The green flag is flying

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After a long absence, my neutral stance on long-term interest rates has changed to one where I expect lower rates for the remainder of this year. For the past six months I have emphasized the fact that long-term rates have risen 75% of the time in the first six months of each year. Going back 43 years readers can see how consistent this pattern has been with most of the rate peaks occurring in June of each year. This year’s top for the 10-year Treasury note was on June 10th at 3.94% with peaks in 2008 (6/16), 2007 (6/12), 2006 (6/28)and 2004 (6/14).  Each of these dates saw maximum bearishness with fears of rising inflation and/or a strong economic rebound. It’s hard not to get caught up with the crowds and experts who at the time were predicting much higher rates but each year investor memories are short and they again believe rates are headed higher only to realize in the second half of the year that they are wrong yet again.

The calendar is only one part of the puzzle when analyzing long-term interest rates. Future inflation expectations peaked on June 18th at 1.91% as these same experts were warning of higher inflation as a result of excess money growth. The Fed has increased its balance sheet by over $1 trillion in the last 18 months but the excess money has NOT gone into the economy in the form of new credit but has been sent back to the Fed by banks afraid to lend or invest. Since we only see the future from our past experiences and banks are busy trying to unwind the problem loans made in the past 5 years is it any wonder why they are reluctant to extend credit until they are 100% sure the economy is no longer contracting?

Capacity utilization is at record lows and isn’t inflation caused by demand exceeding available supply? If companies are operating at a reduced size compared to a couple of years ago and struggling to make a profit or stay in business it’s more likely they are lowering prices in an attempt to buy market share from their competitors.

The most compelling case for lower long-term rates and DEFLATION comes from the Fed’s weekly H.8 report that is released every Friday at 1:15pm (PST). Today’s report should have all readers concerned as the total amount of bank credit FELL $59 billion last week and has declined $83 billion in the past two weeks. Commercial and Industrial loans are now at a lower level than a year ago and consumer credit card debt is also falling at an accelerated pace. If the banks aren’t loaning the $$$ the Fed is giving them where is it going? Last week bank holdings of Treasury and government agency securities ROSE $55 billion! The Fed is buying billions of Treasuries and mortgage securities every week hoping banks sell these securities and use the proceeds for loans to businesses and consumers but the exact opposite is occurring. The banks are sending most of the $$$ back to the Fed for safekeeping and using the remainder to buy MORE government notes and bonds. I have warned for the past year that once a credit contraction begins it is very hard to stop because fear feeds on itself and it takes two to complete a loan. Borrowers must believe the asset they are purchasing on leverage will increase in price. Lenders need stable collateral and if the value continues to decline they will be forced to ask the borrower for additional funds and that is not what either party wants at any point of the transaction.

Even though everyone appears to fear rising inflation the Fed is desperately trying to create a minimal amount of inflation by pushing as much money into the economy as possible. Creating money is NOT inflationary if it comes back to the source of creation and is not used, lent or spent. Investors are interpreting the three month stock market rally as a sign that the economy has hit bottom and that business will soon return to what we saw a few years ago. Unfortunately most people see the world as they need it to be not as it is and there is less than a 1% chance we will rebound back to the boom times we saw in real estate and other industries. The stock market rally is a result of overshooting on the downside with valuations that were only accurate if the Fed and Treasury had not injected billions to save everything that was “too big to fail.”

The patient remains on life support and will remain in that condition for at least the next four years. After this year we will see some positive economic numbers (GDP) and the unemployment rate will plateau because of massive government programs that will create thousands of jobs. One of the characteristics of a true bear market is that it lasts longer than anyone expects and doesn’t end until most have left the arena in search of safer destinations and we are not even close to that point. Most are hanging on hoping that the economy/real estate will bounce back because that is what they need not what is going to happen.

The U.S. economy will NOT rebound until risk taking is encouraged by the federal government and tax programs are initiated that will create confidence that the returns from the risk will be tolerated by Congress. It is common knowledge that large profits are discouraged and that we are in a survival mode. Foreign investors are flocking to the U.S. dollar and Treasuries more because we offer safety than a high return. The U.S. savings rate continues to climb as consumers realize their ability to find credit is close to impossible and spending is limited to essentials only. The fear that foreigners won’t finance our deficit is growing but the increase in savings is being funneled to Treasuries that offer a higher rate than inflation.

The only reason the dollar hasn’t been crushed is because other countries are printing their currency faster than the U.S. but when that ends (and it will) the Fed and Treasury will have a new problem when it has to decide what is more important: defending the dollar or fighting DEFLATION. Gold is a great long-term investment if purchased into periods of weakness as it should cross the $1000 barrier this fall. Gold is not always an inflation hedge and will attract demand this summer from those wishing to buy an insurance policy against the continued credit contraction.

For those that can qualify for a mortgage the second half of the year will offer an excellent opportunity to refinance your house or building but the values will continue to decline after a small bounce in values during the summer months. The media continues to tell us we are close to a bottom for the economy but in reality it is a cliff that will break next year and lead to a lower level. Too many have lost much of their net worth in the past 2 years because it is easier to lose in the company of others than win alone but when this stressful period in history finally ends these same people will have learned a painful lesson that the true winners always use stop losses because you never know when you are going to be wrong. It’s ok to lose $$$ on an investment but not exiting after a small loss is a mistake that takes many years to correct.  I am amazed at the stories I hear every week from investors that lost big $$ last year but their advisors are telling them they outperformed the market with a smaller loss.  Absolute performance is the only way to be judged because you can’t buy a meal or pay the rent on relative performance.

Notes from my scorecard

Only 2 days until my webinar where I will present my interest rate forecast for the remainder of the year and specific investment strategies that will offer high reward /low risk opportunities in the next 90 days. The webinar will be held on Wednesday, June 17th at 6pm (PST) and the cost is only a $200 donation to Food on Foot. Sit in the comfort of your home or office and hear my thoughts on why interest rates are near their peak for the year. There will be plenty of time to ask questions after the presentation.
To register please visit: http://www.earlywarningwire.com/pdf/interestratewebinar2009.pdf

Long-term interest rates

I have been warning readers to expect an increase in rates during May & June and that is exactly what has occurred for the 4th consecutive year and 8 out of the last 11 years. Talk of higher inflation and Fed tightening has driven rates higher since the Fed’s announcement of quantitative easing on March 18th. The 10-year Treasury has risen almost 118 basis points (2.53 – 3.71) while inflation expectations have risen to almost 2% from the expected deflation just 3 months ago.

Can inflation expectations change that dramatically in such a short period of time? Is it a sure thing that Fed printing of money will create runaway inflation? Is the market always right about the future of the Fed and inflation?

These are three important questions that require a history lesson because most forget the past except for extremely painful experiences that tend to direct our future decisions. Inflation expectations have been rising because participants are focused on the late 1970’s – early 1980’s period when money supply growth was accelerating and borrowers were using the money to buy assets they felt would continue to rise in price. This year the Fed has printed hundreds of billions of dollars that have been used to buy Treasury and agency mortgage backed securities. Investor fears come from the eventual placement of that money but for now most of it rests in bank vaults or at the Fed for safekeeping. Crowding out is a term often used today to signify fear that the increase in Treasury debt will raise the cost of borrowing for corporate and non-government borrowers. It is true that government bond, note and bill sales have increased to an annual rate of almost $1.5 billion BUT the rate of issuance for non-government debt has fallen $2 billion with the net effect of less overall debt coming to the market. Outstanding debt has actually FALLEN by over $500 billion in the last year and that is NOT inflationary. Credit continues to contract weekly according to the Fed’s H.8 report and those betting on higher rates will be disappointed for a fourth year in a row when the market realizes that inflation is not created by the creation of money but an increase in its velocity.

Short-term interest rates

The Fed controls the overnight borrowing rate currently at 0.00-0.25% and recent market action seems to imply an expectation of tightening before the end of the year. Do you remember last summer when oil at $140 had traders and investors forecasting an imminent Fed hike in the overnight rate to fight the oncoming inflation? Do you remember 2007 when rates rose in May & June and the consensus was the Fed would need to tighten because the house problem was limited to “sub-prime” and the economy would soon begin another rebound? Do you remember 2006 when rates rose until the end of June as market participants were worried about Bernanke’s credibility and ability to lead the Fed? How quickly we forget these events unless they caused so much financial pain that we are forced to remember. Many short-term interest rate markets (Libor, etc.) have declined because of massive intervention by the Fed and other central banks. If this support is removed spreads would widen immediately causing stress in the financial system. The Fed is desperately attempting to keep rates low to give the consumer, homeowner and business a chance to accumulate savings and/or pay down debt. If the Fed raised short-term rates they would be removing the support the economy needs to have any chance of recovery in the next four years. Bernanke has shown phenomenal patience with markets and experts that have doubted him for the past three years and yet without his knowledge of history and excellent navigation skills the U.S. economy would be in far worse shape than it is today. The stock market’s recent advance is more due to the fact that the economy is not falling as fast as it was in March than to any chance of an end to the longest recession since the 1930’s.

The truck is in the loading zone

Once, twice maybe three times a year we find an extraordinary opportunity which we label “back up the truck.” Last year the EWW’s top pick was a short of the British Pound, a widening in the slope of the yield curve and the beginning of the worst crash in history for commercial real estate. It was a clean sweep as we hit a trifecta with all three landing in the winners circle before the end of the year.

2009 has required patience as the risk/reward has not been outstanding but that is about to change as our first opportunity is in the on-deck circle ready to enter the investment game in a couple of weeks. The 2-year Treasury note recently popped 40 basis points on June 5th after the jobs report showed the U.S. losing fewer jobs than was expected by the “experts” whose batting average wouldn’t qualify for a minor league contract if not for the fact that no one forces them to be accountable with an official scorecard. Last week with everyone worried about Treasury auctions the 2-year rose to 1.40% but has now fallen back to 1.22%. The shorts (betting on higher rates) were so heavy last week that the borrowing rate against the 2-year was negative giving borrowers a unique opportunity to be paid interest on their borrowing. The next 2-year auction will be held on Tuesday, June 23rd and should offer a “back up the truck” opportunity for both cash and leveraged players especially if the rate is above 1.30%. Readers should contact their investment brokers and make sure their accounts are set up for a leveraged trade using the overnight borrowing (repo) that was MINUS 0.15% today. The lender of the money is paying the borrower of the money using the 2-year Treasury as collateral. If you need a referral to an experience professional send an e-mail.  For specific timing I will alert subscribers of my daily update.

I look forward to speaking to many of you at Wednesday’s webinar.

TRUST – the missing part of the economic recovery

June 10th class in Los Angeles at 6pm

June 17th webinar from 6-8pm (same material)

My daily update gave readers notice of a stronger Aussie dollar and gold earlier this year. The cost is only $1 a night and is must reading if you want to make sure your net worth grows every year (including 2008).

The most important word for this year is TRUST and the lack of it in decision making by investors, consumers, business owners, borrowers and lenders. At http://www.dictionary.com the definition is listed as “confident expectation of something, hope” and that is not a current condition for any of the above categories with the exception of short-term stock market traders. In the past five years consumer confidence surveys bolstered the views of many giving them the courage to continue borrowing for the purchase of assets. Prices continued to rise confirming to investors that they had made the right decision and that created more buying on leverage. Unfortunately these consumer surveys done by the University of Michigan and the Conference Board are a relection of recent stock market activity and don’t show the long-term confidence needed to make major decisions. Up until recently following these surveys was profitable because asset prices continued to rise annually but the sea change of the past 19 months is one everyone must adapt to or risk a continuing decline of their net worth.

TRUST encouraged the homeowner to borrow against their residence “knowing” the price would continue to rise allowing them to refinance their credit card balances into mortgage debt at lower interest rates. TRUST that the past would repeat pushed stock investors to not use stop losses and blindly follow investment managers that believed stock prices would never fall as much as they did last year. The result is that most investors no longer TRUST themselves to make a decision about investment managers ability to make them money and are now sitting in cash on the sidelines not sure when they will ever move back into the stock market. (Higher prices?) TRUST in always bullish real estate agents and mortgage brokers that can’t ever be objective about the direction of home prices helped create the meltdown that has caused so many to lose their residences. The never ending belief that real estate prices must rise again has many blindly buying homes with FHA loans that allow buyers to use a small down payment hoping that prices have hit bottom knowing if they don’t the government will step in and modify their loan. Of course they could also walk away without much loss of capital. Business owners TRUSTED that banks would be willing to lend for inventory or new equipment to expand but are now afraid they will be turned down because banks are afraid they won’t be repaid. Consumers for years TRUSTED they could purchase whatever they needed or desired knowing their credit card limit could be increased if needed or a new card acquired. We all remember the stories of pets receiving unsolicited credit card applications. TRUST that banks would lend, the government would not increase regulation, that prices would rise over time due to inflation and that we would always have a job to make monthly credit card, mortgage or insurance payments allowed the U.S. economy to grow for decades. Cycles were welcomed and accepted as a cost of doing business but knowing that a short period of time would heal all financial wounds.

The past two years have NOT been part of a regular cycle in a normal growth period for the U.S. We have witnessed a secular or long-term change that will take a decade or more to resolve due to the fact that we no longer TRUST our ability to make key financial decisions and that markets (stocks, real estate, businesses, etc.) no longer operate like they did over the past 30 years. Since we only see the future from our own past experiences the longer the recession lasts the more it will inhibit risk taking by investors, consumers and businesses. Risk taking will be essential for the U.S. economy to rebound and that only occurs when perceived return is great enough to warrant the risk involved in the investment. When TRUST goes down it takes risk taking with it and that almost always creates lack luster growth at best for the economy. I have written for over a year that the U.S. economy and markets are not binary, if they are not falling it does not mean they are rising, they can be flat or in a tight trading range for many years. I anticipate a very shallow bounce back in the economy in the fall but more from a lessening of the rate of decline than actual growth. Stock investors have been celebrating the past 75 days because the end of world scenarios present in March have been replaced with “green shoots” that have the potential to grow in the next 12 months but it comes with a great cost. The only $$$ entering the economy is from the U.S. government and NOT from risk taking business investment. The patient is breathing only because of intervention by the government and if taken away would be back in the ICU. The business media is focused on a return to the past but that is almost impossible even if the government, Fed and Treasury increase their intervention and assistance to markets. TRUST is lacking and will take years to rebound but society is impatient and not ready to adjust their lifestyles but will be forced to in the next two years.

Consumer Credit

Today’s Consumer credit report showed a massive decline of $15.7 billion for April with credit card debt falling by $8.6 billion. Credit is contracting not because consumers are paying down debt from a surplus of funds but because lenders are cutting credit lines because they don’t TRUST that consumers will be able to pay back new debt. If consumers know they have less credit they are reluctant to spend except for emergencies. Banks have increased their cash holdings at the Fed by over $650 billion in the last year because their TRUST is so low that the Fed is the only place they feel safe with their $$$. It’s a circle of FEAR that can only be broken with lots of time (years) and patience, not one of the strengths of most Americans who always want it now or yesterday. A lack of TRUST has caused the savings rate to rise to a 14 year high of 5.7% and I expect it to rise to the 10%+ level last seen in the early 1980’s.

Employment

This morning’s jobs report appears to show a slowing in job losses in May BUT the government birth/death model (seasonal adjustment) added 220,000 phantom jobs based on previous May job growth which has nothing to do with today’s economy. Many people continue to leave the work force as they become discouraged about the prospect of finding work and 174,000 last month accepted part time work because they can’t find full time jobs. This “real” unemployment rate rose again last month as is now above 16%. The employment to population ratio continues to decline with less people working and more people entering the work force (college graduates, etc.).  The most disturbing part of the report was average weekly hours which fell 0.1 hours and the fall of 0.2% in average weekly earnings. Employers are cutting hours from workers instead of laying them off thus cutting earnings instead of overall employment. If businesses had fired workers instead of cutting hours or pay it would have added 400,000 to the unemployment numbers for May. If the stock market had declined the last two months everyone would interpret today’s news as bearish but because the market has rallied it has taken on a bullish spin. History has shown the stock market frequently discounts events that never occur and the strength being anticipated by stock investors may be disappointing and cause selling later this summer.

Interest rates

As anticipated by the EWW long-term interest rates have risen in May and June as expectations for runaway inflation increase almost daily in the marketplace. A excess of capacity and the fact that $$$ being printed by the Fed is NOT going into the economy but back to the Fed makes it unlikely that we will witness a resurgence in inflation in the next year. If oil and commodity prices continue to increase it will have a devastating effect on consumer spending patterns and return us to the events of last summer when oil prices forced consumers to curtail driving and spend less on other non-essential items. The 10-year Treasury rate rose today to 3.83% with the inflation component at 1.99%. The 2-year rose to 1.29% on fears of an imminent Fed increase in the overnight Fed Funds rate and offers tremendous opportunity for risk averse investors. Do you remember last June when the “experts” told us that the Fed would not ease again and the problems in the mortgage market would be resolved soon? Rates peaked on June 16, 2008 and June 12th, 2007 and June 28th, 2006 and have fallen in the 2nd half of the past 7 out of 10 years.

Summary

Even though the stock market has rallied over 35% in the past two months from a deeply oversold condition today’s news only confirms we are declining at a lesser rate than the market was expecting two months ago. We remain in the early stages of a decade that will be remembered for its slow to no growth due to a lack of risk taking and availability of credit. The patient is alive and breathing but it will be years before it is healthy enough to return to its energetic levels of the early 2000’s.

I look forward to seeing readers at Wednesday’s (6/10) class.

For those not located in Los Angeles my webinar on June 17th.