Macro Check: Rates Holding

A: Just got back from a 3 day vacation, not nearly enough, and I wanted to discuss briefly some of the things I see in the general economy. Its hard to ignore that oil prices have been creeping higher in the past few months and that bond yields have held onto their big moves upward since mid May. This world is a global world and what is going on oversees is fast growth, higher commodity prices, hawkish central banks, higher interest rates and tons of liquidity! Our fed is still on the sidelines as it watches from front row seats the battle of HOUSING WOES vs. INFLATION; which fundamental will win out and force the fed to cut rates or raise them. I'm betting on the latter!

Here is what I see going on right now that is worthwhile to discuss.

CDO / ABX Markets Uncertainty - While it's not making the major headlines as it did a weeks ago, the subprime mess that led to a disruption in the MBS (mortgage backed securities) markets is not going away. Bear Sterns's two hedge funds directly tied to these trades are virtually worthless (valued at 1.5B in 2006), leaving investors with no chair when the music stopped! The trouble in this sector is more than confusing and this morning I heard a very interesting theory to describe it; the cockroach theory! It goes like this. When you see one cockroach creeping around, its virtually impossible to tell how many more are behind the walls. Well, Bear Sterns two hedge funds are the cockroaches running around in plain sight! Question now is, how many more are behind the scenes.

This is leading to a level of uncertainty that the tradable markets hate most! It is leading to a rise in safe haven plays, like gold and other commodites, and is still yet to reveal itself on just how bad the problem is. Expect rates to rise if this problem worsens.

Barry Ritholtz over at The Big Picture has a great post on this topic titled, "WTF is going on in the ABX markets":

Its one thing when we see that the BBB bonds -- the junkiest sub-prime crap in the Residential Mortgage Backed Securities (RMBS) universe -- getting shellacked due to foreclosures.

But today, we see that the AA and even the AAA are getting whacked. It looks like either a fund is getting liquidated across all asset qualities -- or someone is panicking.

The ABX index measures the risk of owning bonds backed by home-loans to people with poor credit. Just take a look at some of the charts he posts to get an idea of the sharp moves in these markets. Crazy.

Historically Low Rates / Tons of Liquidity - Two big drivers of the current boom in the equity markets. Stocks LOVE low rates and liquidity which lead to leveraged buyouts and other types of investments with cheap money! Believe it or not, money is STILL CHEAP and there is a ton of liquidity still out there. Generally speaking, this is one of the main reasons why I think rates are trending higher over the medium term. By this time next year I will be very surprised if rates are at or near current levels; I expect them to be higher especially as global central banks continue to be hawkish and raise their overnight rates.

Housing Woes Continue - Not in Manhattan though! Nationally, housing still has some major issues. Lending rates have surged and held at those new levels, no surprise there, and inventory continues to grow. The latest housing data showed housing startes up 2.3% but building permits plummeting to its lowest rate in 10 years. Builders do not expect a recovery anytime soon and have not cutback on building plans as much as they need to in order to correct this inventory problem. In short, with inventories very high across the country, buyers have choices, control, and patience. Outside Manhattan, many areas are having a tough time!

Here in Manhattan, a strong buyer pool and healthy demand is negating the slowing effect of higher lending rates. Manhattan inventory is very tight giving sellers an unusually strong summer to move properties in. I don't expect this to change anytime soon as inventory takes time to reverse course. I'm hoping that in a few months buyers have more options to choose from.

High Energy Prices / Commodity Prices - Oil is trading at fairly high levels at $75/barrel or so. Gold, wheat, and other commodities are also trading at fairly high levels. While our fed is maintaining that high energy and commodity prices are yet to creep into inflation figures, I wonder if..

a) this represents a flaw in how inflation metrics measure inflation

OR

b) higher raw costs will eventually creep into inflation indicators

To me, its just hard to ignore the rise in these raw commodities and argue that they will never creep into the prices of goods passed onto the consumer. Which leads me to the fed and their recent statement to Congress.

Hawkish Fed / Inflation Trumps Housing Woes - The fed did publicly announce that INFLATION CONCERNS trump housing woes as public enemy #1! To me, that is a hawkish tone that indicates to the tradable markets a higher probability of higher rates down the road than lower ones!

According to Fed testimony:

The economy should grow modestly this year, and even more in 2008, but a pullback in housing and the possibility of even higher energy prices pose serious risks.

"The ongoing housing correction could prove larger than anticipated, and energy and commodity prices could continue to rise sharply" and that could "spread to other parts of the economy," said Bernanke. Therefore the "upside risks to inflation is [the Fed's] primary policy concern."

Can't argue that! I fully agree and inflation SHOULD be the main concern moving forward. If rates don't rise that much I would consider that a winning situation for consumers and small investors; but I'm not too optimistic about the prospects of this playing out.

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