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Today's Market WrapUp 06.13.2007 Mon Tue Wed Thu Fri Puplava Archive
The bond sell-off that began last month with the 10-year UST rising from a low of 4.602% on May 11th to a high of 5.316% yesterday may have reached a short-term top with the RSI near 90, the highest level seen in more than 20 years. Readings over 70 have marked peaks in interest rates previously (as marked below), and the current reading near 90 hints at either a pause or a pullback in rates. Figure 1
One of the causes of the rise in interest rates has been a slew of economic reports over the past month that have been surprising to the upside, removing the hopes of a Fed cut and raising the possibility of a Fed hike with inflation returning to front and center with concern of a slowing economy taking a back seat. The correlation between positive economic surprises and interest rates can be seen by Westpac’s Positive Economic Surprise Index (blue line, left side), which measures the percentage of releases beating Bloomberg consensus estimates in the previous eight weeks, plotted with the 10-year UST yield (orange line, right side) seen below. Figure 2
Not only does the overbought reading on the 10-year UST yield hint at a short-term top, but so does Westpac’s Positive Economic Surprise Index, with the index approaching levels that marked previous peaks (60-65) and approaching two standard deviations above its fifty week moving average, which has also marked previous peaks. The Westpac index has a one week lag, and with more positive economic surprises coming out this week the index is like to reach 60. Figure 3. Westpac Positive Surprise Index
One thing of importance to note, and to prevent readers from turning overly bullish on the U.S. economy due to a string of current positive economic surprises, is to point out the size of the positive economic surprises occurring, which is nothing to write home about. Westpac also compiles an index that measures the size of the economic surprise, both positive and negative. Shown below is the Westpac Size of Surprise Index, bounded by -1 and +1 (z-scores), which illustrates that the string of positive economic surprises have only marginally surprised on the positive side as the index reading is just north of a neutral reading of 0.00. Figure 4. Westpac Size of Surprise Index
The recent positive economic data and a likely bounce in 2nd Q GDP after the 1st Q GDP’s dismal 0.6% reading does not mean the economy is out of the economic woods or financial risks are subsiding, but quite the opposite. Mark Zandi, Chief Economist and co-founder of Moody’s Economy.com, Inc., released his U.S. Macro Outlook on Monday which does not present a rosy economic or investment outlook, with excerpts presented below (click here for link, subscription required):Investors are extraordinarily risk-tolerant. Risk spreads in global bond markets and capitalization rates in global commercial property markets are about as thin as they have ever been, and overseas equity valuations have never been higher. The yield spread between high-yield or junk corporate U.S. bonds and the risk-free 10-year Treasury bond is just over 250 basis points (see chart). The last time they were this narrow was just prior to the late-1990s Asian financial crisis and Russian bond default… Conditions are in place that could lead to a sharp, sustained decline in global asset prices. The odds of such an event are as high as they have been since early this decade, when technology stocks imploded and sent prices reeling across the globe. Figure 5
The most likely near-term catalysts for a global financial shock are U.S. housing and mortgage markets. Further U.S. house-price declines are inevitable given the massive and still mounting number of new and existing homes for sale (see chart). Falling prices combined with loose mortgage underwriting and a rising number of adjustable loans now hitting their first payment resets mean the surge in mortgage delinquencies and defaults will continue and worsen. The performance of the approximately $2 trillion in private label mortgage securities backed by these loans is sure to suffer significantly. If that undermines investor confidence, we could see the broad and rapid re-evaluation of risk that characterizes a financial event. Figure 6
As Mr. Zandi mentioned, delinquencies and defaults are worsening as U.S. home foreclosures surged 90% in May from a year earlier according to data from RealtyTrac released yesterday. May foreclosures totaled 176,137, up 19% from April, and represented the largest amount since RealtyTrac started tracking foreclosure activity in January of 2005. James Saccacio, chief executive officer of RealtyTrac, had the following to say in a statement regarding the newly released data: After a barely perceptible dip in April, foreclosure activity roared back with a vengeance in May. Such strong activity in the midst of the typical spring buying season could foreshadow even higher foreclosure levels later in the year. Certainly not every community nationwide is seeing an increase in foreclosures, but foreclosed properties are becoming more commonplace and adding to the downward pressure on home prices in many areas. What makes matters worse is that the rising foreclosure rates are coming at the supposedly strong spring housing demand period which has been quite lack-luster. Patrick McPherron from DismalScientist had the following commentary in his analysis of the MBA Mortgage Applications Survey released today: This spring is unfolding one of the worst markets for the housing industry in recent memory. Prospective homeowners are expected to hold out for a good deal on house prices, as there is a perception that it’s a buyer’s market. Regulatory authorities are actively tightening up the subprime market, where loose standards were a major determinant of the prior housing boom. Additionally, the next couple of months could reveal an inherent weakness in the economy, signaling that inflation fears delayed a Fed reaction until it was too late to salvage this year’s primary residential housing market. Patrick McPherron isn’t the only one expressing concerns about what delayed Fed easing may mean for the U.S. economy in the future. Paul Kasriel, Senior Vice President and Director of Economic Research at Northern Trust, released his June U.S. Economic & Interest Rate Outlook entitled, “The More the Fed Delays Cutting, the More We Cut – Our GDP Forecast.” We believe the FOMC will get its wish with regard to core inflation, but are less certain that its forecast of Gross Domestic Product (GDP) growth will pan out. One of the reasons we doubt the FOMC’s forecast will pan out without a little interest rate “self-help” is that it never has since 1960. Chart 1 (Figure 7 below) shows that since 1960, every time year-over-year real GDP gets around where it is now, 1.9%, the FOMC has engineered a federal funds interest rate cut. Sometimes these funds rate cuts have come in time to revive the economy. Other times the cuts have come too late to prevent a recession. This time, according to the FOMC and numerous economic forecasters, it will be different: we will experience an immaculate economic recovery. But we doubt it. Figure 7
In conclusion, we believe the housing recession has not yet run its course and that its fallout is spreading relentlessly to other parts of the economy, most notably, the consumer sector. The second-quarter economic-growth rebound, feeble as it likely will be, will represent a false dawn. In the interim, increases in the prices of core consumer goods and services will moderate further. On October 31, the day the FOMC meets, the Commerce Department will release its advance estimate of third quarter real GDP. Our bet is that third-quarter growth will be on the low side of the FOMC’s expectations. Of course, the FOMC will have evidence suggesting that prior to October 31. But with the official evidence in hand on that date, we believe the FOMC will commence cutting the federal funds rate. The housing recession is far from over and the subprime fallout, with more than two dozen lenders in the subprime mortgage sector collapsing, is beginning to spread into other areas of the economy. Evidence of the subprime fallout was presented in last week’s WrapUp with examples of Bed Bath & Beyond as well as housing-related employment. Another indication of the subprime fallout spreading can be seen in the asset-backed security (ABS) market with securities backed by home equity. Markit, the administration and calculation agent for the Dow Jones CDX (credit default indices) index program, has constructed indices for various tranches of ABS backed by home equity. These indices are created from qualifying deals of 20 of the largest sub-prime home equity ABS shelf programs from the six month period preceding the roll. Mr. Zandi mentioned above that “The performance of the approximately $2 trillion in private label mortgage securities backed by these loans is sure to suffer significantly.” The erosion in these securities has already occurred with the BBB-rated tranche falling from roughly 97 to 63 since the 19th of January, a decline of 35%. Erosion has also been seen in the higher quality tranches such as the A-rated tranche that has fallen nearly 9% in the same time frame, though the highest quality tranche, AAA-rated, has only marginally declined. Figure 8. BBB-Rated Tranche
Figure 9. A-Rated Tranche
Figure 10. AAA-Rated Tranche
The trend in higher interest rates that helped burst the housing bubble had lead to rising default rates on home mortgages which has lead to the deterioration in the ABS market backed by home mortgages seen above in Figures 8 & 9. The trend in defaults rates is clearly up as seen in the figure below, and any further increase in rates will only exacerbate the trend. Figure 11
The housing industry isn’t the only industry affected by the level of interest rates as vehicle sales are also negatively correlated to interest rates. A more than twenty year decline in interest rates starting from 1980 has lead to a rising trend in vehicle sales and if we are at a secular turning point in interest rates, moving from a long-term downtrend to an upward trend in interest rates, add declining vehicle sales along with housing to the list of negative economic contributors. Figure 12
Let’s hope the recent bond selloff is over for now and that interest rates will subside instead of continuing to march northward, for any upward movement in rates will only lead to further U.S. economic erosion. TODAY'S MARKET The markets vaulted northward on a surprise jump in May retail sales of 1.4% and a retreat in the 10-year UST yield. The Dow put in its biggest point gain of the year and the highest single positive movement since July 19th of last year, posting a strong triple-digit gain of 1878.34 points (+1.41%) to close at 13,482.35, while the S&P 500 put in a slightly stronger performance, rising 22.67 points (+1.52%) to close at 1515.67 with the NASDAQ closing at 2582.31, up 32.54 points (+1.28%). Investors purchased Treasuries today with the 10-year note yield falling 4.8 basis points to close at 5.20%. The dollar index was up on the day, rising 0.14 points to close at 83.03. Advancing issues represented 79% and 67% for the NYSE and NASDAQ respectively, with up volume representing 88% and 79% of total volume on the NYSE and NASDAQ, reflecting a strong rally in the markets. Energy prices were mostly up on the day after a bullish petroleum inventory release, which showed a smaller build than expected in gasoline and distillates and declining refinery activity. West Texas Intermediate Crude (WTIC) had a strong day, up nearly a dollar a barrel (+1.39%) to close at $66.26 a barrel, and spot Henry Hub rose 2.01% to close at $7.60/mmBtu. Precious metals were mixed with gold staging a late afternoon rally, finishing in the green today at $651.45/oz (+0.65%), with silver up $0.09/oz to close at $13.11/oz (+0.65%). Base metals were mostly down with tin putting in the only positive performance (+0.69%), while zinc displayed the weakest performance (-2.01%).
Overseas markets were mostly up with the Chinese Shanghai index putting in the strongest performance (+2.56%), while other Asian markets displayed the greatest weakness with the Korean Kospi (-0.46%), Taiwan Taiex index (-0.29%), and Japanese Nikkei 225 index (-0.16%) finishing in the red.
The rally in the markets was broad based as all ten of the S&P 500 sectors were up on the day, with the materials, utility, and industrial sectors leading the charge, up 2.23%, 2.01%, and 1.95% respectively. The greatest weakness was seen in defensive sectors such as consumer staples and health care, up 0.85% and 0.94% respectively.
Chris Puplava Copyright © 2007 All rights reserved.
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