By Rodger Rafter

I’d like to offer a few counterpoints and comments on your article about the Fed:

I don’t think the Fed panics. They make cool, calculated moves to maximize gain and minimize pain for their biggest member banks. Yes, they know they’re screwed on both the inflation and economic fronts, but they’ve known that for a long time. For awhile foreign investors have bailed them out by boosting the dollar and flooding the economy with investment capital, but that’s changing. Recently the Fed has shifted into “minimize pain” mode as global imbalances have started to reverse themselves.

Rate hikes have had more to do with protecting the value of the dollar against a sharp decline as foreign central banks are losing interest in US treasuries.

The full argument is here:
http://rebalancing.blogspot.com/2006/07/inflation-accelerating-and-interest.html

Briefly, rate hikes aren’t checking money supply growth because loose lending continues via securitizations, hedge fund borrowing and the private equity boom.

The treasury needs money supply growth because it pays the bills and Wall Street needs credit expansion because it is their life’s blood. Inflationary pressures keep mounting in spite of government’s efforts to lie about their size.

I agree that a recession can’t be avoided at this point. I don’t think the Fed cares about the greater economy, though.

I agree that housing is big. It’s bigger than the stock market, but not as big as consumer spending. Tapped out consumers are bringing the economy down, and housing is tumbling with it, as an obviously bloated, vulnerable and early victim. Housing’s crash adds significantly to the snowball effect, but consumer debt burdens, combined with inflation, combined with the declining power of labor are what is toppling the economy.

You mention the GDP numbers for housing, and it is interesting to note the revisions:
Q4 ‘05 housing growth was revised from +2.8% down to -0.9%
Q1 ‘06 housing growth was revised from +3.3% down to -0.3%

Government statisticians normally assume a continuation of a trend in their early estimates. When they start having to make big revisions, it usually indicates the trend has changed and they’ve been missing it.

Q2 ‘06 is -6.5% for now, and will likely get revised down fron here.
It should get much worse than that before housing bottoms, but it probably won’t take away much more than 1% from GDP at its worst point. Consumer spending, could wipe out as much as 4 or 5% if things get ugly.

Housing and the economy turned the corner in Q4 2005. Most people didn’t notice, though. Here’s the full argument:
http://rebalancing.blogspot.com/2006/07/turning-point-in-1976-us-came-out-of_24.html

You say the Fed has limited control of global liquidity, but I think that is exactly what they are trying to control, via the foreign exchange market with interest rates, and via the money supply with relaxed reserve requirements and banking regulation.

1994 is a nice comparison to the current situation, but I really prefer 1987 for a number of reasons:
http://rebalancing.blogspot.com/2006/08/housing-vacancies-americans-arent-just.html
http://rebalancing.blogspot.com/2006/07/great-american-ponzi-scheme-in-ponzi.html

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It is now clear that the Fed is in panic mode about the risks of a U.S. recession; they hoped to get a soft landing but, obviously, the Three Ugly Bears that I have been warning about since last fall - high oil prices, a slumping housing and rising inflation leading to higher short and long term interest rates - are now killing the economy. The Fed is particularly scared now about the effects of the housing slump, as John Berry’s (being the most insider of all Fed watchers) latest column clearly suggests and as the speech today by SF Fed President Janet Yellen also signals.

Last Friday, commenting on the dismal Q2 GDP report I stated, while arguing that a U.S. recession is coming soon:

    * Residential housing investment was falling in Q2 at an annualized rate of  6.3% (and I expect it will fall at an even faster rate in H2, close to 10% negative growth for the next few quarters).

    * Real private consumption (that is 70% of aggregate demand) was growing only 2.5% in Q2, with durable goods consumption actually falling 0.5% led by lower purchases of cars and of goods related to housing: as housing slumps consumers are buying less furniture, home appliances, etc.  Expect even worse consumption growth in H2, as a further slumping housing sector, higher oil prices and high interest rates are seriously shaking saving-less, debt-ridden consumers whose real wages are falling.”

Today Yellen expressed similar serious worries.  First, she worried about the downturn in the housing sector becoming disorderly: "there is more reason to worry that house prices would fall sharply than that they would rise sharply."  Second, she clearly linked the wealth effects of a housing slump to the risk of a sharp fall in consumption. She argued that the flattening – if not falling - price of houses  "makes the chance of a sizable drop-off in consumer spending seem larger than the chance of a big surge."

Given her statements today, and those by St Louis Fed President Poole suggesting that a tightening on August 8th is only a 50/50 chance now, it is clear that the Fed is really worried about the U.S. slowdown and much more worried about it now than the rising headline and core inflation. Given these statements and development it is clear now that, with high likelihood the Fed will pause in August. Whether this would be only a pause or a stop followed by an easing depends on how fast the economy slows down relative to how much higher inflation will go.

There is now in the market a wishful hope that a Fed ease, possibly followed by an easing in the fall, will prevent a serious slowdown and allow a soft landing of the economy (something in the 2.5%-3% growth rate in H2 2006 followed by a 3% growth in 2007).

beg to disagree. The Fed will not be able to avoid coming recession even if it were to pause now and ease in the fall. Let us consider the best possible scenario for growth now, one in which the Fed pauses on August 8th and then eases twice in the fall by 25bps – i.e. eases twice out of three meetings in the fall - pushing the Fed Funds rate down to 4.75%.  This does not mean that I believe that the Fed will actually ease so much, especially if inflation keeps on rising. The experiment is done for the sake of the logical argument.

Then, would an August pause followed by an easing in the fall prevent the U.S. recession that I am predicting? The clear and strong answer - based on many factors - is no.

The reasons are as follows:

    * In 2000 the Fed stopped tightening in June 2000 (after a 175bps hike between June 1999 and June 2000). That early pause/stop did not prevent the economy from slowing down from 5% plus growth in Q2 2000 to 0% growth in Q4 2000. Also, the Fed started to aggressively ease rates – in between meetings in January 2001 – when it dawned on the FOMC that they had totally miscalculated the H2 2000 slowdown (they were worrying about rising inflation more than about slowing growth until November 2000 when it was too late). And this aggressive easing in 2001 did not prevent the economy from spinning into a recession by Q1 of 2001. This time around you will get into the same patterns: today’s 5.25% Fed Funds rate reflects the effects on the economy of a Fed Funds rate closer to 4% given the lags in monetary policy and the effects of tightening in the “pipeline” as Bernanke and Yellen put it. So, pausing or stopping now will not help (like the June 2000 pause/stop did not help) and easing in the fall will be too late, in the same way in which easing in early 2001 did not help.

    * The current slump in housing will have a much more severe effect on the economy than the tech investment bust of 2000 for several reasons. The wealth effect of the tech bust was limited to the elite of folks who had stocks in the Nasdaq. The wealth effect of now falling housing prices affects every home-owning household.  The link between housing wealth rising, increased home equity withdrawal (HEW) and consumption of durable and non durables is very significant (see RGE’s Christian Menegatti brief on this), much more than the effect of the tech bubbles. This is exactly what Yellen is worrying about now. Last year, out of the $800 billion of HEW at least $150 or possibly $200 billion was spent on consumption and another good $100 billion plus went into residential investment (i.e. house capital improvements/expansions). It is enough for house price to flatten – as they did until now – let alone start falling – as they are also beginning to fall in major markets – for the wealth effect to disappear, the HEW dribble to low levels and for consumption to sharply fall.

    * A housing slump is a triple whammy, as Yellen correctly worries. First, the 6.3% fall in residential investment in Q2 will be followed for the next few quarters by a much larger fall, at least 10% and possibly 15%. Second, the effects on consumption of housing will be severe: already in Q2 durable consumption is falling as falling home purchases lead to lower purchases of furniture, home appliances and other housing related durables. Third, the employment effects of housing are serious; up to 30% of the employment growth of the last three years was due – directly or indirectly – to housing. As housing slumps, the job and income and wage losses in housing will percolate throughout the economy.

    * Could a Fed pause and easing rescue the housing sector? Of course not,  for the same reasons why the Fed pause and easing in 2000-2001 did not rescue the collapse in investment in the tech sector. The reasons why the Fed cannot rescue housing are clear. First, Fed policy in 2001-2004 fed an unsustainable housing bubble in the same way in which the Fed policy in the 1990s fed the tech bubble. Now, like then, it payback time: with huge excess capacity in housing (then in tech capital capacity) even much lower short and long rates will not make much of a difference. Real investment fell by 4% of GDP between 2000 and 2004 in spite of the Fed slashing the Fed Funds rate from 6.5% to 1.0%. Does anyone believe that a 50bps or even 150bps easing by the Fed will undo the housing investment bust that is coming for the next two years? No way. Second, a Fed easing in the fall may be too small – at most 50bps plus or minus 25pbs – and will have too little of an effect on long rates to affect debt servicing ratios of overburdened households. Long rates will not be affected much by a Fed ease for the same reasons – the global conditions that determined the “bond conundrum” of 2004-2005 – that a Fed tightening did not affect long rates. Some easing by the Fed will have little downward effect on long rates and, if inflation is actually rising because of oil and other stagflationary shocks, long rates may actually go up if the Fed easing likely causes increases in long term inflation expectations. Since we are facing stagflationary shocks, the Fed can ill afford to ease too much and too much easing will be counterproductive for bond rates and for housing.  Thus, either way households burdened with ARMs and overburdened with housing debt at the time when housing values are slumping, can expect little relief from lower short  rate or long rate. The Fed just cannot rescue housing; it can only very modestly dampen its free fall.

    * With aggregate demand slumping for structural reasons that I have extensively discussed before, Fed easing and lower long rate will have very little, if any effect, on private consumption of non-durables and durables (the latter already falling in Q2), non-residential investment (that is already falling in Q2 in its equipment and software component) and residential investment (as discussed above).

    * It payback time now for all the bubbles that the Fed created in the last few years: the housing bubble, the equity markets bubble (as P/E ratios are still too high based on cyclically adjusted P/E ratios), the bond bubble. Thus, Fed easing will have limited effect in preventing a bursting of these bubbles. And the Fed easing in 2001-2004 is also behind the commodities (both energy and non-energy) of the last few years. So, we can thank the Fed for causing, in part the oil, energy and commodities spike that is now driving the economy into a severe slowdown.

    * The  Fed can ease as much as it wants or can. But it has limited control on global liquidity conditions. And now that Asia, Japan and EU are – for the time being  but not for too long – decoupling from the US slowdown, ECB and BoJ and EMs central banks are in tightening – not easing mode. So, the Fed ability to affect global short term interest rates and long term interest rates is limited. Only when the US recession will burst the decoupling myth when the US slowdown leads – with a lag – to a global slowdown you will see other central banks starting to pause.

    * A Fed easing will not rescue the economy via a positive effect on the stock market. If the Fed pauses in August you will have a significant and temporary rally (as the instant knee jerk reaction of the stock market last Friday to the GDP report showed). But, as I  argued Friday,  this would be a “sucker relief rally as the short term benefits for stocks of a Fed pause will, in short time, lead to the realization that the pause signals that  the Fed is panicking and realizing that an ugly recession is coming (as in 2000 but only worse). Thus, once the signals of this recession build up, the slowing demand, sales, profits, earnings will severely batter the stock market. Expect 10-15% losses on the major equity indexes between now and year end as the bearish reality of a recession sinks in delusional investors still hoping for a soft landing of the economy.” And indeed, as I predicted Friday, this was a “suckers’ relief rally”: today equity markets took a turn down based on the reality check that lower growth means lower earnings. And expect a true bear market in US equities once the reality of a recession sinks in.

Thus, do not expect the Fed to be able – even if it wanted to by pausing in August and then easing in the fall – to rescue the U.S. economy from the coming recession. It failed to do so in 2001 and it will fail to do so this time around. In almost every previous episode of serious Fed tightening since the 1950s we ended up with a recession. The only exception was 1994-95. But then conditions were very different from now:

a) even then the 300bps tightening in 1994 led to an almost 0% growth by Q1 of 1995;

b)  then the economy was coming out of a sharp recession and sluggish recovery (1990-93) and had very little of the macro vulnerabilities that we are facing today;

c) the economy was then on the verge of the IT technology and internet productivity miracle of the 1990s;

d) inflation was then – unlike today – very mild;

e) it took an aggressive easing in 1995 to prevent the real sharp tightening of 1994 from spinning the economy into a recession in 1995 and even then growth close to 0% in Q1 of 1995 and sluggish through H1 of 1995.

 This time around, the vulnerabilities are much larger than in 1994 and than in 2000-2001.  There will no so soft landing and the recession will be painful. And the Fed will be able to do little to prevent the coming recession. The recession train wreck is having too much of its own unstoppable momentum now – as it did in 1974, 1980, 1990, and 2000 – for the Fed to be able to stop it.  Fed pause or easing will not avert the coming recession. We will now pay for living above our means for too long,  for making serious fiscal and monetary policy mistakes that allowed only a drugged recover, and for creating unsustainable macroeconomic and financial imbalances that festered for too long. Thus, the coming payback will be unavoidable - whatever the Fed does or does not - and most painful for the U.S. and for the global economy.

RGE Monitor

Most Overvalued, Most Undervalued of the 317 Largest U.S. Metro Areas Examined

A new study, House Prices in America, using Global Insight’s extensive proprietary databases on the housing market - which combined data and forecasts for home prices, home sales, housing stock, and household income with a methodology developed by the economics department of National City Corporation — examines current and expected housing prices in the 317 largest U.S. Metropolitan areas.

Study findings indicate that 71 metropolitan areas, representing 39 percent of the nation’s housing market, "are extremely overvalued and at risk for a price correction." While price appreciation continues at a historically high rate - boosted by especially strong increases in markets that are already overvalued - the pace of appreciation is slowing.

Global Insight

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This week brings us the release of three pieces of economic data, but one of them is not considered to be of high importance. The biggest event of the week will be the Federal Open Market Committee (FOMC) meeting Tuesday. With so much uncertainty surrounding this Fed meeting, expect to see plenty of volatility after its results are announced. We may also see s ome pressure in bonds tomorrow as investors prepare for the meeting, but most traders will make their moves post-meeting Tuesday.

There is no relevant data scheduled for release tomorrow. The first piece of economic data of interest this week will be posted Tuesday morning. Employee Productivity and Costs data for the second quarter will give us an indication of employee output. High levels of productivity are believed to allow the economy to grow without fears of inflation. I don’t see this being a big mover of mortgage pricing, especially since it is the same day as the FOMC meeting. Analysts are currently expecting to see an increase in productivity of 1.1%. A higher than expected reading could help improve bonds, but until we get the results of the FOMC meeting, we will likely see little movement in mortgage rates.

The FOMC meeting will adjourn at 2:15 PM Tuesday. Usually, the post-meeting comments seem to have more of an influence on the markets than the rate adjustments themselves as the rate changes are quite often expected. However, this meeting is likely to be different. Many analysts are currently expecting the Fed to leave key short-term interest rates unchanged for the first time after 17 straight increases. There is a pretty good chance of this happening in my opinion, but just how the markets will react may surprise many. Any hint of a possible pause by the Fed has led to rallies in stocks and bonds over the past few months. If the Fed was to make that move at this meeting, the initial reaction will likely be positive for stocks and bonds. However, I believe that once reality sets in, stocks may have a negative reaction because the pause would underscore the concern that the economy is indeed slowing. Slower economic growth means weaker consumer spending and corporate earnings, which leads to stock market losses.

Bond traders will likely be relieved that the Fed is, at least temporarily, at ease with i nflation concerns. Since inflation erodes the value of a bond’s future fixed interest payments and drives bond prices lower (pushing mortgage rates higher), this news will likely be taken positively in the bond market. But traders will also be looking at the post-meeting statement for any indication of whether this is a temporary pause by the Fed or if more increases are likely in the near future. Generally speaking, a hint of more rate hikes in the future will be construed as an indication that inflation is still a concern and would likely drive bond prices lower and mortgage rates higher Tuesday afternoon and Wednesday.

There is also a possibility of Mr. Bernanke and friends making another quarter point rate hike. Unless they were to follow that move with an announcement that it would be the last increase for the immediate future, I would expect the markets to drop considerably and mortgage rates to spike higher. The Fed will eventually have to stop raising rates, but many already think they have gone too far. The goal of the rate hikes is to slow economic activity and control inflationary pressures. But there is also a need for a "soft landing" meaning that the effects of the increases come slowly rather than a "hard" slowdown that could put the economy into a recession. The jury cannot start debating that issue until the rate increases have stopped.

The big economic report of the week comes Friday morning with the release of July’s Retail Sales report. This data is very important to the financial markets and mortgage rates because it helps us measure consumer spending. Since consumer spending makes up two-thirds of the U.S. economy, any data related to it can cause a fair amount of movement in the markets. A smaller than expected increase would indicate that consumers are spending less than previously thought, potentially slowing the economy. This is good news for the bond market and mortgage rates as i t eases inflation concerns and makes long-term securities such as mortgage-related bonds more attractive to investors. Current forecasts are calling for an increase of 0.6%.

Also worth noting are two important Treasury auctions this week. The sale of 10-year Notes will be held Wednesday while 30-year Bonds will be sold Thursday. We often see some weakness in bonds ahead of the sales as the firms participating prepare for them. However, as long as they are met with decent demand from investors, the firms usually buy them back. This tends to help recover any presale losses. But, if the sales are met with a lackluster interest from investors- particularly international buyers, the bond market may move lower after the results are posted. Those results will be announced at 1:00 PM each sale day. If there will be revisions to mortgage rates because of the results, look for them to be made during afternoon trading Wednesday and/or Thursday.

Over all, I expect to see plenty of movement in the financial markets and mortgage pricing this week. The bond market is really at a difficult point to try and predict, especially with 10-year and 30-year auctions this week. The Fed meeting will have the biggest influence on bond trading and mortgage rates, but Friday’s sales data can also lead to significant changes in mortgage pricing. I am expecting to see Monday as the calmest day of the week, but I would strongly recommend maintaining constant contact with your mortgage professional the next few days.

If I were considering financing/refinancing a home, I would…. Lock if my closing was taking place within 7 days… Lock if my closing was taking place between 8 and 20 days… Lock if my closing was taking place between 21 and 60 days… Float if my closing was taking place over 60 days from now… This is only my opinion of what I would do if I were financing a home. It is only an opinion and cannot be guaranteed to be in the best interest of all/any other borrowers.

a la mode

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