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September 22, 2006
The Treasury bond market has had its best week in 18 months, the 10-year T-note today 4.61%, and that dragged low-fee mortgage rates below 6.50%. The improvement in mortgages was not as big as the Treasury move, but catch-up trading should soon take us to 6.25%.
The unsettling backdrop to this decline: nobody has a good explanation for why.
A drop in long-term rates at the end of a Fed tightening cycle is always associated with a slowdown in the economy, usually an abrupt one.
Consistent with that thought, the bond market broke to six-month lows yesterday instantly after the Philadelphia Federal Reserve reported a surprise contraction in business activity. The Philly Fed’s index is a minor affair, covering manufacturing in Mid-Atlantic states; it is brand-new news of September conditions, and it could reflect a brand-new downtrend in the national economy.
It could, but nothing else does. The four-week average of new claims for unemployment insurance remains rock steady, and any significant downturn in the economy has to show itself in the job market.
The housing market is in a straight-line slowdown, but even the most pessimistic Bubbleologists know that housing feedbacks into the real economy will develop slowly. Early week news of collapse in August housing starts and permits (both down double their miserable forecasts) got the usual apocalyptic treatment in the media, but a collapse in new construction is a healthy part of the bottoming process. The last thing a market drowning in unsold inventory needs is more construction.
The twin reversals in commodities and inflation should be good news, not bad. The August producer price index fell .4% versus a forecast .2% increase, and that just on the leading edge of the general reversal in commodity prices. One could argue that the ker-plunk in energy (oil now $60, natgas $4.75, retail gasoline headed for two bucks even) has been caused by an economic fade, but a better argument is the combined effect of price-dampened demand, increased supply, reversed speculation on hurricanes, and reversed speculation in general.
A 32-year-old trader, a tad short of supervision at the $9-billion-in-assets Amaranth hedge fund, got crosswise while playing with leveraged natural gas futures. One week later, Amaranth is a $3-billion-in-assets hedge fund.
Falling energy prices are a consumer stimulant, not a contracting force.
Okay, maybe this three-month bond rally is just a Fed play: maybe the Fed has overshot at 5.25% and will begin to ease. Fair enough, but how far are they going to ease? Bond yields in a normal universe should be 1.50% above the Fed; today they are almost three-quarters under... so, the Fed’s going to ease 2.25%, soon?
The same odd bond-market conditions prevail elsewhere: a UK 10-year “gilt” trades 4.49% versus a 4.75% Bank of England; a 10-year German “bund” trades 3.70% versus a still-tightening 3.00% European Central Bank; the Bank of Japan installed a .25% cost of money, and the 10-year JGB yield fell from 2.00% to 1.63%.
One alternate theory may connect the dots. We do have a reversal in a few overbought markets, but by and large, all over the world, an enormous pool of investment capital is chasing disproportionately scarce investments, and bidding investment returns into the basement. Best example: ask a commercial real estate broker anywhere what cap rates look like, and when they were last so low.
We are so conditioned to inflation as the central threat that we are slow to adjust to the new age. An alternate overall condition would explain the excess of capital, the shortage of investments, and an energy-price spike that did not go wild: in the new age, China’s new age, deflation is the predominant force.
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