2008 begins weak but should end strong

January 14, 2008


Our publishing schedule for 2008 has been changed to each Monday at 5pm. The daily e-mail will continue to be sent Sunday through Thursday evening at 10pm and covers issues that are important for those with a shorter time frame. For subscription details … I will be teaching four interest rate classes this year with dates in February, May, September and November. Each class will be held from 6pm-9pm. Details in next weeks EWW.

Last week the EWW announced its 2008 forecast and our #1 surprise for the year was that the spread between the 2-year and 10-year Treasury would increase due to Fed easing. One week ago this spread was 208 basis points and now stands at 222 bp as the widening trend accelerated due to the market’s realization that the Fed is behind the curve and will lower the overnight rate many times before the end of this credit cycle. The key word is “realization” as markets move in three distinct phases of anticipation, realization and then reaction. The anticipation stage can be the most frustrating for investors as the time frame usually requires extreme patience as one waits for what appears to be obvious to begin…..much like what we experienced in 2007. The EWW warned readers in late 2006 and early 2007 that we were headed for a severe economic contraction. When the “experts” were telling everyone that it was just a sub-prime problem we stood our ground and now many months later see the realization phase of the cycle beginning with the jobs report that was released 10 days ago. The unemployment rate rising to 5.0% sent most eternal optimists seeking shelter and investors running for the crowded stock market exit door. The realization stage will not end quickly as many more months of sour economic statistics will confirm what we knew last year, a recession has begun and won’t end soon. Finally we will see the reaction stage where frustration increases and many begin to believe that the economy will never recover. We are nowhere near that final phase when markets begin to discount the future and not react negatively to bad economic news. So get comfortable as it is going to be a very long and bumpy ride with very few arriving in one piece at the station.

California’s fall picks up speed

The State Controller’s office this afternoon announced tax collections for December dropped dramatically led by a fall in corporate income taxes. Sales tax collections were $40 million lower than a year ago and corporate taxes were $649 million lower than December 2006. Overall tax receipts were $545 million lower than the most recent budget estimate and that will send the governor and legislature into a panic over much needed but politically painful spending cuts. The good news is the realization phase of the cycle almost prohibits a legislature from raising taxes as they attempt to find a way to stimulate consumer spending.

The $417,000 debate

Mortgage brokers, real estate agents and homeowners will want to read today’s report from OFHEO (Federal Housing Authority) which argues against raising the conforming limit ($417,000) for one year. The report does acknowledge the wide spread between conforming and jumbo loans but only discusses the risks to Freddie and Fannie Mae instead of the benefits to the economy. I wouldn’t expect anything else from a government agency but because it’s an election year I expect Congress to step up and raise the limit to 1MM for at least six months. The day this occurs there will a BIG party held by those in the real estate business.

The Fed head visits Congress

Mr. Bernanke will testify before the House Budget Committee on Thursday, January 17th at 7am. The Fed has spent the year catching up to the interest rate market and Big Ben must show the world financial markets that the Fed will use its most powerful tool (Fed Funds rate) to attempt to offset the credit contraction that begin just over six months ago. The next FOMC meeting on January 30th should produce a 50 basis point decline in the overnight rate (currently 4.25%) and the Fed will continue the easing until we drop to at least 3.0%. It is important to note that the three month Libor rate closed at 4.06% rate today and that is 19 basis points lower than the current Funds rate. Of course the Libor market is discounting the next Fed move but that would leave Libor only 31bp above a 3.75% overnight rate which is down considerably from what we saw in December. The Fed’s TAF (Temporary auction facility) has worked well to lower the Libor/Funds spread as they have sold T-bills and replaced them with bank borrowings in their own Fed portfolio.

Inflation, retail sales and housing

The next four days will produce much economic news beginning with tomorrow’s wholesale inflation and retail sales reports. Wednesday we will see retail inflation and Thursday housing starts and building permits. The news is important but the markets are so far ahead of the news that it will produce relief that there are no surprises. With massive monthly revisions from most government news reports (jobs, etc.) the markets have become their own barometers of economic weakness. The stock market’s decline is clearly overdone and the financial sector has discounted more than will actually occur in the next few months. Watch for rallies on bad news for a sign that the worst is over for now. Tomorrow Citibank is expected to announce massive job cuts, losses in mortgage securities and a dividend cut. This is not an investment newsletter and is not a recommendation but one has to wonder if the news occurs as expected will there will be anyone left to sell???

Summary

Today the 10-year T-Note reached a new low of 3.77% but appears to need a rest before making the next move lower (later this year) towards the low 3% range. The markets have done an excellent job of discounting the bad economic news that we have seen in the first two weeks of this year. The realization phase has begun and for many who boarded the train early it may be time to take a few profits and wait for the next train on this long economic journey.

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.