Fed Funds Rate -- Gathering of The Clan

The FOMC has gathered to review the Fed Funds Rate target, which is now 3.0%. I am no fan of rate targeting, and have spent little time over the years trying to divine what the FOMC will do from meeting to meeting. The cyclical case for higher short term interest rates remains in place, so the Fed would be well within its rights to raise the the FFR target tomorrow if it so elects. The consensus says the FFR will be lifted to 3.25% (If I was Uncle Al, in the late twilight of my career and with cool porch sitting evenings at Jackson Hole beckoning, I would raise the FFR to 3.5% and call off the next FOMC meeting, tentatively set for August in sultry D.C.).

To further restore its integrity, the Fed should stop ripping off depositors and establish a FFR which supports deposit rates that offer a real return to individuals after adjusting for both inflation and taxes. Last year, when the FFR was a lowly 1.0%, folks lost less on savings by stuffing cash into the cookie jar than by depositing it at a bank. The situation is better now, but there is still a fair way to go.

The leading edge of the mighty boomer generation turns 60 over the next twelve months. As time passes, they are going to desire more of a savings cushion to protect against life's little shocks and hazards. It would nice to see the deposit structure accomodate them.

Housing Boom To Unwind

As an analyst back in 1970, I covered building materials companies like GP, US Gypsum, Masonite, American Standard and Carrier. Those were not bright days for the industry, but based upon baby boomer demographics, all knew a great residential boom was coming. The perfect time sequence would have been 1975 - 1995. The boom actually got off to an early start, but with several interruptions for rising interest rates and subsequent recessions, it has been extended well beyond 1995. The most difficult period was from the late 1980s through the mid 1990s, when housing languished. It took the Tax Relief Act of 1997 and the low interest rates since 2001 to bring the last stage of development to fruition.

Looking back to the promise for housing in 1970, I would have to say the eventual reality had only a few high points. Financial de-regulation and innovation provided the means of home ownership to many more families than one might have anticipated, but archaic zoning and building restrictions coupled with a profound lack of architectural imagination and a disappointingly small commitment to technological innovation produced a boom of mundane, boring and unnecessarily costly homes from which to choose. There are many upscale Levittowns out there.

But the boom has satisfied a strong desire for thirty and forty somethings who started families later in life to live in secure neighborhoods with better schools and community services and facilities. It has been a period of powerful demand based primarily on strongly felt need and not speculation. The strong pricing trend of houses since 1997 or so reflects the final boomer and early post boomer family demand crunch against light supply.

Looking forward, demand growth should progressively slow over the next five to seven years and may even contract in certain segments of the market from 2012 out to the beginning of the next decade. Over this same period, more supply will gradually become available as more and more boomers cross the thresholds of sixty and sixty five. The developing excess in the market will be seen most heavily in homes with square footage which tops the 3,000 mark.

The smarter builders will focus on the elder boomers' desire to downsize and acquire facilities and amenities that suit new needs and wants. Maintaining the value of expensive larger homes will require a new round of financial innovation, which will surely come, as maintenance of the Nation's housing stock will remain a continuing political priority. However, there will likely be no getting away from the fact that the US will have a five to ten year period of a buyers's market in residential real estate that should fall within the 2008 - 2020 time frame.

I expect to see another major boom in housing starting sometime around 2020 which should last for a generation, but which will not likely exceed the recent one in dimension or price inflation.

From an investment perspective, it is late to play the end of the current boom, not because of excess valuation, but because of the prospect that many builders and suppliers will experience a period of deceleration of earnings growth and, subsequently, down earnings. It may also be a little early to pursue the boomer downsize play, but this one is on my long term radar.

Do we have a BUBBLE now in US housing? It's a hot, buzzy word these days and in my view more apt to confuse than enlighten in this context. Is the end of the present boom drawing nigh? Yes, and house pricing will cool at some point and remain so for some extended time. That should figure in your thinking not only about stocks, but your own needs and desires regarding shelter.

Inventory Build

Output, sales and inventory measures for the economy show reasonable balance save for distributors or wholesalers. Spring sales are running about 8% ahead of last year, but inventories are 12% higher. With distributor sales stronger than both factory and retail, there is likely some involuntary inventory accumulation which will eventually feedback to the factory level. This is a normal development and may extend the slowing of the economy until inventories are trimmed. The imbalance at the distributor level may also affect imports mildy.

Bailing Out China -- Chapter 1

BofA announced purchase of 9% of China Construction Bank for $3 billion. What's the deal? CCB is on its posterior. A book of bad loans and officers who have regularly cleaned out the till. Bof A has a cadre of Chinese and Chinese Americans from its San Francisco hayday. These boys go to CCB to downsize it, put in top notch controls, state of the art payment and deposit systems and, eventually, set up retail banking operations. The bad loans will be sold to some combine of Chinese chieftains, call it Yuk Foo Finance. With the clean up and the BofA imprimatur, CCB can go to the Global capital markets to re-capitalize the bank properly. Look for Bof A and Morgan Stanley to head this one.

Let's spin. BofA and Morgan (who has a deal on with CCB) start to get plum loan and equity deal flow with major Chinese companies. BofA sets up a sino-dollar facility to accomodate deposit flows with BofA safety net. This facility will also recycle dollars to relieve stresses at the central bank in Beijing. Down the road, BofA jointly with CCB gets to issue up to 200 million VISA cards to the locals, backed by BofA's top notch credit card processing. China has a real bank that can help the country grow, and BofA has a diverse cash machine that will earn it a nice return on its investment.

CCB will cooperate as ordered by Beijing and of course it is doubtful BofA would have undertaken such a challenge without carte blanche from Hu and crew.

It is going to take lot of work like this keep China from flat running off the rails.

Do not expect the gang at Morgan to bad mouth the Dragon any time soon.

Inflation And Monetary Policy

Accelerated inflation over the past three years primarily reflects a powerful run-up in commodities prices. The Fed started to tighten with greater vigor at the end of 2004 and has continued that policy. A review of sensitive and raw materials prices shows most have leveled off in the past year save for fuels, which remain in strong long term uptrends and which, being basic to most commerce, foster a widening in business pricing as commerce seeks to recapture costs from a rising fuels bill.

Looking at oil, priced at $55 plus a barrel, it can be argued that with tight capacity but no shortages, oil should be selling in the low $40s per barrel (equilibrium price at $38.50). So there is a fear premium in the market as well as a few bucks per for speculative zeal. Pardon the presumption, but I doubt the Fed would argue with any of that. Because the Fed cannot know that there will be no significant oil or gas supply blowouts in the months ahead, it would be difficult for them to reason that it is ok to ease up now since the market will surely settle down soon. So, I expect them to lean into the wind for a while longer.

It is also worth noting that for oil to lead the inflation acceleration higher over the next year, it would have to move up to $75 or so a barrel at some point by 2006. I doubt the Fed would be willing to sign off on that either, and I also doubt the central bank would trash the economy if oil did start to move in that direction. This brings us back to perhaps having to lean on the economy a while longer and hope for the best -- that fuel prices will fall in line with the rest.

Drooping Dragon

The Shanghai Stock Exchange Index recently entered free fall. Now comes the story that Gov. authorities in Beijing are looking at a $15 billion bail out program to staunch the decline. The market has had a nice bounce on this rumor, although its position is still precarious. Through constant dilution of the market by conversion of state owned enterprises, the Gov. has made a mess of its native equities markets, including the Shenzhen Exchange. It is another example of a rapidly growing economy which has far outstripped the financial foundations needed to keep it on a sound footing.

China is planning a grand entrance on the world stage as a modern, major nation when it hosts the 2008 summer Olympiad. Rest assured it will be quite a show. Next year, Beijing plans to begin letting major foreign owned financial companies in to China to compete. Beginning with the year 2007, Beijing will become preoccupied with The Games set for summer '08. So, I figure there is an eighteen month window for Beijing to begin rapidly reforming its financial system before it is too late to keep the economy from a slide brought on by a weakened financial foundation. If Beijing fails to take action, it would not surprise me if the 2008 Games turn out to be a grand finale for the capitalist revolution underway since 1979.

Big trouble in Big China by 2010 would be big trouble for everyone.

To see a three year chart of the SSEC, click here.

Long Term Liquidity Trend

The Fed's tight management of the Fed Funds Rate during the Greenspan era belies enormous volatility in monetary liquidity. It is living proof of economist Art Laffer's judgment that you cannot consistently manage both the price and supply of money at the same time. Since the end of 1999, the Fed has been allowing one of the largest liquidity bubbles in US history to unwind. Much of the excess liquidity generated over the 1995 - 2002 period was burned off or consumed in the simultaneous crashes of the tech / telecom sector of the stock market and the economy. There has been enough liquidity spillover to give the housing market a good boost, but not enough to generate a serious general inflation.

Since the end of 2003, the growth of the real economy has consistently outpaced that of liquidity. The effects on the capital markets of the consequent substantial rise in the velocity of money have been muted by the continuation of a negative real short term interest rate. The bringing of the economy and liquidity into better balance has required considerable skill by the Fed and a fair measure of good fortune. Greenspan owed everyone this after the "banana boat republic" monetary policy he ran from 1995 into the new millenium.

Did the Fed lose its marbles over the 1995 - 2002 period? No, it worked with the Clinton team to engineer an economic and stock market boom that would provide a dramatic increase in revenue flow designed to put the US budget into balance. The effort was blessed by development of remarkable balance between economic supply and demand and a rising Dollar. But, alas, they lost control of the liquidity genie. It happened too fast, and the bubble was created. The budget went into surplus, but all hell broke loose anyway. The US went from soaring prosperity to the brink of economic depression in a mere half dozen years.

The US has moved back from the precipice, but there are tremendous challenges ahead, and the Fed must begin to work harder to maintain better balance in the execution of monetary policy. To this end, at some point, it must address the changes it made to reserve rquirements for jumbo deposits in 1992. It is still way to easy for the banks to evade the reach of the Fed by funding through jumbos with low or no reserve requirements. The latter is a technical but critical point. "Uncle Al" is in the home stretch of his tenure, and the Fed needs strong new command. I am hoping he keeps the monetary reins balanced to hand over to the new chief next year.

Bond Market Profile -- Brazen Bulls

10 Year Treasury: 3.91%, 30 Year Treasury: 4.24%

The Treasury Bond market normally prices off the FFR or 91 Day T-Bill rate. Based on very long term relationships, the Bill, at 2.99%, implies a long bond yield of 4.50%. This relationship is a rule of thumb, not a precise axiom of the game.

Short rates are too low relative to the recent inflation range of 3.0 - 3.5%. The Fed, leery of the strength of the economic expansion, has brought rates up very slowly. The Fed has faced a headwind, too. The ratio of short term credit demand to the supply of loanable funds in the system although rising sharply, is still quite low relative to the supply of loanable funds. Rather than drain permanent reserves and imperil the economy, the Fed has been pressed to move short rates up in small increments. A fine point perhaps, but an important one to keep in mind.

Bond managers, reluctant to sacrifice yield in the environment by staying short, have pressed to pick up yield along the curve and through adding spread by downgrading quality. The Treasury bond yield barely protects the purchasing power of the money invested in it, but it is still better than taking a very short duration position.

The recent sharp rally in bonds dating back to mid-2004 reflects bond manager awareness that basic cyclically sensitive data is flattening out, indicating a continuing economic slowdown that managers expect will eventually lead to lower inflation readings. So the bond market has felt comfortable long despite the nominal premiums in yield over inflation because expectations are strong in favor of a deceleration of inflation resulting from the slowdown.

There is no "conundrum" here. Bond manager behavoir has been normal. The group can get uneasy, however. Signs of economic strength or a short term boomlet in commodities prices can add 50-100 basis points to yields in short order. But so far, the underlying consensus conviction that inflation is headed lower, perhaps to 2.0% or slighly less remains strong.

As mentioned last week, the bond market is overbought and sentiment as measured by the normally reliable Market Vane survey of bond traders is now far too bullish, with 76% of repondents recommending the long side. It would be a surprise not to see the 10 year Treasury head right back up to 4.50% or beyond in the next several months.

One thing to watch out for is when the Fed says it has reached its goal of removing accomodation and is now in a neutral posture. Since "removing accomodation" has been a euphemism for tightening the reins, a neutral posture might well be consistent with rate and liquidity moves in either direction. This change could increase uncertainty among bond players and result in some premium building in note and bond yields, since it opens the question of whether the economic slowdown might soon end and give way to faster growth.

Link to a nice long term chart of the Treasury here. It shows the long term bull market in bonds is still intact. Note that as in the past we are basing under the yield downtrend line. I suspect if monetary policy is again set to support moderate growth, the downtrend line will likely be challenged once more.

May Employment Situation

Civilian employment increased by more than 400K in headcount during the month.

Measured yr / yr, jobs growth rose by 1.9% -- reasonable performance.

Growth of the labor force has been creeping up and increased by 1.4% over the past twelve months. This is still low enough growth not to force the Fed's hand on monetary policy.

Hourly earnings increased by 2.6%, which lagged inflation of over 3.0%. Bosses continue to be profound cheapskates, and are not rewarding the rank and file for productivity gains. This practice of "poor boying" the labor force undercuts sustainable consumer purchasing power and intensifies growing class differentiation. You do not have to be a populist to recognize that corporate greed is a long term economic negative.