operations.

The key to the next twelve months is surround yourself with a support system that is not afraid of change. Many times each day I hear the “experts” say on business TV that they have never seen anything like this before in their lifetimes. These comments are an attempt to cover their losses or bad forecasts made this year. Is your investment professional telling you that he only lost 10% of your money this year but that is exceptional performance because the S&P 500 is down almost 20%? That’s absurd because a loss is real reduction to your wealth. But since everyone else lost $$$ it’s rationalized because 99% of people would rather lose in company than win alone.

Are you one of the few that is willing to stand outside the crowd and change your way of thinking about the future?

The U.S. government saw the black swan and panicked

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 Last week I wrote about the black swan (a once in a lifetime event) that had entered the U.S. financial system. On Saturday (9/13) Lehman was allowed to fail but AIG was given an $85 billion lifeline from the Fed and then this morning the Treasury and Fed threw all their chips down on the table in an attempt to stabilize the markets. The good news is that anytime a government floods the system with money a pick-up in consumer demand soon follows but the bad news is that it will take years before we again see an expansion of bank credit anywhere near the levels of the past few years.

Today’s changes

1) The SEC announced a ban on short selling of the shares of financial firms. Shorts (betting on lower prices) did NOT cause the recent decline in the U.S. stock market. Short selling helps create liquidity and adds to price discovery especially when prices move violently in one direction. If real estate had short sellers real estate agents would be much more objective and recent price declines would end much sooner. This is the worst part of the government intervention program and hopefully will end soon after the presidential election. The vast majority of short selling was done through normal channels of borrowing shares. The government should have required a clearing house for credit default swaps (bets on companies failing) but couldn’t come up with a solution in the short period of time they had yesterday and this morning.

2) The U.S. Treasury will guarantee all money market funds (both individual and institutional) for the next year. The Federal Reserve will offer non-recourse loans to banks that purchase asset backed commercial paper from money market funds. Those investors that have been purchasing $100,000 CD’s from banks nearing a takeover by the FDIC (WAMU?) now have another avenue to obtain higher than U.S. Treasury rates. In effect the government is now guaranteeing agency paper (Fannie & Freddie) and anything else you might find in the typical money market fund. This should drive bank CD rates higher as they begin to compete with money market funds that will be purchasing the lowest grade junk paper knowing these assets instantly become government guaranteed. This is the true definition of moral hazard as institutions begin to take risks they would never consider if not for the guarantee. This provision of the government plan might not last long as Congress realizes taxpayers’ money is creating a new set of risk takers.

3) Originally Treasury Secretary Paulson planned to shrink the balance sheets of the twins (Fannie & Freddie) by 2010 but now has announced they will be supplied with an unlimited bankroll to purchase mortgage backed securities. Will they pay market prices? Will sellers hold back hoping for higher and higher prices? This will create more credit availability in the mortgage market and tighten residential spreads considerably and caused today’s dramatic rise in Treasury rates as traders sold government bonds and bought mortgages. The key to this plan is the overall level of long-term interest rates. The 10-year closed today at 3.81% and the inflation component at 192 basis points. Traders initial reaction was that the government intervention will soon lead to inflation but the chances of that are remote at least for the next few years as banks need to rebuild capital before they can even entertain new loans and unless they sell all of their mortgages at par (100 cents on a dollar) capital injections will still be needed in the next year.

4) Much of the reaction by the government today was caused by the recent decline in stock prices. It’s an election year and stock market movements receive the most daily attention by the press. This week everyone in the country was either affected or at least aware of the escalating waterfall decline in share prices. With the end of short sellers in financial stocks, stock prices rose today and yesterday the most since 1929 (sound familiar?) and will continue to be the barometer of the nations health to those in Washington. Today’s actions were a decent first step but the real solution is more time that is needed to heal bank balance sheets. Unemployment is soaring with California announcing today a rate of 7.7% and on its way to 10%+. The next problem that the federal government will face is the deterioration in municipal (state & local) balance sheets. Uncle Sam will be forced to step-up with hundreds of billions in loans to these entities with no chance of taking back warrants or stock options as they have done with AIG and anyone else that uses the government safety net. But that is a problem for 2009 and for now everyone is relieved that this weekend will not bring more endings for big U.S. banks or brokerage firms.

5) Real estate prices will be affected in only a small way with today’s actions creating a little more liquidity but not enough permanent capital to make a meaningful difference. Everyone is anxiously waiting for home prices to end their decline and begin a new advance to new heights but sadly we are at least another 5-7 years away from the bottom and any price rise will be met with an immediate increase in supply coming from homeowners anxious to lose less or break even. Many small regional banks will be taken over by the FDIC or merged into bigger banks and government regulation will soar in the next four years no matter who wins the presidential election. The biggest growth industry for those seeking employment will be the federal government as it will be creating many new agencies to oversee the financial industry.

Next Week’s calendar

Today’s actions will be front page news again next week as Congress rushes to pass a bill that will be understandable, effective and easy to implement. Tuesday (9/23) Bernanke and Paulson will testify before the Senate Banking Committee at 7am and since Congress has agreed to the basics of today’s announcement it should be more of a love fest than the usual attacks we see near an election. Wednesday (9/24) Bernanke goes before the Congressional Joint Economic Committee and gives his forecast for the economy. I’m sure he will say it has been helped tremendously by today’s announcement. Market volatility will continue to be high as many hedge funds are forced to the sidelines to lick their wounds and analyzing if they want to enter the investment arena again. Pay careful attention to the inflation component of the U.S. Treasury 10-year as it will give good clues as to the world’s perceptions of this economic plan and its future inflation expectations. The last thing the Fed wants is to have to raise short-term interest rates while it provides billions in liquidity to cash starved banks and brokerage firms. The best bet is for everyone to reduce leverage and accumulate cash reserves as the black swan is not leaving anytime soon.

I will have much more on Sunday night for my daily newsletter subscribers.

Are all swans white?

This week we begin with a simple question but not an obvious answer. A 17th century discovery of an Australian black swan may have a connection to today’s economic environment. An April 2007 book “The Black Swan” written by Nassim Taleb should be must reading for anyone courageous enough to believe that history does not always repeat especially when it is expected by the majority. Taleb’s theory is that almost all consequential events in history come from the unexpected. The past 18 months of turmoil in the mortgage, real estate and credit markets continue to surprise almost everyone because they continue to see the future only from their own past experiences. Everyday we hear from an “expert” that they have never seen anything like this in their lifetime. Acknowledgement is the first step in a long process of change but the fear of experiencing something new has investors, consumers and forecasters in a state of paralysis. Early in 2007 Fed Chairman Bernanke told the world the mortgage problem was limited to sub-prime and would soon be a part of history. Real estate investors continued to buy for fear they would miss opportunities and big profits if they didn’t buy the first dip because their experiences showed appreciation always overcame any price declines in a few months or years. Stock market experts continued to forecast higher and higher prices and made the career ending mistake of adding to losing positions (FNMA & FRE). Most of us form our opinions from what we read in newspapers/internet and hear on television from business news channels. We then have a basis or reason for our thoughts and investments and if wrong at least we lose in company with others because the thought of winning alone is too scary. It’s the biggest reason that so few have profited from the downturn in real estate, stocks, interest rates, etc. This year’s winners made billions because they realized that stock market gurus are always bullish, real estate agents never say it’s a bad time to buy and are never blamed for being too bullish but shunned if they miss an upmove in prices. It’s one of the reasons money managers give performance figures on a relative basis expecting kudos for only losing 10% of an investor’s portfolio if the S&P is down 15%. A loss is no better on a relative basis than absolute because you can’t spend relative dollars. A black swan (unexpected event) is almost never good (9-11) and the events of the last two years lead me to believe this swan will have a much longer life than expected because the only solution is time and lots of it. The answer is not that we recover by using the methods that got us into this mess (easy credit) but a slow rebuilding of bank capital. Unfortunately the “white swan” method of lower short-term interest rates has already been used and is not having an effect on credit availability. Heavy government intervention/guarantees and years of a positively sloped yield curve are the only reliable methods that have a chance of preventing a repeat of the Great Depression of the 1930’s. Patience is not something that comes easy to most Americans but will soon be life’s lesson to many whose financial fortunes are decimated in the next few years. Those who have lived by the sword (credit) will be unable and unwilling to deleverage and be forced to begin again from ground zero. Yes, the black swan has arrived and she will be staying longer than anyone can imagine.

The Fed

A few short months ago expectations were centered on a return to 1970’s style stagflation and thoughts of a Fed that would need to raise overnight interest rates to save the dollar and slow down the coming economic advance. Obviously this has not happened and now the market has begun to talk about the need for Fed easing. The next time you read the “experts” predictions about the economy ask “why should they be correct?” It will take awhile and you may need to join a group therapy session but the realization that these “experts” continue to be very wrong with their forecasts of future Fed policy and interest rates is one you must deal with sooner than later. The truth is the Fed is every bit as confused as everyone else. Fed Vice-Chairman Kohn spoke Thursday at the Brookings Panel on Economic Activity and told a packed audience that “we are in unchartered waters.” He is second in command to Fed Chairman Bernanke and much more influential in policy decisions than the Fed District Presidents that give regular speeches on the economy and are followed closely by financial markets. The Fed is well aware we have an acute capital problem and that banks are NOT lending because they don’t have the funds needed for prospective borrowers. Fannie and Freddie are now officially under the federal government wing but have been directed to reduce their mortgage portfolios beginning in 2010 (very doubtful). The Fed MUST find a way to create a positively sloped yield curve where short-term rates are substantially lower than long-term rates giving banks a can’t miss opportunity to make $$$ by borrowing at the overnight rate and then lending or purchasing higher yielding government securities. This is the next big bull market and you don’t have to be a bank to participate in the profits.

The U.S. economy

Today’s retail sales report showed that the consumer is slowly retrenching under a mountain of debt that has reached a breaking point. August sales fell 0.3% with July revised to a -0.5% and June now only +0.1%. The revisions all were downward with the only positive point coming from a slowdown in gasoline sales due to a decline in oil prices and drivers staying home or taking public transportation and trains. An hour of wages continues to buy a very small amount of gasoline. Falling commodity prices led to a decline in the producer price index (-0.9%) and we will soon witness negative CPI numbers and the beginning of a deflationary period in the U.S. The key to the future trend in long-term interest rates will come from the inflation component of the 10-year Treasury which recently fell below a five year low of 2.00%. A strong dollar is also assisting in lowering inflationary expectations and should give the Fed room to focus on the economy and credit contraction rather than the risk of runaway inflation which is what the “experts” told us was a sure thing only a few short months ago.

Lehman and WAMU

We rarely write about individual companies and this is not a blog that ever recommends stocks (consult your investment professional) but their future is important as it relates to future government involvement in the marketplace. This year’s Fed sponsored bailout of Bear Stearns (through JP Morgan) created expectations that many other firms “too big to fail” could come and be rescued by Uncle Sam. Last weekend’s takeover of Fannie and Freddie solidified those thoughts and that is the reason WAMU and Lehman are having such difficulty finding buyers at any price for their shares. Why should a public company buy them when they can wait for the government to help them through financial guarantees? It is clear these two companies will not survive in their current state and probably will find suitors at some price (LEH) or be liquidated by the FDIC (WAMU) but the uncertainty created by these most recent government bailouts has buyers waiting for a call from Washington (Fed, Treasury, White House?). Uncertainty always drives markets lower in price and the government MUST soon send a clear message to investors that they will continue to take over institutions or that they are done and the marketplace will determine their fates. Is WAMU going to be GOMU? Or CHAMU? Will Lehman be purchased by a consortium of institutions with a guarantee of no losses from the government? The longer our leaders wait the worse it will be for investors and this country. It doesn’t help the situation when the new CEO of WAMU is quoted on the front page of the Seattle Times earlier this week when asked what he could do for his new company: “I have no idea, probably nothing.” I’m sure that did NOT help comfort shareholders and employees. Leadership appears to be in short supply everywhere but especially in Seattle.

A long road trip

Unfortunately the U.S. has a very low savings rate at a time it is most needed because it will take years for the de-leveraging process to be completed. Credit is the oxygen needed for any economy to grow and the Fed will soon be forced to create credit but forcing banks to lend will not be easy. They have been burned badly by underwriting guidelines that won’t be seen again in our lifetime. Those that see the next few years being a repeat of the 90’s, 80’s or 70’s will soon learn that history does repeat but not when expected. It’s time for everyone to step away from the crowd and your usual spending and investing habits and realize the black swan has arrived and the sooner you acknowledge its presence the easier it will be to survive and prosper in this new environment.

The DE-flation train is picking up speed, are you prepared for the ride?

Can you afford NOT to attend my next class?

Only 12 days until my next interest rate class on Wednesday September 17th at 6pm. Seating is limited to 20 attendees and we are rapidly filling the room. I will have detailed forecasts for investments, interest rates and the economy. Please register as soon as possible.

Today’s job report was another indication that we are in the early stages of a severe economic and credit contraction not seen in this country since the Great Depression of the 1930’s. The job loss of 84,000 in August would have been much worse but the seasonal adjustment (Birth/death model) added 125,000 phantom workers. As usual in a downturn, all previous months job numbers continue to be revised downward with July jobs being reduced by 9,000 and June 49,000. Considering that the US population grows every month these job losses sent the unemployment rate up to 6.1%. A staggering 2.262 million workers were employed in July but unemployed in August, and that is the largest one month change since January 1994. The recent extension of unemployment insurance benefits did have a small impact on the growth of the potential workforce but it is clear that we are headed for much higher levels of unemployment over the next 1.5 years. The only category to show job growth last month (+17M) is the one that should show the most growth in the new year…government payrolls. Temporary jobs fell by 37,000 as employers see no signs of a pick up in consumer spending. In the past twelve months the US has seen 662,000 jobs disappear and this is after a seasonal adjustment of +876,000 so the real loss has been over 1.5 million. With the Presidential election only two months away I doubt we will see a second stimulus package until next year when it will be painfully obvious to the new legislature that this is no ordinary economic contraction that can be solved with lower interest rates. Since we only see life from our own experiences we have become accustomed to the Fed reducing short term interest rates to a level that stimulated loan demand and banks responding with a generous amount of credit. When was the last time you saw the Fed ease but banks tightened their lending criteria? You haven’t unless you were around in the early 30’s and that is the problem! If we were alive during that time period we would know how to react, but since we weren’t we continue to act as if this period is a repeat of the 70’s, 80’s and 90’s and it isn’t even close. Banks are so desperate for capital (you can’t lend what you don’t have) that they are now offering to pay customers who close their existing credit lines.

Deflation, Deflation, Deflation

Most people have never experienced deflation (lower prices) although many homeowners have painfully learned this year that house prices can and do fall. Deflation of asset prices has also been felt this year in stocks and most recently commodity prices with oil having declined over 25%. Mortgage lenders are suffering from deflation as the value of their mortgages decline (yes, they are an asset to a lender) and workers are learning of deflation with Thursday’s announcement that unit labor costs fell 0.5% in the 2nd quarter of this year. Luckily these labor costs have risen 0.6% in the past 12 months but with continued productivity gains could easily go negative next quarter. The economic world has definitely changed but the BIG question is: Have you changed how you see the future? Probably not, as we are so conditioned to expect rising prices from our investments, especially our home. The key to the next few years is to pay off debt, increase cash reserves and understand that 99.99% of people will not seeing the change in the economy because it is too scary for them to integrate into their system. Fear creates uncertainty and we need to believe everything will be ok. A year ago residential real estate agents told us that houses were cheaper than the year before so it was a great time to buy. This year they are cheaper again so its another great time to buy. How can they be objective? They only earn a commission from selling you a property. Money managers continue to buy shares in Fannie and Freddie despite massive losses and violate the cardinal rule of investing: never add to a losing position. Do they really believe the twins will survive? Probably, because they know that if they take their losses now they will be out of a job. They freeze, unable to make rational and common sense decisions and most importantly lose any sense of objectivity. The most important recommendation for readers is you MUST surround yourself with advisors that are not afraid to change and have past experiences that will allow them to see that the future is not always a repeat of the recent past. Asking your advisor about their biggest mistakes and how they overcame them is a good start and if the answer is everything has always been rosey, head to the exit door quickly before it is too late.

The Dollar and the British Pound

On January 8th I listed three best bets for 2008 and one was that the British Pound would fall from 1.95 to 1.80 later in the year. Early this week the pound crossed under the 1.80 level giving us a home run on that call. For those following I would exit the position and enjoy the profits from a currency that is clearly reflecting the weak economy in England. I expect the Bank of England to lower overnight interest rates in the next few months giving tremendous profit potential to those who bet on a widening UK yield curve.

US interest rates

This has been a year where profits accrued to those that did not follow the experts in their forecasts of higher long term interest rates due to rising inflation. We did see higher CPI numbers in the summer but inflation is always a last part of an economic cycle and this time is no exception. The US 10 year’s fall to the 3.60% has been a direct result of lowered inflationary expectations with the inflation component of the 10 year recently breaking below the “key” 2.00% level. I’m not sure if we can stay below this level for long but it has anchored the 10 year far below the experts forecasts of 4.00%+ for the remainder of the year. The problem for the Fed is that it MUST find a way to increase the spread between short and long term interest rates so that banks have a chance to build their badly depleted capital bases. This will take time and can be accomplished through higher long term rates (doubtful) or lower short term rates (probable). The call for a wider US yield curve was our second best bet for 2008 and this train has not left the station yet for those that want to ride on what offers tremendous profit opportunity.

Is Texas one of the 50 states?

This week’s release of the Fed’s Beige Book showed the growing weakness around the country with the exception of Texas where employment is growing and the unemployment rate remains near a record low. Abundant natural resources (oil) and growing job opportunities are creating a haven for workers around the country as they seek a new destination. Multi-family buildings remain a viable investment as Fannie and Freddie continue to offer financing at very low rates. There are very few bull markets left in the US but Texas clearly stands out as one state that is suffering the least from the declining US economy.

The home stretch

With less than four months remaining in the year and a new president about to be elected the US economy has seen much better years. The federal government will be forced to react swiftly and boldly next year especially in the area of credit and the economy can NOT grow without an expansion of credit. Unfortunately for many in the real estate area things will never be the same and the vast majority will leave next year for jobs with less pay but more stability. The willingness to change is hard especially for those that did so well financially in the past few years. But the economy will recover (slowly) and prices will stabilize (but not rise) as investors learn the most painful lesson of their lifetime: history does repeat but not when you expect it!