Market Conditions - Interest Rates, January 2006

The clock is ticking on the remaining days in Fed Chairman Greenspan's term in office. We have exactly 15 days before the new Fed Chairman Ben Bernanke takes office (Senate confirmation vote is scheduled for 1-31) and ends the current Fed tightening cycle.

Since June 30, 2004 the Fed Funds Rate (short term) is UP 325 basis points from 1.00% to its current 4.25%. The US Treasury 30 yr. interest rate is DOWN 105 basis points from 5.59% to its current 4.54%.

In just two weeks the long reign of Fed Chairman Greenspan (1987-2006) will conclude and with it a remarkable period of financial history that began with Fed policy cloaked in secrecy and ending with transparency that has taken much of the volatility out of financial markets. As many of you know I read at least 15 daily newspapers, monitor 5 different financial new services, watch Bloomberg and CNBC TV (sometimes at the same time) and watch most world financial markets for 18 hours a day (6am-midnight) and am constantly amazed at how the markets are able to digest so much news each day and just yawn and act like it's no big deal... since the Fed began increasing the Fed Funds rate on 6-30-03 the long term US bond market has not only risen (interest rates down) but done so without the gyrations that we so often saw in the late 70's and early 80's. As an example just look at the last 2.5 months where the 10 year interest rate peaked at 4.66% on November 4th and has stayed in a 31 basis point range (4.66-4.35) despite a very uncertain oil market and most importantly the BIG unknown... a New Fed Chairman beginning February 1st. One of the items that bothers me is a feeling in the financial community that the FOMC will not change with a new Fed Chairman and that other FOMC members will have an impact on future Fed policy.It seems it would put this probability at less than 5%... it will soon be Bernanke's world and everyone else will guessing his first move in office and that could cause more volatility than we have seen for many years.

A month ago the Comptroller of the Currency sent banks a strongly worded memo urging them to tighten their underwriting guidelines for home loans and last week another memo was sent to commercial real estate lenders with many of the same requests... slowly but surely the Fed will make it more difficult for lenders to give credit to the riskiest borrowers who have found it so easy to buy, borrow and watch as prices soar... 2006 will NOT bring a crash but it will bring a flattening in prices.

Much has been written about the yield curve (interest rates plotted against time) and after the Fed increases the Funds rate on 1-31-06 to 4.5% we will officially have short term rates above long term (10 yr.) rates. But patience is in order as history has shown that inversions last much longer than desired by Wall Street. Over the past 37 years the longest inversion occurred from April 1968 to June 1970 (26 months) with the shortest from February 1982 to June 1982. The average time of inversion has been just over one year since June 2004 history does repeat itself... just not when it is expected... normally an inversion occurs when short term interest rates rise faster than long term interest rates but in the last 19 months long rates have fallen... as a result if long rates continue to decline it will make this new inversion more severe without any action from the Fed... in many ways the NEW Fed (Bernanke) will be watching long rates to see if it can ease (lower short term rates)... so if you want to know when (not if) the Fed will drop short rates just watch long rates... they always lead a Fed easing and this time will be no exception.

With oil stubbornly trading above $60 it is no surprise that we are seeing an increase in oil drilling. In California it is estimated that over 3,000 abandoned wells will begin production in 2006. The longer that oil stays above $60 the more likely that oil drilling will increase bringing more supply into the market and that will help cap the price at 2005 highs of $70 per barrel. The major change between the oil price surge in the mid-70's and the 2005 price increase is in the way OPEC has invested the proceeds of its oil sales. 30 years ago 52% of oil revenues were spent on imports from trading partners with the other half being used to find more oil... today OPEC recycles almost 90% into imports as it comes to the realization that they are closer to the end of its ability to find "cheap" oil and that new exploration would be prohibitively expensive... this is good for global commerce but not a good sign for future oil supplies from the Middle East.

When digging into the jobs number from Friday January 6th it is interesting that the payroll diffusion index (number of industries showing "net" job growth fell to 54.9% from 66% in the previous month. With real estate and construction fueling most of the growth in the US economy in 2005 the winter months are not the best time to judge job growth so we will have to wait a few more months to see if we again see a pickup in these areas. The other statistic that caught my eye was the "quit rate" (those who involuntarily lose their jobs) which fell to 11.4% from 12% the previous month. This is a key statistic for the Fed (Greenspan) and is one of the reasons why it is much to early for the Fed to consider easing monetary policy and will just sit at "4.5%" for at least six months. The other key stat comes from the lending sector as we saw that last week's h8 report showed unabated growth in commercial and industrial loans. It will take at least six months for the inverted yield curve to have an effect on demand for credit

Monday's (1-09-06) London Financial Times had two interesting articles about demand for global real estate. The first on page 18 said that 44 different private equity-style property funds were launched in 2005 with over $100 Billion in assets. In 2004 funds raised just $20 Billion in these real estate funds. The 2nd article on page 20 was about how property funds are finding it difficult to find any properties to buy and as a result they are investing in real estate with higher risk and less return. Why don't they just wait for prices to pull back??? The managers of these funds only get paid if they put the money to work in real estate and are afraid that if they don't invest quickly that investors will demand their money back... this is what happens at the top of a bull market... $$ chases assets that have already risen in value... many of these investors will soon learn a painful lesson... "never confuse a bull market with brains".

GM announced last week that the generous discounts and rebates it has offered for the past many months weren't achieving the results expected, so they have decided to do what most of us do when we have a product that isn't selling... lower prices... it is reducing 57 of its 76 North American models by an average of $1300... that's is not inflationary and one of the many reasons the US inflation rate is hovering under 2%.

***Keep up to date with Scottsdale's market conditions here.

What is the best place to buy real estate....an article in last weeks Wall Street Journal entitled "Stagnant Market Rocks Lake City" was unusual about real estate prices declining... the city of Cleveland. The best quote in the article came from the CEO of a real estate investment trust who said that after entering Cleveland 10 years ago it was now going to close its office and sell its approximately 4.5 million square feet of office and industrial properties. He said that he just doesn't see the opportunity going forward in the Cleveland market... but obviously due diligence is needed.


Finally some good news for the hundreds (thousands??) of mortgage brokers and real estate professionals out there. What is the one thing that everyone would love to happen to make their business soar in 2006??? of course... lower long term interest rates... refinancing of houses, more home buyers, etc. making RE people jump for joy... we will be watching the bond market and long term interest rates (The Treasury will begin issuing 30 yr. bonds again in 2006).... and found that in the last 43 years the longest period (in days) between interest rate peaks was 2037 days. Using the 5 yr. US Treasury which peaked (rate) on 3-26-71 and then peaked again on 12-03-76 it gives us another reason to believe that long term rates will decline to NEW lows in 2006. The 5 year peaked on 11-11-05 at 4.52% and the previous peak was 2-11-00 at 6.76% and that is a difference of 2100 calendar days. It's just one of many reasons that the summer of 2006 will see another (and maybe the last) opportunity to lock in low long term mortgage rates. The Fed finally begins easing later this year (August 8th??) it will be the best time to lock in low financing rates. Just like June 30, 2003 when the Fed began to tighten and everyone predicted long term rates would rise (and were wrong!!!) when the Fed begins to ease they same "experts" will predict that long rates will fall and fall and fall....but they will be wrong again.....this time it will the signal to lock as long rates will begin an advance in the face of Fed easing.......don't worry about missing the opportunity of a lifetime as we have at least six months to prepare.

The bad news is that for 42 out of the last 43 years (1995 the only exception) long term rates have risen in the first half of the year at least 25 basis points with the average of 100 basis points. The average advance has taken about 81 calendar days.

The bottom line is that long term rates may rise in the first half of 2006 and then fall dramatically toward summer...


For all your mortgage needs we recommend:
Matt Smith, Mortgage Broker
Scottsdale Mortgages/Loan Brokerage
I have personally worked with Matt Smith since 1994!