Bonds: up or down?

Where's safe for your money? It's like a minefield: we seem to be zig-zag running between financial explosions. Housing? Overpriced, full of bad debt. The stockmarket? Due to drop when earnings revert to the mean. The commodity market? Distorted by speculation and manipulation.

How about bonds? Clive Maund thinks US Treasuries are due for a pasting as yields rise to factor-in inflation; but Karl Denning is still firmly of the DE-flation persuasion and thinks a stockmarket fall may be our saviour:

The Bond Market no likey what's going on. The 10 is threatening to break out of a bullish (for rates) flag, which presages a potential 4.20% 10 year rate. This will instantaneously translate into higher mortgage and other "long money" rates, destroying what's left of the housing industry.

There is only one way to prevent this, and that's for the stock market to blow up so that people run like hell into bonds, pushing yields down!

He also gives his own theory as to why the Fed stopped reporting M3 money supply rates:

The moonbats claim that The Fed discontinued M3 because they're trying to hide something. In fact they discontinued M3 because it didn't tell you the truth; it was simply NOT capturing any of the "shadow" credit creation caused by all the fraud (and undercapitalized "insurance" which, in fact, is worth zero), but it sure is capturing the forcible repatriation into bank balance sheets when there is no other when it comes to access to capital for companies and governments.

So, two elephants are riding the bond seesaw: fear of inflation, and fear of losing one's capital. I hope the plank doesn't snap. Antal Fekete reckons the bond market can take all the money you can throw at it - but what goes up will come down.

Cash still doesn't seem like such a bad thing, to me.

A secular bear market in housing?

It's now generally accepted that houses are overpriced. I think valuations will not only go down, but (notwithstanding bear market rallies) stay down for at least a generation.

Here's some reasons, some having a longer-term effect than others:

• house prices are now a very high multiple of earnings, choking the first-time buyer market.
• presently, there is increasing economic pessimism, which will further inhibit buyers.
• the mortgage burden now lies in the amount of capital to be repaid, rather than the interest rate; that's much harder to get out of, and will prolong the coming economic depression, either through the enduring impact on disposable income, or through the destruction of money by mortgage defaults on negative-equity property - and as valuations fall, there will be more and more of the latter.
• fairly low current interest rates allow little room to drop rates further to support affordability - and at worst, rate drops could sucker even more people into taking on monster mortgage debt. But interest rate reductions are unlikely to benefit borrowers anyway. The banks have survived for centuries on the fact that while valuations are variable, debt is fixed. They got silly with sub-prime, but by George they will remain determined to get all they can of their capital back, and preserve its value. The people who create money literally out of nothing - a mere account-ledger entry - are now tightening lending criteria and will continue to press for high interest rates; for now, they will content themselves with not fully passing on central bank rate cuts, so improving the differential for themselves, as compensation for their risk.
• food and fuel costs are rising, and given declining resources (including less quality arable land annually), a growing world population and the relative enrichment of developing countries, demand will continue to soar, cutting into what's left of disposable income.
• our economy is losing manufacturing capacity and steadily turning towards the service sector, where wages are generally lower.
• the demographics of an ageing population mean that there will be proportionately fewer in employment, and taxation in its broadest sense will increase, even if benefits are marginally reduced.
• the growing financial burden on workers will further depress the birth rate, which in turn will exacerbate the demographic problem.

In short, there will be less money available to chase house prices; and in my view, less to chase investments, too. It may be very similar in the USA - as Jim from San Marcos says now (repeating himself from last May):

A market goes up when more people want to buy, than those that want to sell. Well, all of these first time home buyers have no spare cash for the Stock Market. The Baby Boomers, sometime in the future are going to want to sell. The question arises, "Sell to Whom?"

Returning to houses, there are still those who think valuations will continue to be supported by the tacit encouragement of economic migration to the UK.

Now, although this helps keep down wage rates at the lower end (where is the Socialist compassion in that?), the government is pledging the future for a benefit which is merely temporary, if it exists at all. Once an incoming worker has a spouse and several children, how much does he/she need to earn to pay for the social benefits consumed now and to come later? State education alone runs at around £6,000 ($12,000) per annum per child.

And then there's the cost of all the benefits for the indiginous worker on low pay, or simply unemployed and becoming steadily less employable as time passes. And his/her children, learning their world-view in a family where there is no apparent connection between money and work. The government makes get-tough noises, but in a recessionary economy, I don't think victimising such people for the benefit of newspaper headlines will be any use. I seem to recall (unless it was an Alan Coren spoof) that in the 70s, Idi Amin made unemployment illegal in Uganda; not a model to follow.

So to me, allowing open-door economic migration to benefit the GDP and hold up house prices doesn't work in theory, let alone in practice.

Besides, I maintain that in the UK, we don't have a housing shortage: we have a housing misallocation. There must be very many elderly rattling around alone in houses too large and expensive for them to maintain properly. This book says that as long ago as 1981, some 600,000 single elderly in owner-occupied UK property had five or more rooms; the ONS says that in 2004, some 7 million people were living alone in Great Britain. Then there's what must be the much larger number of people who live in twos and threes in houses intended for fours and fives. Before we build another million houses on flood-plains, let's re-visit the concept of need.

Maybe we'll see the return of Roger the lodger - if he's had a CRB check, of course.

Would I buy a second home now? No. Would I sell the one I live in? I'd certainly think about it - in fact, have been considering that for some years.

Round and round

"from the Chrysopoeia ('Gold Making') of Cleopatra during the Alexandrian Period in Egypt. The enclosed words mean 'The All is One.'"

Here's a piece by Brian Pretti yesterday, on the Federal Reserve and its attempts to shore up the system with interest rate cuts.

His prose is a little sparky and luxuriant, but his point is that even though the official interest rate may drop, the lending market has become more bearish and there may be higher rates (or more stringent terms) for riskier loans. He feels that lending has not previously enjoyed the discipline of a proper open market, which is why pension funds ended up buying pigs in pokes (subprime packages dressed up as a form of reasonably secure bond).

But why is so much wealth tied up in housing, anyway? I've previously suggested that lenders like to put money into houses because they rise in value, yet that rise is mainly the result of increased lending. It's what looks like an infinite loop, but there are other factors involved, that will lead to braking and possible breakdown.

Over a long period, house prices have increased:

a) because wages tend to increase faster than RPI; but in a global economy, Western wages are stalling; and in an ageing population, social costs (and therefore taxes) are rising.

b) because, sometime after WWII, we moved from a pattern of one significant income earner per couple, to two, who could bid more as DINKYs (dual income, no kids yet); but unless we learn to live as threesomes (TRINKYs) or in larger communes (FAMILIES), this driver has gone as far as it can.

c) because interest rates fell a long way, so people could service much larger mortgages; but now interest rates can't go up much, without widespread repossessions and bankruptcies - of registered voters. And whenever things get difficult, the temptation will be to drop rates further, which expands the lending and ultimately tightens the noose.

d) because lenders got rich and reckless in the boom; they might have offloaded the loans, but they may still have to pay a price for their deceits.

Meanwhile, we have diverted money into real estate that should have been powering business: R&D, startups, expanding small firms. Instead, large concerns are wiping out their potential successors: shopkeepers' children are stacking shelves for hypermarkets.

Democracy is rooted in a degree of economic independence and social equality. In effect, by permitting excessive concentration of capital, we are in danger of enslaving the next generation: the first of the "mind-forged manacles" is the limiting of their aspirations.

Risk avoidance leads to stronger dollar

That's the analysis of Kathy Lien at DailyFX.com yesterday:

These days, cash is a valuable commodity since a liquidity crisis means a lack of cash. The sharpness of recent moves and the lack of liquidity have probably pushed more traders to liquidate positions than to add funds. Flight to safety continues to send the dollar higher against every major currency with the exception of the Japanese Yen as more victims of the subprime and liquidity crisis surface.

There's a possibility of an interest rate reduction:

...the biggest question on everyone’s mind is when the Federal Reserve will cut interest rates. The market is current pricing 75bp of easing by the end of the year. There has also been speculation of an intermeeting rate cut.

But:

Like many central banks around the world, the Fed has been reluctant to lower rates because they feel that the markets need to be punished for their excessive risk appetite. Furthermore, they have said that they need to see market volatility have a “real impact” on the economy.

This, she thinks, is becoming apparent:

With major losses and bankruptcies reported throughout the financial sector, we expect companies to layoff staff left and right. [...] For the people in the “real economy,” their 401ks have taken a harsh beating while their mortgage interest payments are on the rise. It is only a matter of time when we see economics reflect that. The bad news is already pouring in with housing starts hitting a 10 year low and manufacturing activity in the Philadelphia region stagnating. Since the beginning of the year, the weak dollar has provided a big boom to the manufacturing sector. Now that the dollar has strengthened significantly, activity in the manufacturing sector should also begin to slow.

US economy over-dependent on housing sector

The Daily Reckoning Australia summarises Dr Kurt Richebacher's analysis: the US economy depends on the housing sector to a dangerous degree, so even a stall in housing will have a big effect.

"...property bubbles have historically been the regular main causes of major financial crises. During its bubble years in the late 1980s, Japan had rampant bubbles in both stocks and property. While the focus is always on the more spectacular equity bubble, hindsight leaves no doubt that the following economic disaster was mainly rooted in the property bubble. Both bubbles burst in the end, but the property deflation has continued for 13 years now, with calamitous effects on the banking system."

I suspect we have a similar problem here in the UK.

And another thing...

Surely, people who can't afford their mortgages don't have big investments. So aside from default losses impacting on portfolios, I don't see a great need to sell one's holdings (or a wonderful opportunity to buy).

But when the market is worried, private investors tend to get rid of their stocks, which as they drop in price are snapped up by the patient, crocodile professionals. Watch for data on the changing proportion between private and institutional holdings - please let me know when you spot it.

Pessimism overstated?

Seeking Alpha has a useful round-up of stats and news items on the US housing debacle.

I shall try out a contra-contrarian position here.

It's obvious that adjustable-rate mortgages (ARMs) will pose a problem for American borrowers as they emerge into a variable and now-higher interest rate environment. We are approaching a peak in this process around October/November and again, that's known about, so with all the belated hoo-ha in the media now it should be factored-in to the market.

The packaging of mortgages into collateralized debt obligations (CDOs) and their sale to perhaps naive institutional investors, is now better understood and has started a bout of worry that has spread to prime lending, too. So we have a reasonable dose of pessimism in the mixture, with Michael Panzner and Peter Schiff ensuring we're taking the medicine regularly.

One of Michael's posts last week included a detail of a "charming colonial" house in Detroit going for $7,000. Over here in the UK, somebody screwed a 0 to the side of our house prices over recent years, and if I was shown a residential property fund that would snap up streetsful of properties like the one in Detroit and wait for the turnaround, I'd be tempted.

When recession hit the UK in the early 80s, house prices plummeted in Consett, a Northern steelworking town where the local works - the main employer - closed and unemployment rose to 36%. Now the median price is £152,000. This was a working-class town, not a fashionable area, and at that time (1981) the national average house price was £24,188. So even if you'd bought a house in Consett at that price (and because of unemployment and deep pessimism, it would have been far less), you'd have made a 7.3% compound pa capital gain in the 26 years since - plus income from rent, less expenses.

I don't think the housing market runs the economy, it's the other way round. When we have a real economy, our wealth will be more secure. Perhaps the USA needs to wait for a fresh President who can take tough decisions early, in time for the fruits of his/her labours to show and be rewarded with a second term.

It's early days, but the pessimists in my Dow poll (see sidebar) have the upper hand. I still think there may be a small bounce by the end of the year, when we've digested all the bad news and are ready for a sweet. Please cast your vote!

More on US housing woes

An informative piece in Dr Housing Bubble on the various factors that are turning the housing market upside down.

If I read the first graph rightly, there's a peak in the numbers of temporarily-fixed US mortgages that are due to come back onto the current variable rate in November this year, which suggests we may have a difficult autumn ahead. Further cutbacks in discretionary spending, presumably.

US mortgage difficulties to continue next year

There are now forecasts that mortgage defaults and foreclosures will continue into 2008; comparisons are being made with similar drops in the early 1980s and 1990s. Peter Schiff reminds us that the biggest losers will be the lenders, but to the individual mortgageholder that won't seem comforting.

US house price bubble has been deflating for some time

Tim Iacono in Seeking Alpha (July 5) reexamines the housing market to check underlying trends at different price levels, and finds certain sectors have been dropping for some time. As in the UK, the overall average has been skewed by way the high end has held up; a more detailed examination suggests the decline for ordinary houseowners is well under way.

UK housing market also a bubble

The conventional view is that house prices are still rising in the UK. Merryn Somerset Webb, editor of Moneyweek, begs to differ (25 June) and the index to which she refers is here; Michael Hampton (Financial Sense, July 5) is also pessimistic.

For those who want to know what prices houses have actually fetched, see Nethouseprices.com, which gives much other useful information.

Housing corrections and stock corrections related

Tim Wood, in Financial Sense (13 July), tracks housing cycles and the Dow, and predicts a drop in the Dow sometime, to follow the drop that has already occurred in housing. He also sees a series of 4-year cycles; Contrary Investor connects the Dow and Presidential terms, in an article earlier this month.

More on housing loan losses

Stephanie Pomboy's MacroMavens site gave this worrying picture of banks' exposure to real estate risk, on 7 June 2005 - (I'd be grateful for an update for 2007). The Mogambo Guru recently (12 July) quoted her firm as saying (in Barron's) that $693 billion of mortgages are now in the red, with a possible $210 billion in outright losses.

Inflation, housing losses and a stockmarket bubble.

Richard Daughty aka The Mogambo Guru lays about him on 12 July. The housing bubble continues to deflate and inflation is up.

Apparently M3 (no longer reported as such by the Fed) has risen from 8% to 13.7% since figures ceased to be released officially. Looking across the water at the UK, our M4 (bank private lending) has averaged over 13.5% over the four quarters ending 31 March, so it seems we're in the same boat.

A disturbing element in Daughty's report is the notion (relayed from Gary Dorsch at Global Money Trends) that the strategy of US Treasury chief Henry Paulson is to engineer a stockmarket bubble to offset the losses in the housing market. This, as cinemagoers used to say in the days of continuous showing, is where we came in.

More on real inflation figures via iTulip

Further to my post of 9 July re "real" inflation, I have received the following comment from the originator of the charts - thanks.

I am the author of the charts referenced above. For the latest, see here:

http://homepage.mac.com/ttsmyf/RD_RJShomes_PSav.html
http://homepage.mac.com/ttsmyf/recDJIAtoRD.html
http://homepage.mac.com/ttsmyf/newestHousData.gif

FYI, thru today 7/12 for the Real Dow, and thru 2007 Q1 (= mid-Feb 2007) for Real Homes: Real Dow is 2.24x the +1.64 %/yr curve, which is a 55% drop thereto, and Real Homes national (green points) is 1.78x the ca. 54 level, which is a 44% drop thereto.

Housing to drag the Dow down?

iTulip is pessimistic about the effect of a housing downturn on the US stockmarket, and skeptical about reported GDP.

Energy crunch?

Frederick Sheehan's article Reaping the Whirlwind, originally posted in Whiskey & Gunpowder, is reproduced today in Prudent Bear. The prose is rather poetic, but the issue is how an overheated world economy is straining the world's capacity to grow energy supplies to cope. Worse still, new housing designs in the US and upgraded housing in the developing world, are building-in permanent excessive energy demand.

Subprime mortgages: bad news and more to come

Following the collapse of Braddock Financial's $300 million Galena Street, Reuters (6 July) looks ahead to what other hedge funds will have to report.

The Mogambo Guru includes subprime loans in his latest Daily Reckoning rave. I do hope someone posts his Agora Financial conference speech onto YouTube.

Houses and mortgages - reality worse than the news?

Rachel Beck of AP has an article in The Arizona Republic (July 3), showing that dodgy housing data may be understating the scale of the problems.

Planning for the crash

The Contrarian Investor's Journal reveals Part 3 of its thoughts on the crash-to-come, and addresses the dilemma of whether we are to prepare for inflation, or deflation.

I think I agree with the writer's analysis that it may play out as follows:

1. The current inflation will continue until some big scare or crisis starts the run
2. Then there will be deflation, but governments will try to get out of it by printing even more money
3. Printing more money won't work, because people will have lost faith in the currency, so (if you follow the link provided by the writer) we will eventually get to a surge in the price of gold

But we don't know when stage 1 will end, and holding cash may reduce your wealth relative to other assets. So where do you invest?

Buying gold now may mean a long wait before the market comes round to your point of view (if it ever does) and as some (e.g. Peter Schiff) have pointed out, even if you're right, you may find the government forces you to give up your gold, as it did before.

Houses are overpriced, but rather than a general sell-off of real estate I could imagine a long period of house price stagnation, with people staying put if possible. You haven't lost money till you've sold, or the bank has forced you to sell. If you really have nerve, you might sell, live in a tent and buy a bargain when (if!) the housing market tanks - but would your partner agree? Christopher Fildes was suggesting (in the Spectator magazine) moving into a hotel, some years ago - but look at what's happened to London house prices since then.

Some businesses continue even during a depression, if they provide essential services. It's interesting that Warren Buffett and George Soros have both bought into railways recently.

I can't call the play - personally, I am looking to reduce debt and trim personal expenditure, increase cash savings, and otherwise invest with a weather eye on the macroeconomic situation.