Home Prices & Recessions – Prices Turn Up First

There seems to be a growing sense that home prices are not going to recover, on a national scale, before the economy shows signs that the recession is ending. To confuse this notion with some facts, the chart below shows the year-over-year percent change in the median price for existing homes over the course of the business cycle (shaded areas are recessions). Recession definitely impacts home prices, some more than others for many different reasons – affordability, real interest rate levels, unemployment rate, etc. But in each cycle, home prices recover before the economy does -- at least as far as NBER dating is concerned. Because the perception of recovery lags reality, this means that home prices begin to recover long before consumers believe the recession has ended and certainly before the unemployment rate starts to turn down. All of which is to say that in the coming months we will see home prices begin to recover even though the recession is not officially over. My forecast is for home prices to begin move higher in the third quarter (www.econmkts.com) and to finish 2009 with prices about 11% below year-end 2008 levels.

FOMC Unwind Steepens Fed Fund Futures & Signals Growth

My post yesterday parsing the FOMC Statement noted that the Fed was ready to unwind and today Fed fund futures have caught on (see chart below). The Fed believes that that there is no need to rush the process because there is plenty of slack in the economy to provide inflation cover against rising energy and commodity prices. The S&P Goldman Sachs Commodity Index has risen from a low of 305.585 on February 19 to the current level of 458.3169 -- a 50% increase but still well below the high of 893.859 hit almost one year ago to the day.

The rise in commodity prices reflects recovery from depression fears not inflation and so too is the steepening Fed funds futures curve. Against May 29 and March 31 levels, there hasn't been much price change in contracts expiring between now and early 2010. Thereafter the expectation for higher rates grows. Compared with May 29 expectations, the market has raised its funds forecast for Spring 2011 by 50bps to 2.25%. Not inflation, a return of optimism.

FOMC Statement -- Fed Begins Focus On Unwind & Inflation to Come

The FOMC statement today reflects a committee that believes the credit crunch is past, the economy is close to stabilizing, and believes the economy's slack buys it some time on inflation as it starts focusing on the unwind.

In the April statement, the Fed wrote:

Information received since the Federal Open Market Committee met in March indicates that the economy has continued to contract

This month --

Information received since the Federal Open Market Committee met in April suggests that the pace of economic contraction is slowing.

A tepid upbeat statement, upbeat nevertheless and here is a key component that colors the verbiage later in the statement:

Businesses are cutting back on fixed investment and staffing but appear to be making progress in bringing inventory stocks into better alignment with sales.

In April --

Weak sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories, fixed investment, and staffing.

The Fed didn't drop the difficulties in obtaining credit as an oversight. While consumers remain under the same pressures, businesses are doing the normal recessionary rebalancing but can now do it without being frozen out of credit. Big progress. Progress enough, in fact, for the Fed to drop this into the statement:

The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time

In other words, we see the inflation risk on the horizon but the economy has some time. Time is necessary because the unwind of the balance sheet will not take a week or two -- and unwinding the short-term paper facilities comes first.

In April the statement had this line that is not in the current June statement --

The Federal Reserve is facilitating the extension of credit to households and businesses and supporting the functioning of financial markets through a range of liquidity programs.

The April statement ended with this line --

The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of financial and economic developments.

The June statement ends this way --

The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

The shift in language may seem small but the implication is big -- the Fed is telling us that if conditions warrant it they are ready to start pulling back.

Bernanke Set to Defend Record Amid Debate on New Term

The article is on Bloomberg this morning and the opening paragraph says a lot about the problem with the debate. Bernanke sounds like the guy who lets his partygoers get drunk, drive home, and then wants credit for the rescue effort after the inevitable pileup --

Federal Reserve Chairman Ben S. Bernanke will defend his unprecedented actions to prevent a financial collapse as debate on whether he should be reappointed begins.

We did have a financial collapse and we got there because of his two major failings --

1. Bernanke's focus on inflation targetting instead of credit growth (still is, by the way)-- even though domestic inflation in a rising trade deficit economy with a strong currency propped up by the trade surplus country means little. Capital inflows impacting interest rates mean more. Too much money chasing too few investment opportunities creates the inflation in assets rather than goods & services. Bernanke could only opine that the Fed can't do anything to prevent an asset bubble.

2. When the subprime crisis started (just as capital inflows began to slow, by the way) Bernanke displayed his astonishing ignorance of the capital and foreign exchange markets by insisting this was just a subprime/housing problem and lowering interest rates (thereby boosting growth in China and we saw what happened to oil as a result -- our easy policy ignited global inflation) He should of known this was a collateral problem best solved through the open market desk and by the government buying up surplus homes rather than insolvent financial institutions.

Bernanke proved academics make a lousy Fed Chairman -- he had to bring the economy closer to his academic strengths, depression, before getting it right. In addition, he failed (as did Greenspan) to recognize the theory of second best, meaning, in this instance, you don't run policy as if we have free floating capital and foreign exchange markets when we don't.

This is not to say Summers or Yellen would be any better. The very fact that Summers is in the mix makes this very political choice an underscore to the regulatory changes in the financial sector. Once the economy is on the upturn the government wants the say on how the inflows of capital are to be allocated. After all, the deficit in national saving will be owed to the government not the private sector.

Oil Price Technicals -- A Picture of Shifting Supply & Demand

Oil is a key indicator for the turn in the economy and, as my last post illustrated, for when the yuan is going to resume revaluing to the dollar. Technical analysis of price action isn't mystical -- price patterns reflect shifts in the balance of supply and demand -- how people are voting their money rather than their opinions.

The chart below is the daily spot dollar price for Brent crude (this is an index so divide by 10 to see the actual price). The move from the low set year end has a decided counter-trend price pattern and has barely retraced more than 23.6% of the decline that began in July. The current run also looks a bit exhausted as prices broke through their channel ceiling and have since pulled back to the top of the channel. The daily slow stochastic is giving a sell signal as it breaks down through 80.

So the daily chart gives every indication that the six-month oil market run has topped out but I wouldn't put the big bear hat on just yet. The price is still above some important moving averages that now look like support and commodities typically retrace 50% of a trend move before the trend resumes. In addition, commodity prices almost always have that counter trend look to them when coming off a bottom -- as opposed to stocks and bonds. Lastly, the weekly chart (see below) is still signaling higher prices.

In sum, oil prices are taking a brief breather before the uptrend resumes. The 50% retracement level is $80, also a level where some believe China will resume yuan revaluation to the dollar. Look for oil to hit $80 before any serious down move could resume -- if it does resume.

The Yuan, The Dollar & Oil

China manages the Yuan to its self interest and its interest is making sure it remains the world's low cost producer -- regardless of the global imbalances created. In the past decade China kept the Yuan fixed to the dollar despite a growing trade surplus (how do you think they ended up with all those dollar assets). China finally agreed to open its currency to a managed float in mid-2005. Why then? It appears that oil above $55 per barrel did the trick. And when oil prices began rising at an accelerating pace in 2007 the Yuan's revaluation to the dollar did the same. What then going forward? Hard to say what price oil must rally through to get the Yuan again appreciating against the dollar, but current trading levels aren't it. My guess is $80 oil will do it.

Bernanke's Trail of Talk

Thanks go to Austrian Filter for putting these quotes together. The site has many more and includes some of Paulson's bon mots as well. I just culled out some of the Bernanke quotes from when it all began. You can go to the site to get all the whole sorry trail of talk.

March 28th, 2007 – Ben Bernanke: "At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained,"

May 17th, 2007 – Bernanke: “While rising delinquencies and foreclosures will continue to weigh heavily on the housing market this year, it will not cripple the U.S.”

June 20th, 2007 – Bernanke: (the subprime fallout) ``will not affect the economy overall.''

October 15th, 2007 – Bernanke: "It is not the responsibility of the Federal Reserve - nor would it be appropriate - to protect lenders and investors from the consequences of their financial decisions."

February 29th, 2008 – Bernanke: "I expect there will be some failures. I don't anticipate any serious problems of that sort among the large internationally active banks that make up a very substantial part of our banking system."

Bernanke had no sense of the extent to which subprime mortgages were a creature of the securitization market. No sense of the impact of falling prices on these securities on the banking system just as the inflow of foreign capital began to ebb because the U.S. trade deficit began to shrink. Even if one forgives the lack of foresight on the part of the Chairman of the Federal Reserve, he and Paulson decided to attack the problem by supporting security prices rather than the price of the underlying asset -- homes. During the real Depression, the Government came in, bought wheat, and plowed it under to support prices. What a different world in which we live today.

Bank CDS Spreads React To Financial Regulation

The point of the new financial regulations is to turn banks with somewhat sketchy portfolios into pillars of strength by having to put up lots of capital under the watchful eye of the Fed -- and keep them from ever again making bad decisions with over-leveraged capital. The market read the plan and decided instead that banks are now more at risk.

In the past week, C CDS has widened 91.2bp, BAC 45.91, WFC 41.78. GS widened to 160bp from 125bp last Friday and JPM went from 87bp to 108bp in the same period. That is quite a percentage leap for firms that are out from under the TARP.

In fairness to the banks, credit spreads have widened throughout in the past week. Reregulation may only be one reason and the Fed/Tsy will surely let us know what the other reasons are.

Still Wide Credit Spreads And A Tightening Fed -- Market View for Summer 2010

As everyone has now figured out (if they didn't know before) markets aren't rational only efficient at averaging out everyone's expectations for the moment. The graph below charts out the yield on the Jun 2010 Eurodollar contract against the average Fed funds rate expected for summer 2010. Remember that the Euro contract is the yield on a three-month deposit made the day the contract goes to delivery, so the rate necessarily includes an expectation of where the funds rate will be plus a credit spread.

The market, in its infinite wisdom, is pricing in the Fed raising the funds rate several times between now and summer 2010. By August 10, the rate will be 1.5%. Considering all the depression talk that is quite a run to be discounting especially with no easing in credit spreads. At present that forward spread for summer 2010 is 47 basis points and has generally averaged around 42 basis points since May 10 -- when the winter scare was finally priced out of the market.

It is not quite clear to me how the Fed will be actively raising the base lending rate while banking spreads are still at recession-like wides. Looking at the level of the Eurodollar rate against the spread to expected Fed funds, someone is going to be wrong. The Fed will not be tightening, not for a long time and there is a very good chance that Bernanke will not even be running the Fed when summer 2010 rolls around. Reads to me like an arbitrage opportunity (at your own risk, etc.)

Reich Takes Aim At Financial Market Reform And Misses

In his blog, Robert Reich gives his opinion on the financial reforms formally announced yesterday. Thankfully he summed his views up nicely in the first paragraph --

"The plan doesn't stop stop bankers from making huge, risky bets with other peoples’ money. It does increase capital requirements and oversight, but it doesn't require bankers to take their pay in long-term stock options or warrants, and it doesn't even hint that banks should go back to being partnerships instead of publicly-held corporations."

Obviously Reich missed that class in Money & Banking 101. If he showed up he would know that dynamic capital requirements act like reserve requirements to limit bank leverage. As for the nature of the bets, well I would like to think that there are quite a few traders, bankers, and risk managers on the look out for black swans.

If Reich really wants to make money trading less profitable he should want less of it floating around with no place to go. The solution is letting the East Asian currencies revalue to free market levels against the dollar. Import substitution and export sector growth will result. Smaller trade deficit, greater profit potential in the nonfinancial sector -- and the financial games will slow by necessity. But if the Fed/Tsy insist on quickly returning to high real interest rates and a strong dollar policy we will again have too many dollars chasing too few capital investment opportunities and then this recession will have been for naught.

Payrolls Boosted Big By Birth/Death Adjustment

The May payroll number was a good sign but before getting too far ahead of today's data remember that these numbers are subject to huge revisions and include fudge factors. Because the BLS can't know to survey a firm that didn't exist a month ago BLS fudges the not seasonally adjusted payroll numbers with a birth/death adjustment. This May, on a nonseasonal basis, payroll employment was +319,000 of which 220,000 was added because of this adjustment. Interesting to note that of the 129,000 nsa increase in construction workers this month about 43,000 came from birth/death. I find it difficult to believe that so many new construction firms have come on stream in the current environment. During the annual benchmark revisions I suspect a good part of this will go away.

The chart below illustrates the running 12 month change in total employment and the change without the birth/death adjustment. For the 12 month period ending in May, Labor reports a loss of 5.4 million jobs -- which includes an add of 811,000 jobs from the birth/death adjustment. Draw your own conclusion.