Now That The Govt Has Kicked The Can Down The Road Again, What Can We Expect?

Now that Senate Majority Leader Harry Reid and House Speaker John Boehner have decided to agree to disagree Congress will apparently move forward and approve the bill extending the debt limit and opening the government back up for business. The outcome of these now ritualistic events are the worst kept secret since Luke discovered who his father was. It's Darth Vader, if you didn't know. This is how our government functions (or does not function, depending on your perspective) now. The rancor has reached epic proportions, when you consider the seriousness of the impact if the parties involved were actually serious about anything. Would either party let the US Government not only shutdown but more importantly default on it's worldwide obligations? It really is hard to fathom despite our lowly opinion of the folks that we elected to legislate on our behalf.

How Did They Agree To Disagree?

They really did not agree on much. The agreement is all of a continuing resolution to keep things status quo until December when we will revisit this all over again. The debt limit has been extended until February 7, 2014 at which time it will need to be extended again. So this is really more can kicking than agreeing.

Whither The Markets?

Despite general annoyance at what goes on in Washington DC most folks only care about the impact any of these machinations have on the bond and equity markets,  both of which impact their wallets. Equities will rally, at least initially. It is important to point out that equity markets never really faltered throughout this ordeal and are nearly as high as they've ever been and in the case of the small cap Russell 2000, they are at record highs. So where do we realistically go from these levels? Most likely higher. Markets don't tend to change trend until they do and until then they generally continue to follow suit. "It's a bull market until it isn't." This is a popular market refrain. As long as the Fed continues to inject it's stimulus in to the market through it's quantitative easing the market should continue to see gains. When the stimulus ends the market gains will end. Until then, pour another drink.

The bond market is a different animal than the equity markets. It is the "rational" of the two. Whereas the equity markets tend to be more emotion driven, the bond market takes a more sober tack. Given the Fed's QE (quantitative easing) it is not likely that yields can or will climb too high. Again, once the tapering does begin, yields probably will climb. However, unless the Fed increases the stimulus it is unlikely yields and therefore mortgage rates will fall back to their historic lows. If you procrastinated on that refinance four months ago, might be wise to get up on in there and get it done. It will probably take something none of us want to see for the Fed to start injecting that much additional stimulus.

What Have We Learned From All Of This?

Well, it's safe to say that the markets have learned to almost completely disregard what goes on in Washington except when it pertains to stimulus. The absence of any significant sell off in either market reflects this disregard. It's mostly the media that makes any kind of hullaballoo about the goings on in the nation's capital. With a couple months respite from thinking about budgets and debt limits consumers can go back to the malls, the analysts and money managers can go back to trying to figure them out and the media can pick up on the next big story, maybe Syria makes it's way back on to the front page.

Should The Fed Have Tapered?

At the last Fed meeting on Wednesday, September 18, the Fed elected to bypass the widely anticipated beginning of tapering its historical stimulus package. Following its decision to forego some sort of tapering, there was much consternation and hand wringing regarding the confusion the Fed created by not following the script the market had laid down for the Fed to follow. Apparently the Fed did not get the memo that it is supposed to do exactly what the majority on the Street anticipate. Many market participants claimed that the Fed misled them with its intentions and caught them off guard. Many are claiming that instead of creating more transparency with its post meeting briefings it is creating more confusion by being too open about their intentions. How exactly does that work? Many of these comments are laced with a certain amount of bitterness from being caught off guard by the Feds inaction.

Did The Fed Mislead The Street?

Leading up to the meeting it did seem that the Fed had indicated from its earlier meeting in June that it would indeed consider scaling back some of its stimulus possibly as early as its next meeting. Thus began the street's incessant forecasting of the timing and amount of the impending first taper. To go back and read the notes from the Fed meeting in June there is no specific reference to either the timing or amount of any such taper. So the Street created its own details of the initial taper and that became gospel to all of the financial news outlets including CNBC and Fox News. These two news outlets ran daily commentaries about the prospective tapering and therefore reinforced the notion of a taper at the September meeting and between $10 and $15 billion as the initial reduction of stimulus. Where did the Street get these amounts from? They are not written down anywhere in the Fed's minutes. The Street jumped to conclusions on tapering, placed trades accordingly, got it wrong and the trades went against them, and now it's upset. Perhaps the Street will learn a valuable lesson from this latest episode. Not to front run a Fed that is not sure itself what it is going to do from meeting to meeting.

Did The Fed Miss An Opportunity?

The question remains, did the Fed miss an opportunity to begin tapering? Most economists that have been interviewed believe that some sort of tapering is warranted as the benefits of stimulus have less apparent impact on the real economy and only serve to drive up values of risk assets. This is an interesting question. The logic for tapering at the September meeting was that the Street had presumably priced in a reduction of stimulus and markets would not be adversely affected. A side benefit was that the Street would interpret tapering as a vote of confidence by the Fed on the state of the economy. After the initial rally in markets, particularly equity markets, markets have since sold off. Hindsight is 20/20 and it is very difficult to say how the Street would have handled an actual taper and not the idea of a taper. It is fair to say however that given the markets behavior since the "non taper" it is hard to imagine the market behaving any worse. The Fed has indicated that it is leaving the door open to any and all options regarding its stimulus package. After reviewing the latest data it has determined that tapering back was not warranted. With this in mind it is hard to justify the Fed tapering at this time.

Are Historically Low Mortgage Rates Gone for Good?

First of all I would like to acknowledge those that lost their lives on September 11, 2001 and the loved ones they left behind.

Since July of this year as the 10-year treasury yield has climbed mortgage rates have followed suit. As mortgage rates are a function of the 10-year treasury yield, when treasury bonds sell off and their yield climbs mortgage rates typically climb as well. To contemplate why mortgage rates might come down in the future it is important to understand why they have moved higher in the present.

Why Have Treasury Bonds Sold Off?

Although the Federal Reserve controls short term interest rates it has little direct control over long term interest rates. The Federal Reserve raises and lowers the Federal Funds rate, the rate that banks lend to each other for overnight loans. Long term rates are a function of those short term rates plus a "premium" for tying funds up over a longer period. The plot of interest rates over time is known as the yield curve. The "normal" yield curve is upward sloping with long term interest rates higher than the short term rates. This curve reflects a healthy economy where future economic prospects are good and higher long term rates reflect the markets belief that the Fed will raise rates to control prospective inflation. However, on occasion the yield curve becomes inverted where short term rates are higher than long term rates. This yield curve typically indicates a weaker economy as economic prospects are dim. Current economic data points to an improving economy. Money managers and analysts suggest this as the reason long term interest rates are climbing. This may be one reason but it may not tell the whole story.

The speed at which rates have gone up suggests a stronger reason for the rise. The debate between popular analysts on TV whether rates can stay low for much longer is a reflection of money managers shifting funds away from fixed income to other asset classes, in many cases equities. As bonds are sold their yields rise. Bond price and yield have an inverse relationship. The opposite is also true. If bonds are purchased their price rises and their yields fall. So what would cause the sentiment among money managers and the general investing public to change regarding the outlook for bonds? If the economic outlook for the US and global economy were to deteriorate money managers will seek the safety of treasury bonds.

So What Direction Are Rates Likely To Go?

Depending on your outlook for the economy, you will either believe rates will stay elevated and keep rising or will fall back down to their historic lows. Most analysts suggest that rates are capped and will not rise much further and going forward may even fall back. The logic behind the cap is the historical spread between the Federal Funds rate and the 10-year treasury, which has never exceeded 400 basis points or 4.0%. Given the tepid economic growth both in the US and abroad it's hard to believe that rates will continue their rise. The traditional bond spread suggests a cap of 4.25% on the 10-year treasury and therefore a mortgage rate for a 30-year fixed rate loan of about 6.80% which is roughly 230 basis points above todays rate. The argument for rising rates is continued economic strength, which is unlikely. Current levels of unemployment and lower levels of consumer credit do not indicate an environment for greater economic acceleration. The argument for falling rates is weaker economic growth which is also unlikely. An improved real estate market and rising equities values continue to increase the wealth of average Americans. So where does that leave mortgage rates? Rates are probably range bound at this point. As the 10-year treasury yield trades between 2.50% and 3.00% mortgage rates will trade accordingly between 3.90% and 4.60%.

Will We Ever See Rates Back At Their Historic Lows?

For mortgage rates to fall back to their historic lows, the US economy would have to enter a recession, which is on the low end of probability. It is certainly possible. What is more realistic and probabilistic is that the economy slows from its current pace without entering recession and rates fall back close to their lows. This would actually qualify as almost catastrophic, not wanting to speak in hyperbole. The Federal Reserve would almost have to consider their efforts to rejuvenate the economy a failure after spending trillions of dollars with such low growth as a result.

An Inconvenient Consumer

Jim Cramer of CNBC Article on August 14: "Though Hardly Bearish, Cramer Grows Less Bullish"

The article describes Cramers caution due to Macy's disappointing earnings announcement. The article goes on to describe how Cramer explains that there are not enough catalysts in the economy to support the stock market if we lose the consumer. He also cautions that areas like financials could be hurt as higher interest rates take a bite out of housing. In other words, without the consumer the economy takes a hit and as a result the stock market loses steam.

Well, let's see if we all understand this correctly:

The stock market crashes in 2008-9.

Real estate crashes.

Financials face a crisis and the Fed bails them out with tax payer money  (read: consumer).

Corporations cut back dramatically and let go of staff (read: consumer)

Corporations earnings skyrocket as a result of layoffs and stocks subsequently surge making a handful of beneficiaries super wealthy (read: NOT the consumer)

Corporations will only hire part time workers at reduced wages and reduced hours (read: lower discretionary incomes).

Now, four years later, after a massive surge in profitability and cash hoarding by corporations (read: no CapEx spending) the consumer must be relied upon to spend so markets can maintain their momentum and it's up to the consumer (read: on his back) to do this? Really? While corporations sit on a reported trillion dollars in reserves? Really, again?

Sorry, Mr. Cramer, but this is asking a bit too much just so you can maintain your bullish sanguinity on your CNBC program. Welcome to the real world where most people are struggling to get by and not participating in the surge in equities that they helped support. How about if the markets give some back?

Will We Commit Sins of the Past?

Today is August 1st and equity markets are surging. The Dow is eclipsing 15,630, up 0.87%, the S&P 500 has pierced 1,706, up 1.20%, and the Russell 2000 continues to outperform, up 1.30% to 1,058. The financial press is reporting the rise is due to good economic data abroad (read: China) and domestic (read: fewer jobless claims than anticipated). This is all subterfuge for the real reason: it's the first of the month and funds are buying, plain and simple. However, the dark side to all of this are rising interest rates. The 10-year treasury touched 2.70%, up 12 basis points, or 4.28%. This is important to note because consumer rates are driven by the 10-year treasury, such as mortgage rates. This brings us to the point of todays missive: what happens when rates rise enough to stifle the real estate market and lending markets?

Rising Mortgage Rates, Declining Standards?

The rise in interest rates has already taken a toll on the refinance market. Applications for refinance loans  are down significantly from just 6 weeks ago. Applications overall are down, which includes purchase loans. As mortgage rates continue to rise, refinance loans make less sense to homeowners and the cost to buy a home becomes less affordable to prospective homebuyers forcing them to pursue a cheaper home or declining to buy entirely. And what of the effect on lenders and financial institutions? Banking analysts are cheering a steepening yield curve but what about lost revenues from less lending? It's likely that there will be a trade off between the two and initially revenues will probably dip before lending reasserts itself. But how can that happen with rates rising? Who will these borrowers be and what will be their motives for taking out a higher rate loan? The short answer: borrowers who qualify under lower lending standards which is the inevitable outcome in the lending industry. Already some lenders are lowering their guidelines for loans. It can take the form of more flexible loan products, such as a higher loan-to-value allowance and or lower underwriting guidelines such as lower credit scores. All of these things add up to making loans more available to more borrowers to keep generating loan business. This process is inevitable and it's already happening. When one lender starts the easing process the rest are sure to follow. The ultimate result is a weakening of the industry and future problems down the road.

Are We Destined to Make the Same Mistakes and Face the Same Problems?

Yes.

Here's why: Pressure. The system from the top down is predicated on making money. The tightening lending standards are a reaction to an event (financial debacle or similar). As soon as enough time has passed and the market has healed itself, the fear of making bad loans is far outweighed by the fear of not making money. The more flexible lending standards and more exotic credit products are justified by a healthier economy and in this case, real estate market. And so the cycle repeats itself as the market inevitably heals itself  and allows itself to expand and grow. And it works for a while and the industry thrives until the next calamity. By the way, what is the "system" referred to above? The system is our way of life, the financial markets and the structure put in place to support it (legal, governmental, etc.). Although the tone here seems somber and apocalyptic, it is not. To the contrary, these are just observations of what are natural events happening given a set of circumstances. This is not a condemnation of the system or how it behaves. In fact, it would be unusual if things did not unfold the way that they do.

Markets Sending Conflicting Signals

Since Fed Chairman Bernanke's press conference back in mid June, markets have been erratic. Interest rates have soared along with oil, while equity markets swooned and have stormed back, and gold has attempted to halt its decline as well as other commodities. With markets hanging on every word from the Fed Chairman, volatility has come back to the markets. After the market close July 10, the Fed Chairman spoke in an attempt to clarify the Feds position on easing and markets responded positively the following day. Most markets rallied as a result. Economic data has been light this week, the first week of earnings, so there were not a lot of other data points to justify the markets positive bias. The treasury market rallied sending its yield down 11 basis points, while the Dow, S&P 500, Nasdaq, and Russell 2000 all closed with gains of at least 1.10%, with the stand out Russell 2000 logging its 5th straight record close.

What Gives With The Market Moves?

The current explanation for the equity markets resurgence is a widely held belief that the markets overreacted to the Fed Chairmans comments to the media after the June meeting. The the Chairmans soothing words on July 11th, markets have recorded record gains, eliminating Junes swoon. Although rates continue at elevated levels relative to May, treasuries have staged a mini comeback sending yields well below the highs. This is little reassurance for prospective borrowers who are still staring at higher interest rates for home loans and other purchases. The question is why are equities and fixed income rallying together? Typically these two markets are associated with being negatively correlated, when one rises the other falls. The surmised "Great Rotation" was based on this understanding. As money would flow out of fixed income assets and in to equities, rates would rise as equities benefited with higher prices. However, it seems what is taking place is a combined reaction by both markets to the overreaction to the Feds June meeting and a "short" covering by investors in  both markets. An indication that this may indeed be the case would be both markets behavior early next week. By then shorts have probably covered and the markets should see some consolidation until either earnings act as a catalyst or some other market moving event takes place.

Oil Is Up Over $100 a Barrel But Gasoline Prices At the Pump Hold Firm. Huh?

There has been much made of the rise in the price of oil and lack of corresponding move in the amount consumers are charged at the pump, particularly during the traditionally high driving season. Articles are starting to hint that higher gas prices are coming as a result of the rise in oil, but why hasn't it happened yet? Typically when oil rises gas prices at the pump react spontaneously, and when oil falls gas prices at the pump "fall like a feather". This time around there is almost a stubborn resistance of gas prices to follow oil higher. Most analysts point to falling American demand at the pump to explain this phenomenon. However, as the traditional summer driving season heats up and American families hit the road, gas prices have not only held steady but seemed to have bucked the trend and in some cases declined as summer has rolled on. As the economy continues to improve and demand continues to grow it is likely prices will ultimately give in and start to rise creating a headwind for consumers. Until that happens, happy driving!

The Dollar is Being Blamed For the Rise In Commodities

One thing that most analysts agree on is that the U.S. dollars decline has led to the rise in commodities like the metals and oil. Gold has found support and has currently stopped declining while copper and other metals associated with a growing economy have firmed. What is not so easy to explain is how these commodities will perform going forward with expected economic weakness out of China and other "BRIC" economies that were supposed to lead the global growth story. After witnessing the dollars strength against other currencies, particularly the Japanese yen, the dollar has declined recently, most likely the result of relaxed anxieties by the market of further rate rises in U.S. treasuries. Typically, a currency's strength is a function of that currency's interest rate structure. A strong currency is associated with higher interest rates as it attracts investors which drive up the exchange rate against other currencies.

2013 Mid Point - Where Are Markets Headed For the Remainder of The Year?

Today is the last trading day of June. Monday is July 1st and the first trading day of the 3rd quarter and the start of the second half of the year. The first half of the year could be characterized as successful from the Feds perspective as its policy of quantitative easing resulted in record low interest rates as well as the best first half for equities since 1999. Mortgage rates remained at record lows and more homeowners were enticed to refinance their existing loans or take out new loans to purchase property. But as we look forward to the second half of the year, what should we expect from the bond market as well as the equity market?

June Ended with a Thud Amongst Increased Volatility and Rising Rates

On June 19th the Fed issued its policy statement and Fed Chairman Ben Bernanke gave his post meeting press conference. It did not take long for markets to start deteriorating. The equity markets sold off and effectively ended a never ending rally, finally giving investors the pullback they had been clamoring for. Interest rates had been rising but the chairmans words were fuel for the fire and treasuries sold off dramatically spiking all interest rates with them including mortgage rates. Most strategists conveyed that rates could and should rise. It was how fast rates started rising that most strategists warned about. In 2 months time mortgage rates rose 1%. ( See an earlier June article about the impact of the rise in mortgage rates on consumers.)

Looking Forward: The Bond Market and Interest Rates

The 10-year treasury sold off on the final trading day of June and closed with a yield of 2.519%. The yield is 0.81% higher than 6 months ago. Because so many rates are predicated on the 10-year treasury yield, all consumer credit is affected particularly mortgage rates. The biggest fear is that rising rates will harm the nascent housing recovery. This is probably a legitimate concern. However, it is no bigger a concern than the lack of participation by first time homebuyers squeezed out of the market by large investors such as Blackstone Group buying up properties as investments and causing the prices to become less affordable. The combination of the two dynamics will cause the housing recovery to stall out. Going forward most strategists see interest rates as range bound. It doesn't seem logical that rates will rise with such an anemic economic recovery. The problem is that there are other forces at work that will affect bond prices. The least of which is created by the markets themselves. The sentiment in the market place that rates must go up will ultimately cause them to rise. Money managers are advising clients to get out of bonds and rethink their portfolio mix. Once a sentiment takes hold in the market place it is very difficult to reverse. As a result, despite a weak economy, interest rates will continue to rise and the Fed will be helpless to stop it. This week saw many Fed governors come out publicly to calm markets after the firestorm created after Bernanke's testimony. The governors were trying to talk markets down. Although rates ended off their highs, the markets seemed somewhat unimpressed with these governors soothing words. 

Looking Forward: The Equity Markets

After having an impressive first half of the year, equity markets stumbled in June and experienced the kind of volatility traders love and investors lose sleep over. The equity markets were on a nice trajectory through the first 6 months of the year and then June hit and the markets lost their composure. A nice 6 month chart of the Dow Jones Industrials reflects the change. The equity market has a nice gradual slope from January to May, fighting off the sell in May crowd only to get brought back to reality by June swoon. June actually produced a negative return for the major index. Again, Bernanke's words after the Fed meeting caused markets to swoon at the thought of an end to quantitative easing. That and weak data out of China, which is now more important to investors than anything else, was enough to produce the pullback that market participants had been calling for. The equity markets, unlike the bond market, seemed impressed by the soothing words of the other Fed governors and rallied the final week of June to avoid an even worse June performance. Going forward, how effective will Fed speak be to calm and talk up equity markets? As the market is a discounting mechanism and QE "forever" seems to have not only been priced in to the markets but even lost some potency, and with earnings growth outlooks tempered but not really priced in, equity markets are facing some serious headwinds in the second half of the year. As earnings disappoint equity markets will likely give back some of the multiple expansion they experienced the first half of the year. Multiple expansion is only legitimate if forward guidance can justify it. With more companies lowering expectations, beating lowered expectations will not alone cause markets to cheer at these elevated levels.

Forecasts and Guesses For The Second Half of The Year

The tone of this article at best is sober so the forecasts should be equally sober. The 10-year treasury will continue to struggle and its yield will rise to end the year at the psychologically important level of 3.00%. There will be fits and starts but the yield will have a positive slope and not for the right reasons.

The equity markets, despite the bulls incessant calls for more gains, will fall to end the year, and this will be a good thing. Look for the Dow to end the year around 14,000, the S&P 500 to end at 1,500, and the Russell 2000 to end the year at 850. There is no technical or logical reason for these numbers other than the rationale that investors will increasingly agonize over the Feds next moves and will start to look less favorably on the impacts of QE and price in negative concerns.

Immediate Reaction to Fed Statement and Bernanke's Discussion

The reaction to the Feds statement and particularly the Fed chairmans comments afterwards was dramatic. The equity markets sold off dramatically and the treasury market sold off with the 10-year note yielding 2.32% rising 12 basis points. Mortgage rates are likely to reflect the 10-year note sell off on Thursday. Mortgage rates are likely to rise at least 25 basis points as a result.

The change in language by the Fed that may have spooked the markets was the Feds description of the waning risks to the economy. This is different from previous language that described continued risks to the economy. Also, Mr. Bernanke was vague if not completely opaque regarding President Obama's comments to Charlie Rose of PBS just days earlier regarding his future with the Fed, which most expect to end when his term ends in January 2014.

Two Fed members (Bullard and George) dissented regarding the Feds policy.

FOMC Meeting: Its Impact and the Expectations

The Fed concludes its two day meeting Wednesday, June 19, with much anticipation. All eyes are on the Fed chairman and whether he will give more insight in to the possible reduction of quantitative easing, now popularly referred to as "tapering".  The financial community and the broader community can thank the media for yet another catch phrase to banter about, not unlike formal popular phrases such as "irrational exuberance", "fiscal cliff", "new normal", and acronyms like "BRICs", "PIGS", and "ZIRP". Although these catch phrases typically go by the wayside after their usefulness runs its course and the media gets exhausted, taper may actually hang around a bit longer than the others. Although there are no real expectations that the Fed will announce a beginning to tapering of the existing QE policy at this meeting, there are growing concerns that inevitably the Fed will have to taper at some point in the future. There are heightened concerns that as a result of the impending end of Ben Bernanke's tenure there will be a "handing off" of sorts of the current policy to Bernanke's successor with at least some indication that an exit is being considered by the current Fed members. This concern is reflected in the bond market through rising rates and in the equity markets through increased volatility.

The impact on the bond and equity markets from the Feds statement may be muted. Bond yields have risen substantially the past 6 weeks and equity markets have seen increased volatility, while rising back to the former highs of the recent past. Although economic data such as labor market and real estate market data have shown relative improvement, the metrics set by the Fed which will drive the decision making policy have not been met. Unemployment still rests higher than the Feds target and inflation has not come close to the Feds desired target. With regards to inflation, if there is any real concern it's that it may be too low. There is increasing evidence that deflation may become a bigger concern than previously thought. Few anticipated that the result of Fed money printing (QE) would be falling prices, but inflation metrics such as PPI and CPI are reflecting weaker prices not stronger prices. This would be a dangerous development as deflation destroys what makes credit markets and the US economic system work. In a nutshell, increasing prices make borrowing and using leverage economically viable by effectively lowering its cost. Deflation eliminates or at least mitigates this process. As such, it seems unlikely the Feds hand will be forced to announce any concrete plans to begin tapering and the markets reaction to the statement should be muted.

The markets expectations of the Fed are another matter. The Fed is not entirely in control of market behavior or market sentiment, for that matter. Regardless of the Feds statement, the market may decide that it will move on without the Fed and price assets without considering Fed comment and guidance. The market will ultimately decide whether it trusts the Fed. The market is seeking clarity from the Fed after many Fed members have made both dovish and hawkish statements about Fed policy going forward. This market uncertainty causes the rise in rates and the volatility seen in the equity market. It will be the Feds job to soothe markets by clarifying its position on current policy and its future course. The Fed chairman has been doing this for nearly eight years now and is quite adept at it. Ben Bernanke will try not to add additional uncertainty to the market and will seek to allay any fears the market has regarding current policy and the transition from his leadership to his successors leadership.

Here We Go Again: Mortgage Rates Are On the Rise. What's the Impact On the Market?

After seeing rates hit all time lows on the 30-year fixed mortgage, rates it seems are starting to move higher. The press and media are reporting that we're seeing the end of the 30 year bull market in bonds and that rates are going higher from here. Or at least they are not going any lower than what we've seen the last several years. This may or may not be the case. Rates have risen only to come back down again as soon as additional weakness in the economy has surfaced. To be sure, if a sustained weakness prevails in the stock market, the bond market could see renewed interest by safe haven seeking investors. Just the same, what do rising interest rates mean to the average homeowner and the housing recovery?

Typically, rising rates are not beneficial to the real estate market. Higher mortgage rates mean higher payments and less purchasing power for buyers and less incentive for homeowners looking to lower their monthly obligations through a refinance. All of these things result in less economic activity. Less purchasing power means fewer affordable homes for first time homebuyers, a staple of a healthy real estate market. The ripple effect of fewer home sales is difficult to quantify but it can mean fewer sales commissions to realtors and loan agents, fewer sales of furniture and other housing related items, and fewer taxes collected by local governments. The impact can be significant. As rates have been extremely low for some time now and many borrowers that could and did take advantage of the low rates, sometimes on multiple occasions, borrowers of all kinds have become very sensitive to rate movements. Modest rate increases can dramatically affect lending volume, as evidenced by the Mortgage Bankers Association weekly mortgage updates.

Recently, the rise in rates has garnered a lot of attention and created much consternation in the investing community. Many analysts insist it's not rising rates that are causing them concern but the rate at which the rise has occurred. Since the last Fed meeting in the first week of May, mortgage rates on a 30-year fixed mortgage have risen just shy of 1%. For a 30-year conforming loan amount of $417,000, the interest and principal payment would rise just over $29 with a rise in the rate by just 0.125% or 1/8 of 1.0%.  This does not sound all that impressive or substantial. However, to put this in to context, this rise would result in a loss of purchasing power of just over $6,400. Still not impressed? This was by just an 1/8 of 1.0% rise in rates. Rates have risen 7 times this amount by 7/8 of 1.0%. The loss in purchasing power by this move in rates is $41,960. Still not impressed? This is in a month. Now you're impressed. This is why analysts are claiming it's not the rise in rates as much as it is the rate of the rise. If you're a first time homebuyer and you waited a month to move forward with your purchase recently, you were just priced out of the market. So what would be the alternative? Either prices have to come down to meet this new economic reality or fewer homes are sold and the ripple effect discussed earlier takes effect. Neither alternative are that attractive or appealing. For the prospective refinance borrower, these types of moves are deal breakers. Ironically, it's environments like these that often times get borrowers off the sidelines and motivated to effect a transaction. What is so alarming to analysts is how quickly things can turn and how fragile the economy may be to any hiccup in the recovery. For example, a misstep by the Fed in its policies or a black swan event or exogenous event out of our control.

Interest rates will probably rise at some point to what economists describe as normal levels and this will be healthy for the economy. Artificially low rates can cause imbalances and distortions in the economy that may be unanticipated. Ideally this rise will occur gradually and cause few disruptions to the economy. Rates are still low by historical standards and most homeowners should still take advantage of these low rates to lessen the burden of their mortgage payments. Housing prices should find their equilibrium in a rising rate environment where first time homebuyers can successfully purchase a home that is within their budgets.

The Fed Should Taper While Confidence is High

The Federal Reserve would be wise to consider tapering economic stimulus while investors have confidence in the approach and its results. Waiting too long could have deleterious results. Two negative outcomes immediately come to mind. The first would be a bigger equity market correction than necessary and the second would be a more dramatic spike in interest rates.

What is With the Value of Investor Confidence?

In the investing world investor confidence reigns supreme. It is always subtly present no matter how discrete. Every tool used by the Fed in supporting the economy and the markets relies on it. Why is this the case? Shouldn't markets be more rational? Not necessarily. Because markets are influenced by humans and humans are emotional, this tends to have a big impact on how markets behave.

Strike While Confidence is Still High

Friday, the equity markets sold off and many investors were rattled, as reflected by the biggest losses coming at the close. After two weeks of talk of possible early tapering, investors finally seemed to embrace "sell in May". Despite the late weakness in the equity markets, investor confidence remains high and the Fed is still getting the benefit of the doubt regarding the efficacy of its economic stimulus known as quantitative easing (QE). It's not too late for the Fed to taper and have the markets interpret it as the Feds confidence the economy is on a self sustaining path of growth. By doing this, it could be that markets rally in the face of tapering as investors see better economic growth and therefore discount higher future earnings. One negative alternative mentioned at the outset however is that investors lose confidence in the Feds approach and believe the Fed is being forced to taper before it wants to. This is a scenario where markets may sell off and possibly dramatically. Under this scenario, it's possible the bond market sells off and yields spike as a result and that the equity markets sell off  as investors seek the safety of the sidelines looking to book first half of the year gains. Early year gains in the equity markets create an environment where investors are more inclined to book profits and ride out a possible market correction which only exacerbates a sell off.

For this reason, it would be wise for the Fed to consider tapering earlier rather than later. If investors lose confidence and markets start to decline, tapering by the Fed may only exacerbate declines and result in harming both future economic growth and employment. Unfortunately, this is the part of the whole process that was expected to be the hardest to manage, the eventual exit of stimulus.

The Fed is Going Against The Basic Advice of Every Financial Advisor

The Federal Reserve is years in to and trillions of dollars vested in it's rehabilitation of the economy known as Quantitative Easing. To be sure, the Fed has the best interests of the economy and the wealth of the nation in mind. Unfortunately the tool it has decided to use and reuse is it's unforeseen effects, most notably the "yield grab".

The common mantra of every financial advisor to each of their clients is "diversification, diversification,  and diversification". Just the other day a well-respected and experienced money manager with a large fund was asked his opinion on the stock market and it's recent stellar performance. His take was maintain the long term view and stay diversified. By taking this approach the common investor can avoid the stress and the resulting mistakes short term and medium term traders make.

There is only one problem with this venerable advice: the Fed won't let you do it. Diversify, that is. The Fed doesn't make it illegal to diversify, that wouldn't work. No, through their actions the Fed has orchestrated one of the most massive "squeezes" ever seen. By printing money (QE) and purchasing mortgage backed securities and treasuries and therefore reducing the yield curve, everything from FDIC insured savings accounts to junk bonds (corporate) offer very little in return to investors. As a result, investors pursuit of yield has forced them to allocate monies that would normally be invested more cautiously in to more risky equity assets.

Unfortunately, and perhaps the cruelest twist to this effect are the investors that are most affected. Investors that are nearing retirement or are already retired and would normally allocate more and more towards less risky fixed income investments are left without many options. At a time in their lives that financial advisors would be suggesting they get more exposure to insured bond funds and reduce exposure to equities these investors cannot afford to as there  just isn't any yield. The result is less diversification and more reliance on equities. As long as equity markets are rising this doesn't present a problem. Unfortunately, equity markets don't move in one direction. They also go down and sometimes they go down a lot. This can be very uncomfortable for an investor living on the return of those investments.

Fixed income and their yields are not the only asset class suffering. Recently most commodities are also being affected. As the Feds policies pump up the equity markets unfortunately those policies have not had the desired effect on the economy as a whole. As a result, as the economy has not responded well to the Feds money printing, commodity values are reflecting such and are falling leaving another losing asset class that investors cannot rely on. It may be that equities can "save the day" and suffice as the lone asset class that investors need to rely on. However, this does not change the fact that the Feds actions are responsible for forcing investors away from responsible investing habits and creating the potential for catastrophic results should some black swan event rear its head.

JPMorgan and Risk Taking 101

Now that the dust has settled for the time being, thanks in no small part to Morgan Stanley bungling the Facebook IPO, the reality is that the true extent of the losses that may be attributed to the "hedge" that JPMorgan used is still unknown and incalculable. What is odd is how JPMorgan describes the position. The bank would rather refer to the mistake as a hedge gone bad as opposed to a trade gone bad. Perhaps the bank feels public perception of the gaffe would be less severe if it was construed as a mechanism to protect against a potential loss versus a overly aggressive position taken by the bank to increase profits at the expense of depositors and tax payers. Regardless, what cannot be changed is the impact this will have on the perception of Jamie Dimon as a beacon of omniscient banking knowledge and experience. At the very least, Mr. Dimon should be less vocal and outspoken about suggesting less banking regulation going forward. What are your thoughts? Leave me a note in the comments section. Thank You!

Are Lower Mortgage Rates Really Helping the Economy?

The Fed's intention by implementing it's Operation Twist is to lower long term rates which should lower rates for most homeowners mortgages. The theory goes that as people save money in one area they will spend it in other areas. But is this true? Can the Fed really manipulate homeowners and therefore consumers?

Will Rates Fall Low Enough to Make a Difference?

Typically most homeowners will look for at least a quarter percentage dip from their current rate to even consider refinancing their mortgage. This is more rule of thumb than anything more financially sophisticated. Some homeowners are more focused on rate, others on nominal dollar savings, and others on costs associated with refinancing. Right now most analysts expect Operation Twist to lower long term rates by 20 basis points or 0.20 percent. Based on the refinancing rule of thumb discussed above the Feds actions won't lower rates enough to provoke widespread refinancing by homeowners. If most homeowners that were qualified based on traditional measures such as credit quality and sufficient home equity have already refinanced, and that is a big assumption of course, how many of these folks will be encouraged to go out and do it again, probably having just gone through the process? In an effort to generate more revenues, banks are looking at more ways to charge fees to consumers and some of these are showing up in home loan closing costs. A borrower who refinanced 6 months ago will probably face higher closing costs requiring a bigger savings from refinancing to justify the time and expense involved.


Now that Rates Have Fallen Low Enough, Will Consumers Spend Their Savings?

We have just given the Fed the benefit of the doubt that Operation Twist was successful in lowering rates and that a slew of homeowners have rushed out and refinanced their mortgages. With lower monthly housing payments of around $200 each (I made that up. Most homeowners I've talked to seem to have a love affair with saving at least $200 to even consider refinancing) homeowners are feeling flush with cash and cannot wait to go....(drum roll please)...save it. Sure some folks are going to feel good enough, at least initially, to go out to dinner one more time each month, but how long will that good feeling last? With the latest consumer confidence figures out and not looking very optimistic, how realistic is it to think consumers will be in a spending mood?

Now That the Entire Mortgaged Population has Refinanced, What GDP Growth Can We Expect?

The most optimistic outlook would only contribute a modest bump to GDP, and that's assuming most go out and spend their savings. How do we figure this? Well, let's look at some rough numbers since we cannot be truly accurate. If there are about 75,500,000 residential mortgages on US properties and each of them were refinanced, and each could save $200 a month, and each homeowner went out and spent those extra $200 each month, that would add about 1.2% to our national GDP. For simplicity, let's ignore the velocity of money for now, because I think it is very realistic to assume not that many mortgages can or will be refinanced for various reasons already discussed. So if the actual number were half these numbers, is this a substantial boost to the economy? Maybe so if you're talking about an election year and you're looking for any port in a storm. As important as the contribution to GDP is the improvement to the US labor market, particularly in an election year. Can this modest contribution to GDP from Operation Twist help to bring down unemployment in the US? Perhaps as part of a larger package to stimulate economic growth Operation Twist can be considered a successful endeavor by the Fed, but on its own it will probably not succeed.

Twist and Shout

On Tuesday the FOMC was late in delivering it's much anticipated statement following an extended governors meeting. Apparently the wording of the final statement caused the delay. However, it should be noted that three governors voted against the statement and may have caused some of the delay in finalizing the statements language. The focus of this meeting by the markets was the Boards anticipated details on its operation "Twist", which is goofy terminology for selling short term securities and investing the proceeds in long term securities in an effort to lower long term rates and flatten the yield curve. This mechanism is meant to stimulate economic activity and resuscitate the staggering American economy. The more likely explanation for operation "Twist" is to show the public (the voting public that is) that the Fed is not standing idly by while the economy and the markets flounder. Will this latest effort achieve its goals? Only time will tell. Up to this point more dramatic actions (QE and QE2) by the Fed have not achieved their intentioned goals. It's interesting to note that typically a flat yield curve reflects a struggling economy if not outright recession. Falling long term interest rates (what the Fed is trying to achieve) reflect a market that does not anticipate growth and therefore inflation in the future. The markets could very well get spooked by the profile of the Feds desired yield curve and actually have an adverse reaction to the Feds latest actions.

What's Most Likely to Happen?

We like to anticipate what will happen so that we can look back and see how accurate (or not) we were in our assessments. Here's my take on the likely outcome of the Feds latest moves: Operation "Twist" WILL lower long term rates initially and more qualified creditworthy homeowners will be able to refinance their current mortgages and reduce their monthly obligations, more so than if nothing was done by the Fed. What is difficult to assess or establish is whether this would have occurred anyways as a result of natural market forces (investors fleeing to the safety of Treasuries) as equity markets tumble. What will not happen, unfortunately, is the Feds real desired outcome of inflating the US equity markets once again to create a wealth effect that will result in a trickle down effect that will then spur more business activity and therefore more demand for labor.

Why It Will Not Work

The Fed is trying to fix the wrong problem (slowing economic activity) using the wrong mechanism (lowering interest rates). The real problem the US finds itself with is an over-leveraged and over-burdened society that has over the last 30 or so years lived beyond its means. The Feds approach is to "fix" things so that we can all go back to doing things the way we used to. That is the wrong approach to take and it will not work. The Fed simply cannot fix this problem and it does not have the answer and should not be leaned on further to fix the economy. What the Fed can do for a start is to let the markets know that it should not be counted on for additional stimulus to inflate equity markets to create a wealth effect. Until this is done, market volatility will continue. Once investors understand that the markets must stand on their own, more realistic levels of value can be achieved and more price stability should occur. A possible outcome of this should be fewer companies trying to maintain lofty stock values to appease shareholders. The quick and dirty way to appear profitable is to cut what typically is most companies biggest expense, which happens to be labor.  Until companies reach some kind of cost/revenue equilibrium, hiring will not occur. As one of the Feds dual mandates is to maintain employment, it is in the Feds interest to let companies achieve economic equilibrium. Lower long term interest rates are not the answer to achieving this economic equilibrium.

Market Reacting to Greece Fears or Just Reacting?

From one day to the next the stock market and the bond market seem to move because of concerns in Euroland and specifically Greece. In many cases Europe and Greece seem a very convenient excuse for traders to move in and out of positions on a whim, and the media without any better explanation, are happy to use them to explain moves in the market. The reality is that the markets are sensitive to almost everything that occurs around the world, both financially and politically. To think there is no connection with Europe and Greece would be naive. However, the likely reason for the volatility in the markets is just traders moving in and out of positions trying to lock in profits and not get caught on the wrong side of a trade. Fundamentals do not seem to be relevant or that important to the markets currently. And as markets and trades are increasingly computer model driven, it is advisable for small traders and investors to stay away. Trying to guess which way the wind is blowing in a particular week could be devastating to a portfolio. The sidelines are the best bet in this environment, but if the sidelines are not for you, focus more on the technicals and less on the headlines.

FEDERAL RESERVE BOARD RAISES DISCOUNT RATE

The Federal Reserve raised the discount rate by 0.25 to 0.75. This is the lending rate the Fed uses when it makes emergency over night loans to banks. The market has taken the move in stride, in fact, the market has garnered strength from the move and continues to move higher using the increase as a vote of confidence in the economic recovery.

Early Foreboding: Foreign Holdings of Treasuries Fall

In what could be a negative foreboding for the US governments ability to continue to finance it's budget with Treasury securities, foreign holdings of US Treasuries fell, specifically holdings by China, which fell below that of Japan, leaving China as the second largest holder of US Treasuries. The obvious conundrum for the US Treasury is the threat of higher interest rates to continue to attract demand for it's securities at a time when the US's amount of outstanding debt is at an all time high. In turn, as Treasury's securities yields rise, these higher yields will ultimately be passed on to US consumers in the form of higher mortgage rates, credit card rates, auto loan rates, etc. at a time when the US consumer is continuing to strain from too much debt and must continue to deleverage.

What happens if rates start rising before the US consumer is prepared? Unfortunately, for many homeowners who have adjustable rate mortgages or two-step loans (loans that go from a fixed rate to an adjustable rate) higher rates may translate in to higher mortgage payments additionally limiting consumers discretionary income, meaning fewer car purchases and other purchases that will help sustain the US economy after the inevitable withdrawal of Federal stimulus.

Forcing the US government's hand?
The government has pledged to keep rates at exceptionally low levels for an extended period. This language has been incorporated in to the Feds policy statements for the past year. However, the Fed only controls short term rates, not long term rates. And those short term rates have been cut as low as they can go. Long term rates are moved by the market. As long term rates move higher, the yield curve steepens. While this is good for banks and financial institutions, at some point there must be a correction as depositors demand higher rates for their money, causing the yield curve to flatten.

EU Has Answer for Greece?

On Thursday, February 11, 2010, the U.S. equity markets rallied as investors looked forward to details on a Greek bailout plan. Unfortunately, no details would be forthcoming on Thursday, so the markets decided they would rally in anticipation of details that would outline a lifeline for Greece and presumably other troubled Euro nations that may find themselves in similar straits.

It appears that markets will move on any information or disinformation in the marketplace. It seems that the markets moved based more on the fact that they had sold off and were primed to be bid up by participants. Can anyone explain the recent moves by United Airlines' stock while the rest of the market (and other airlines) seemed mired in a limited trading range? Hard to explain this one. Because of the lack of retail participation in the equity markets (atleast the last 12 months), we can only assume that professional investors are picking particular stocks and bidding them up between eachother hoping for retail participation to then unload on at inflated levels. Sound paranoid? You bet it is. And why not. If you bought the S&P 500 ten years ago and held it until today, you'd be up exactly your dividends received and that's about it. Why take that chance with risk when you could have performed as well or better in a fully-insured bank ceritifcate of deposit, or better yet, AAA-insured municipal bond? Should investors be skeptical? You bet they should.

On the political front, Washington DC remains covered in snow after a historically massive snowfall and government offices remained closed for a fourth day. I think this respite from political haggling over everything from health care reform to job creation plans, is much needed. The amount of cynicism in Washington DC rivals only that of Californian's belief that the state can be saved from it's budget woes. Is there a savior for California? I saw a nice commercial with Meg Whitman this morning. Maybe she has an actual plan. I say give her a shot. Maybe the entire working population of California can go to work for eBay. Just a thought.

Market Takes Big Hit on PIGS and Jobless Claims

On February 4th the equity and commodities markets got crushed after fears of budget issues with PIGS (Portugal, Italy, Greece, and Spain) rattled investors in the Euro zone and continued to cause angst in the US markets. The dollar also weighed on commodities.
It's hard to take these moves seriously when the news of the day drives the market dramatically up and down, with the end of the world one day and an economic rebirth the next. The best thing for investors to do is keep their wits about them and evaluate their long and short term objectives and not get caught up in the capricious market undulations. Over reactions to the swings in the market can indeed ruin a portfolio. If you are in it for the long haul, it's best not to watch the market every day. If you are a short term investor or trader, it makes sense to stay defensive and hold small positions and honor your stops.
The market rally that started in March 2009 is officially over. Several technical levels have been breached. The S&P 500 closed below the technically significant level of 1,073 and closed at 1,063. The Dow fell below 10,000 for the first time in 3 months and closed just above the important psychological benchmark. I think the market will remain volatile and we will see a bounce back that reassures investors only to be followed by further declines.