Tuesday, July 03, 2007

The Emperor does not share your optimistic appraisal of the situation

At the beginning of the year, I wrote out my basic forecast for 2007. Now that we're closing in on the All-Star break, it seems like a good time to review what's working and what's not.

On housing, I had this to say...

Housing will weigh on the economy in 2007, in terms of lost jobs from construction and reduced mortgage equity extraction. However home price declines will be modest in most areas and the housing market will clearly be recovering by the end of the year. Business investment will remain strong, and this will help keep any decline in consumer spending from causing a more severe slowdown in overall growth.

Housing has been bad, but hasn't really leaked into the general economy yet. I still think it will. Home prices are declining, but nationwide, the price declines have been indeed modest. My thought that the market would be "clearly recovering" by year-end seems unlikely, however.

On the Fed...

Once it becomes clear inflation is slowing, the Fed will make two cuts. The first will likely be in June and the second most likely in August. At that point, the market will price in no further Fed action for some time.

The economy is doing better than I thought, and so these cuts haven't happened, and probably won't until Spring '08, but I'm still thinking a cut is the next move.

On Treasuries...

[The 10-year will finish at] 4.90%...For most of the year, the 10-year will hang around 4.50%, possibly rallying even further, but once it becomes clear the Fed is done (probably 4Q) the 10-year rate will move rapidly higher.

I was right that the 10-year would sell off once it was clear the Fed was done, I was just wrong about there being a cut or two first. I recommended a neutral duration anyway, so no money made or lost here. On the slope, I predicted a +20 slope between 2's and 10's. The steepener call has worked out nicely.

On Corporates...

[Investment grade] Mildly wider, outperforms Treasuries.While I see corporate profits remaining fairly strong, corporate spreads will likely suffer due to increased supply and continued shareholder-friendly activity. However, the widening will not be enough to overwhelm the income effect. Financials will outperform industrials.

Corporates have indeed widened mildly, but financials have underperformed. Shareholder activity has indeed weighed on industrial spreads, but the sub-prime problem has weighed on financials even more.

On MBS spreads...

Tighter. MBS will benefit from increased buying by foreigners and banks, and supply will remain tight as housing activity is light.

I was dead wrong on this. MBS have moved wider almost all year, partially on higher vol, and partially because Asian buying has been light.

Later this week, I'll post on where I think we go from here. Here is the preview:

  • Fed cuts come back into the picture
  • Rates rally, curve gets steeper
  • High quality financials rally
  • High yield continues to struggle
  • Housing remains anemic
  • MBS tighten as foreign liquidity comes back into this market

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