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We all know the old saw that you can't have your cake and eat it too. Still, some folks see depression if the economy continues to slow and hyper-inflation if it speeds up. In effect, they see stagflation, a beast that hides out with Sasquatch. Sasquatch and Stagflation are often spotted just briefly at the tail end of recessions - the US exception being the late 1970's when the misery index (the sum of the inflation rate and the unemployment rate) went through the roof.

Thirty-year home mortgages average slightly more than 1.5% above the 10-year treasury bond rate, in normal times. These are not normal times; or are they? Numbers have a nasty habit of returning to normal but aberrations can last for decades.

During the 36 years from 1966 until 2002, the baby boomer generation born after WWII went from teenagers to retirees or near retirees. Prior to 1966, home mortgage rates were seldom above 6%. From 1966 until 2002, mortgage rates stayed very high, the moving average staying above 6.5%.

By 2002, a combination of factors caused inflation rates to fall. Inflation is the result of too much money trying to buy too few goods. By 2002, China was producing goods like crazy just as the baby boom generation was finally saving for retirement. Many boomers added chunks of money to 401-K retirement plans. Year after year, the price of manufactured goods fell.

As usual, the pundits got the story upside down. The pundits said that Americans were not saving. In truth, Americans' net worth soared. Part of the savings was hidden by the accounting system for 401-K deposits and withdrawals. A $10,000 deposit might grow to a $30,000 value and then be withdrawn. The result, according to government accounts, was $20,000 of "negative savings". Millions more were saved through the process of buying and maintaining homes. Millions of people paid down principle on mortgages, bought building supplies at Lowe's (NYSE:LOW) and Home Depot (NYSE:HD) to add to their homes, and put sweat equity into their homes. When they sold the homes for capital gains, they got no credit for ever saving any money.

Inflation also fell because trade doors had been opened. The best way to increase the supply of goods is to be open to global competition. Inflation also fell as a result of productivity. The amount of goods available is increased as a result of productivity. US trade is growing at double digit rates. The extra good news is that exports are booming.

In 2003, the 10-year treasury bond hit 3.3% and the 30 year mortgage went down to 4.8%. The lower the mortgage rate, the more valuable the home. Home prices soared. American families, who had never "saved a dime", found they had substantial wealth. Americans do poorly with stock investments because, outside of 401-K accounts, they refuse to buy when times are tough. They buy when times are good, paying high prices, and they chicken out when times are tough. They do much better with homes because they hold on during the tough times.

BACK TO GLOOM AND DOOM


The doomers believe the US economy is in deep recession. They believe nominal GDP is going to approach zero over the next two to four quarters. Since the rate on the 10-year treasury bond averages about the same rate as the nominal GDP, if nominal GDP falls to 2%, the ten year bond will approach 2% and fixed rate mortgages will approach 3.5%.

Doomers tend to forget that the invisible hand of Adam Smith is always at work. The higher the price of oil, the greater the incentive to produce oil; the lower the growth of the economy, the cheaper the cost to purchase houses, the largest asset owned by most Americans. Jobs are still plentiful. Salaries tend to hold up or go up; a stable pay rate can make one all the more qualified to buy a home as  interests costs fall.

The doomers will retort that it is real GDP that will be negative while the nominal GDP is kept up by a very high inflation rate. On the way up, inflation hawks said it was foolish not to count food and energy in the inflation rate. They said the core rate misrepresented inflation because we must eat and we must consume energy.

The assumption that rapidly rising food and energy prices means very high inflation is a poor assumption. Again, inflation is too much money chasing goods. If a family has $1,000 to spend on goods and services and if food and energy costs double from $100 to $200, the family still spends $1,000 per month. They simply shift their spending around. Sure, families may borrow to meet unexpected jumps but the debt must be repaid. The average expenditure remains at $1,000 per month until incomes rise. Inflation is a weighted average of cost. A family that spends an extra $100 on food and energy while reducing its newspaper, telephone and vacation budget by $100 has maintained the family GDP at $1,000. Because families are afraid of how bad the economy will get, for the first time in a long time, even the official measures of savings are positive.

The inflation hawks who focused on headline inflation on the way up, should focus on headline inflation on the way down. The price of gasoline has fallen from above $4 to the $3.58 range and based on current wholesale prices, gasoline will be at $3.39 in a week or two. Headline inflation is now being pulled downward by falling energy prices. If inflation is falling and if GDP is slowing, the 10-year bond rate should be falling. It is. In the past few weeks, the 10-year bond has gradually moved lower by about half a point. It is currently at 3.81%, implying 30-year mortgages of as low as 5.3%. One of the lowest rates seen in many years.

Oops, let's not forget about the credit crunch. Banks were hammered when the value of trillions of mortgage backed securities fell by an average of about 5%. Five percent does not sound like a terrible disaster but the worst performers were concentrated. As a result, banks are in a short term scramble to increase their capital ratios. Thirty year rates are running at 6.4%. As the treasury rate falls, the value of the holdings of the banks will soar. Soon after, they will be eager to lend.

Downey (NYSE:DSL), a savings and loan company, has fallen 94% in value even though it has solid core deposits. It would be a gamble to invest in DSL but there is risk in all investments. Should this savings and loan survive, it will likely double and double again in price.

TIGHT MONEY MEANS LONG RATES WILL FALL

If one only looks at the rates offered by the FOMC it looks like money is lose; however, money is printed when it is lent, deposited and lent again. By raising credit standards, banks have slowed the velocity of money; by saving more of their incomes, consumers have slowed the velocity of money. To keep GDP from falling down the tube (GDP = M x V), the FOMC has had to increase the supply of available money. In good times, a $1 increase in M by the FOMC results in a much higher GDP as that $1 becomes $5 due to the magic of the multiplier effect (again, it is deposited, lent, deposited, lent).

Money supply charts show that the FOMC has not had to flood the markets with money to the degree of past tough times. For example, immediately after 9-11-2001, the FOMC opened the discount window wide. Suddenly 0% car loans were available and auto sales soared. A potential depression was averted.

Besides, the FOMC is not the only central banker. The FOMC stayed tight for 19 consecutive months, throughout most of 2006 and 2007. The US economy slowed. Today, central bankers in the EU, Australia and many other countries are keeping their foot on the brake. The world's economic train is definitely linked. It is linked in multiple ways which makes those who look for one constant link lose faith, but the links are always there. If the money chasing goods in the EU is sopped up, it affects the demand for goods in the USA.

FUTURES MARKETS


When gasoline went above $4 per gallon, Congress looked for scapegoats. An attempt was made to sacrifice speculators on the temple alter. The fact of the matter is that speculators generally level markets and reduce prices. The more speculators you have, the more likely you are to have fair prices.

Nice bargains can be found at public auctions. For example, I once purchased a Lone Ranger - Merita Bead advertisement for less than half its value because there were few bidders. The same sign on EBAY at the same price would have attracted hundreds of bidders. Hard commodities markets have gotten most of the attention, but the financial futures are where the action is.

One form of financial future is the interest rate swap. An investor who believes inflation is going to soar should bet on rising interest rates. He should sell long term bonds, even though he has none to sell. He might accomplish a sale by entering an interest rate swap.

With the 10-year trading at 3.8% and short rates trading at 3, he might swap the interest on one million dollar's worth of bonds for interest on 1 million dollar's worth of short rate funds. In other words, he would agree to pay 3.8% or $38,000 in interest per year in exchange for a variable payment to start at $30,000. The settlement is in net payment. Thus, stable rates would leave him with a loss of $8,000 per year. If the yield curve steepened, as a result of a fall in short rates, he would lose more than $8,000 per year. If short rates were to soar to 6.8%, he would collect a net of $30,000 per year. A business might enter such a swap to offset the risk inherent in a business project.

The above example was simplified by excluding the risk premium. A few days ago, the 10-year swap rate was at 4.7%. The difference in the 3.8 yield and the swap rate is the risk premium. In this case, the risk premium being "charged" by the market is .9%.

Swaps can be made between currencies. "You pay me the London short rate and I will pay you the US short rate."

Tight money in Europe, Japan and Australia is causing these economies to slow. The slowdown in one nation influences the GDP of its trading partners.

Commodities and interest rates tend to trade together. The slowdown in world economies is reducing the price of oil and the price of money. The difference in the price of short term money and long term money is a difference of leverage. Mortgages represent highly leveraged money.

If you believe the economy is weak, you should consider buying levered financial assets, such as banks or savings and loans that hold mortgages. You could also purchase long bonds or you could do the reverse of the example swap from above. You would pay $30,000 to receive $47,000 but face the risk that the $30,000 would increase.

Big banks such as Wachovia (NASDAQ:WB) and Bank of America (NYSE:BAC) hold substantial amounts of long dated paper. Surely, some of it is hedged, but obviously a lot was not, as shown by the steep decline in the price of these stocks.

The levered financial assets will pop before real estate prices pop. The real estate market will not show much strength when the offers to purchase rise enough to start taking out the lower rung on houses available. In other words, a lot of sellers are refusing to lower their price more but are waiting for the market to recover. About one third of the metropolitan districts saw rising sales last month.

IF IN THE MARKET -- BUY NOW!

If you are planning to buy a home, now is the time. Bargains are being picked off daily. Because the trade doors have not been closed, because productivity is still soaring and because demand from boomers has slowed, the risk of much higher interest rates is low. One can buy right now on favorable terms. NC Credit Unions are offering variable rate loans tied to the one year treasury index. The index fell to 1.5% a few months ago but is currently at 2.3%. Add a Credit Union spread of 2.5% and you have a 4.8% loan!

A bargain price at a bargain rate - with prospects good that the slowing economies of Europe, Japan and others will cause less demand for goods, lower inflation and lower long rates. Those who take out a variable 4.8% rate today, may soon be able to refinance at 5% for 30 years.

SIX MORE WEEKS OF UNCERTAINTY?

Congress will reconvene on September 8. The deadline for passing a CR is September 30. Will Congress pass an energy bill before the deadline?

Russia has thrown a monkey wrench into the negotiations to admit Russia to the WTO, to pass the US-Russian 123 Agreement and to negotiate a settlement with Iran. Or has it? Passing the 123 agreement right now seems to be a stretch but both countries have much to gain.

Monday, Iran had more discussions with the IAEA and then made a big to-do about contracting with 6 companies to find suitable sites for nuclear power plants. It is known that the UN + 1 has offered to assist in the construction of at least 1 additional Iranian nuclear power plant. Could it be that another step has been taken toward a final deal?

Turkey has not been the best of friends with Iran but the two countries have recently discussed pipelines and trade. Turkey, like so many countries in the region, has to walk a narrow path between Russia and the West. Under pressure from the USA, Turkey decided to wait at least a month before making a deal with Iran. Iranian deals with dozens of nations are pending. I believe the "hard deadline" with Iran is September 19.

A month from now, Congress will be locked in tough debate and the Iranian - Russian - Iraqi situations will be arriving at a head. Between now and then, oil prices should trend lower, home sales in many markets should show small improvement and long interest rates should trend downward.

The see-saw is low interest rates pushing up home prices. How weak is the economy? How low will oil and interest rates go?

Source: How Low Before Housing Blows?