I've been extremely busy this week and haven't had much time to devote to the blog. To all those that have made comments, there will be responses sometime this weekend if at all possible.
We've reinverted, as the 2-year is 3bps higher on the week, while the 10-year is 5bps lower. This is an interesting move, because its signalling that the Fed either will not cut or will hike rates, but this will eventually cause short-term rates to fall even further. Its kind of a bet on the 1999-2000 cycle repeating itself. As you remember, that ended in recession in 2001 and a deflation scare in 2002-2003.
I'm highly skeptical on this viewpoint. I think middle class consumers will cut back their spending to some degree over the next 2 years, at least as a percentage of their income. This should result in a lower velocity of money, causing inflation to subside. The Fed does not want to exacerbate the housing problem. Hiking short term rates further would do just that. It would be particularly damaging to sub-prime borrowers, who are more likely to have ARM mortgages, and therefore are directly impacted by rising short-term rates.
It is widely believed that the Fed was a major contributor to the housing bubble. The boom in sub-prime mortgage lending could never have happened without the extremely low short-term rates of 2002-2004. Today, the Fed knows that every 25bps it moves higher, there are that many more homeowners who won't be able to afford their reset. They can't ignore that fact. That doesn't mean they wouldn't hike if they needed to. But it does mean that they won't hike just to prove they have the kahunas to do it.
I also don't think we can ignore the Fed's role in the banking system. Sub-prime foreclosures are going to put some stress on some banks. The Fed doesn't want to add stress to an already stressful situation. Remember the last time we had a really bad housing market was during the S&L crisis. Now, it wasn't really home loans that got the S&L's into trouble, but the point is that a repeat of that kind of situation isn't out of the question in today's market. Why would the Fed increase the odds?
I really think this is a case where the Fed needs to see clear evidence of increasing inflation before they will hike further. If you really think inflation is on the horizon, the play is to assume short rates stay where they are for a little while, but longer rates rise.
Friday, May 04, 2007
Neglectful Blogger
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4 comments:
I see the Fed in an impossible situation.
Ultimately, if the "American Consumer" is what is propping up the world economy, the Fed must attempt to prop up the American Consumer.
Problem: cut rates and the dollar toilets -> inflation -> the Consumer toilets.
Problem: raise rates and the Consumer toilets as you have explained.
I would say that the Fed has been painted into a corner.
if the Fed were to cut rates now, it would be the 2nd LOWEST inflation has ever been when they've cut. Think about THAT every time you read "the Fed can't cut because inflation is too high" argument...
(I read this from a good source somewhere recently, can't remember where so don't have a link I'm afraid)
The Fed will trim rates to something like 4.50% starting this year, to give a small boost to an economy which is slowing because of high debt levels. Dec '07 Eurodollars are the best investment in the market, just close your eyes and wave them in at 94.92 today...an easy 40bps in it for you..
That sounds right: There does not seem to be either latitude or compelling logic for any Fed adjustment in the near-term but I do think things are going to get worse in the housing and mortgage lending sectors for a few more quarters yet so the pressure to ease rates will rise; all the punditry aside I fail to see any sign of a bottom yet (although the home builders are getting close) and don't see total catastrophe either. I must be quirky.
As to causes, clearly the Fed's ultra low rates were contributory but that might not have led to so much trouble if it had not been accompanied by relaxed regulation of the financial sector, the mortgage lenders in particular.
Add to that Wallstreet's interest in and heavy promotion of the previously rather sleepy mortgage sector to fill their new derivatives pipelines (CDO, etc).
Add that yet again to the introduction of risk assessment software designed to automate the loan underwriting process (so that even an under-trained sophomore could do it) and loan velocity skyrockets while effective (and nuanced) evaluation of borrower and risk plummet.
Add to that yet again the unbelievable amount of money all the middle men can get either by running origination operations or securitizing the resulting loans and greed completely overwhelms any sense of fear or prudence; from the very top of investment bank management to the bottom sales force at the corner mortgage brokerage any lingering sense of fiduciary obligation is expunged and the question of whether a particular CDO might be appropriate for particular buyer or a particular mortgage appropriate to a particular borrower becomes moot -- move product dammit -- makes it hard for anyone to do the right thing.
The metaphor of the perfect storm is a bit overused but it fits very well here (and I do not believe we have even hit the eye yet).
I do think the Fed has created their own prison. I think they now realize they cut more than they needed to, and money growth is faster than they want it to be. I don't think they are afraid of hiking. If they felt the need to create a recession by hiking rates another 100bps to get inflation under control, they would. I don't think they need to.
Traderb:
I should look that up. Even if that's not exactly right, the point that inflation is very low today by historical standards is worth noting.
RW:
Good points all. I will say that I think the lax lending standards were in part a result of low rates. Banks and bond holders were looking for more yieldy products, and sub-prime lending offered that. As recently as 2005 I was getting the pitch that the recovery rate on sub-prime pools was very high and therefore your level of defaults didn't matter than much. While I passed on that pitch, its obvious that many didn't.
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