Monday, June 29, 2009

Who Blinked First?

Among the games we played as children one was to see who could go the longest without blinking. Usually if you blinked first or flinched, there was a derogatory name that you were called because you lost. Wimp, dufus or stupid were some of the names I recall. Today I think it strange that no matter what game you played, the losing names were the same. What does this childhood game have to do with the market?

We have been in the midst of a showdown (Chicken or Who blinks first) between the bond traders and the Chairman of the Federal Reserve, Mr. Bernanke. The battle has been over the yield on the ten year T Bond. The traders think it should be over 4% and the Chairman wants it as low as it can be to try and save the housing market and in turn the economy. As I said in the last posting , watch two things - housing and employment for the recovery. I think these are the two things that are most important to the Fed. They watched the yield on the 10-year bond stretch for 4% and they saw mortgage rates spike. The spike in mortgage interest rates dropped a lot of buyers out of the market so mortgage applications fell rapidly.

For the last month interest rates outside of short-term, less than a year, have been rising. The bond traders are concerned about the impact on inflation as a result of all the money the Fed is putting in circulation. Because they were concerned about future inflation they demanded higher interest rates to compensate for the potential of inflation down the road. As news came out indicating the recovery might not get fully underway till 2011 and that recovery might be very anemic, the concerns about inflation were replaced by concerns about deflation.

The world and the United States are awash in excess capacity. When you have so much excess capacity, it is very hard to increase prices. Because of this excess, prices are still coming down and my current thinking is that prices will continue to fall for the balance of this year. For the first time in many generations, Americans are becoming savers and price sensitive. When we had oil prices at $4 a gallon we said the demand destruction drove down the price of gas and in turn the price of crude oil. The recent run to $70 a barrel for crude oil and the commensurate increase in the price of gas will create demand destruction, but at a much lower price level. The run up in crude oil was an anticipation of an economic recovery around the world. Today that recovery seem less certain and less likely to be robust. Watch the price of crude oil for it may well fall below $50.

With a decline in crude you will see renewed strength in the dollar against all major currencies. A strengthened dollar will increase the demand for US Government bills, notes and bonds. We are already seeing that shift just slightly with the significant amount of buyers in the Treasury auctions this week. The yield on the 10-year bonds was 3.50% on June 29, 2009. If we see a decline in oil to $50 a barrel, I would expect to see the yield on the 10-year bond close to 3%. So who blinked first? I think the bond traders forgot one very important fundamental, never fight the Fed. If you try and fight the Fed you will almost always lose and may not be able to come back again and play the game.

Dan Perkins

Sunday, June 7, 2009

Is the wicked witch dead?

The unemployment number that came out Friday was so far off the charts that one would think it came from “OZ” or “Never Land”. For the first time in five months, the market failed to rally on the unemployment data. Why? The talking heads have declared that the recession is over, in fact, one talking head said that it ended Friday. He made his projection that the recession was over on Friday based on data that was one month old. So, did the recession end on Friday, June 5 or Friday, May 1?

I said in my last Blog that you need to follow two things about the recovery in the economy, employment and housing. Just to re-iterate, employment means new jobs being created and housing means new and old homes are being sold to the plus side. So far this year we have lost in excess of 2 million jobs in the United States. The unemployment rate stands at least 9.4% and is at the highest level since 1983.

I was speaking to a client over this past weekend and we talked about how misleading the talking heads are to the public. The Chairman of the Fed testified this past week before congress and he felt the rate of the decline in the economy was slowing-- he did not believe that unemployment has peaked nor are we over the hump in housing. I also mentioned in my last Blog that it would be difficult for the President to get housing moving anytime soon if interest rates continue to rise on longer dated maturities. On Friday FNMA 30-year conforming home loan had a rate of 5.29%.

The chart above shows a major reversal in mortgage interest rates over the last month. Starting later this year and continuing into 2010 we have billions of dollars of adjustable rate mortgages that will come up for rate resets. Homeowners will find it difficult to refinance their loans if interest rates continue to go higher. If I am right and unemployment continues to increase, we will see more and more mortgage defaults bring more and more supply on the markets.

I truly believe that interest rates on the long end of the yield curve are too high considering the no growth and high unemployment in the economy. I do think there is a battle currently going on between the Fed and the bond traders for control of the fixed income markets. The bond traders, for now have the upper hand, have moved up yields because they want the Fed to step in and buy more bonds. If the Fed becomes more aggressive in buying more bonds then the prices for bonds will rise and the bond traders will make a great deal of money when they sell their bonds to the Fed at higher prices than they paid.

Many of us have seen the movie “The Wizard of OZ” and at the end, Dorothy kills the wicked witch by accidentally spilling water on her. I’m melting” the witch says as she disappears. Today we have a play on Broadway called “Wicked”. It also is about Oz yet it has a different ending. I think the outcome on the direction of the American economy is not, as the munchkins say, the witch is dead everything is great and good, however the recession is more like the ending of “Wicked”, you haven't seen the last of me.

Dan Perkins