More Avenues Into Bonds

Last week it seems my "Bond Market Has It Right" stirred up a little hornet nest under my doorstep. Ok by me, since most feedback was in agreement and positive. One cannot look at price inflation in aggregate terms. Rising prices show up on the cost side pervasively, to make for an economic tax, understood conceptually for oil but apparently not for producer prices generally. We recognize wages have failed to keep pace with phony reported economic growth. We easily conclude that job growth is dismal, whereas my contention is outright job loss occurs in current months. The US Federal Reserve Reflation initiative is often criticized as fueling speculation more than legitimate growth, whereas my view calls their doomed effort a failure to generate systemic inflation, with China the true obstacle. They both impose a wage ceiling and obstruct the "cost push" dynamic for desired price inflation. The housing market is on the verge of a long hissing decline. These are fundamental reasons not often discussed as to why the long-term interest rates proceed lower. The easy part is the Asian trade surplus recycle (not since June 2005 though) and the Persian Gulf petro sales recycle (ratcheted up since Asians withdrew).

More must be stated on the bond rally, which is NOWHERE NEAR FINISHED. Gold competes with govt bonds. Gold will not skyrocket until the current bond market rally ends, when long-term rates bottom out, and until the USFed begins to cut rates in desperation. My edumacated jackass guess is that the 10-year TNote yield might bottom out sometime like next spring at between 4.2% and 4.4% in defiance to inflation-based analysts. Long-term rates rose when the masses expected the USFed to inflate until the cows come home. Well, the cows might be coming home, dragging some of the housing foundation and support beams with them. Oops, those are bears! The nightmare of adjustable rate mortgages (ARM) is only in its early stages.

Many are the avenues to feed the bond rally. We are in Kondratiev Winter, are we not? They are discussed in analytic detail in the upcoming September Hat Trick Letter due in mid-month imminently. The urge came to spill some of my beans, which surely will seem like rain on hopes, as investors rue their setbacks until the USFed wakes the hell up and moves to an easing bias. This clueless cast of hack economists is between 40 and 60 basis points wrong high now, too full of pride to cut rates and trigger a possible rout on the USDollar, which is supported by a threat of a rate hike. Little Ben demonstrated his monetary testosterone alright, only he stands wrong-footed on interest rates. The 3-month TBill yield is at 4.69% while the 2-year TBill yield is at 4.82%, both below the goony USFed official target of 5.25% which has stood for two months. What an embarrassment! What a bad bluff!

The TNX index is charted below. The 10-year TNote yield might offer a bounce here. But when the 20-week moving average is encountered near 4.9%, rising rates will feel resistance. Look out below on rates if and when the 20-week MA crosses the 50-week MA, which could happen by wintertime. A conceivable target for long-term rates is under 4.5% where plenty of past congestion was seen. Notice how gold rallied past the 700 mark last winter, when long-term TNX rates were not pushing the high levels. Notice also that gold struggled this summer when the TNX surpassed the 5.0% mark, precisely when the housing sector was seen to have topped out. With rates falling, not only are bonds in competition with gold, but questions have arisen on asset deflation, even as the principal scourge of rising energy costs has been mitigated. Next up is debt deflation from housing stress.

RUE DE STOCKS
As the housing market stall turns into a decline, and even gathers momentum, consumers will lose their homequity piggy banks. Perhaps $1 trillion in housing valuation will shrink in the next 12 months, which would be almost 5% of the estimated $22 trillion in property values. With consumption pullbacks come reduced earnings on Main Street, connected loosely to Wall Street. Stocks will seek refuge in the USTBonds during a Dow or S&P stock downturn, as is customary. It is inconceivable that the USEconomy and consumer retail industry can walk away unscathed when housing gathers more downward slow-motion momentum. Housing price reductions will feed upon themselves in a vicious feedback loop. First out are flippers, then second home owners, then rental property owners, then option ARM holders who take it in the skivvies. The number of underwater mortgage holders will tragically give birth to a new class in the USA: bankrupt owners of residential real estate.

RUE DE MORTGAGE FINANCE
The Fanny Mae debacle has not been fully played out. It has gone into federal hibernation, or better yet a Federal Witness Protection Program. How can mortgage backed securities (MBS), aka mortgage bonds, be liquidated by Big Fat Fanny with the oversized hedge book haunches, when doing so would wreck havoc on their own bond portfolio? They are stuck in the mud off housing's back porch, or locked in the root cellar where potatoes and mushrooms flourish. How can mortgage bonds be properly valued when their underlying collateral is on the verge of a substantial property value cut, like a lawn mower running over the collateral? Fanny Mae is waiting for their day of execution, a gallows event to be written by property devaluations, illiquid loan portfolios, and guaranteed writedowns. The MBS bank debacle is the next infection spread from sick Fanny to the banks, who are not immune, who did NOT fully offload risk. Sure, many banks sold mortgage packages to Fanny, but much of the bank profit and portfolio recycled cash found its way into bank-held mortgage bonds. Pretty dumb, huh? Call it recycled roundtrip risk !!!

Fanny Mae has other problems in differentiating their mass of mortgage bonds. They are not fungible, as each is different. Each has a collateral rating tied to lateness, delinquencies and foreclosures, with regional identification. Apparently, being DTC-eligible aint enough to assure value. The Depository Trust Corp markings only help to pool loans into packages for servicing ease. The plight of mortgages and especially their property homeowners is analyzed in the September HTL report in gory detail.

Billion$ in mortgage bonds will suffer losses. Banks will sell some Treasury Bonds in reaction. Speculators will enter the picture by selling and unwinding their spread trades. Higher mortgage bond yields encouraged a spread trade, long MBS and short USTBond. Their unwinding will lead to higher mortgage rates and lower USTBond yields, since the govt bond buybacks will be necessary in covers. Look for Fanny's interest rate swaps to cause bigtime disruption. Could they be essential in averting a yield curve inversion? Just as the housing boom occurred with wave after wave of refinances, the housing decline will unfold with wave after wave of foreclosures on the household side, and wave after wave of writedowns on the finance side. Each formal foreclosure costs a bank $80 thousand, not a small item.

RUE DE CORP BONDS
As consumers pull back and buy less at the retail shopping shrines (malls), a wide swath of corporate bonds will come under pressure. Just like with mortgage bonds, corporate bonds will take losses, especially those outside the financial sector. Spread trades based on corp bonds over TBonds will also be unwound. They bought the higher yielding corp bond, shorted the USTreasury Bond. Backwash demand will appear to buy back the USTBond in the anchor position for such spread trades. This effect will pale in comparison to the MBS unwind, which will happen in waves. We were shown a preview of this phenomenon in summer 2005, when General Motors and Ford Motors debt was downgraded. The unwind of spread trades and profitaking in default swaps gave a giant assist to USTBonds, as long-term rates formed a bottom. See the same TNX chart above.

HEADWIND ON THE RUE
The gold road faces a headwind from the faltering crude oil price. These two commodities are critically linked. The commercial key monetary commodity is crude oil, which fuels and fortifies the real tangible economy. The financial key monetary commodity is gold bullion, which stands guard as watchdog over monetary abuse, and there is plenty of it. Gold has come down in price in sympathy to crude oil. However, crude oil might be stabilizing in price. My argument in the September HTL report in support of oil is that a Global Energy War is being fought to secure oil supplies. So why should any decline persist if militaries are pursuing it?

Never under-estimate the power of Goldman Sachs working with the Senators from the State of Oil occupying the White House in pushing down the crude oil and natural gas price. Their motive might be an outcrop of November elections for the US Congress. Power lies in the balance, which is perhaps directly connected to profit.

GOLD PROSPECTS
The gold price will resume its northerly course ONLY AFTER long-term bond yields bottom out. Gold will rise ONLY AFTER the hacks at the USFed move to an easing bias and actually cut rates. For now the markets are accepting their bluff of rate hikes, whose motive seems obvious in supporting the USDollar. The favorable autumn gold season cycle will help to support gold, but only after the bond competition is removed. As stated last week, the gold bull resumes not when price inflation arrives, but upon the arrival of the mortgage finance crisis extended from eroding collateral against mortgage loan portfolios. All in time. Like with a truck struggling to find second gear, only to find its speed in a slide, the gold price retreats as it awaits the knuckleheads in the USFed to change course in monetary policy. These guys could not run a summer camp budget, let alone a banking system.

INTERRUPTIONS ON THE RUE
Plenty of events could disrupt the bond rally. Trade war is one. Financial embargo is another. If anyone thinks the war in Lebanon is over, or the war in Iraq is over, check at a clinic to see if you are brain dead. Does anyone find it suspicious that the day after the BTC oil pipeline opened in southern Turkey, connecting the Caspian Sea, suddenly Israel attacked Lebanon? The distance from the Ceyhan port in Turkey to the Syrian border is only 100 kilometers. The significance of this BTC pipeline, and its one million barrel per day flow, is discussed in the Geopolitics section of the September Hat Trick Letter due out before next week. It bypasses the Russian-Iran sphere of influence. Israel might be challenged to secure a corridor from its own border as far north as to Turkey. This would require a United Nations peace keeping force along the Mediterranean Seacoast. Think Global Energy War and ask how low crude oil will go. Think US housing crisis and ask how low gold will go. Not far for either in my book. The past three years are mere foreplay for what comes in the next three years for both crude oil and gold. The US housing bear market is in its early stages.

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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 24 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com. For personal questions about subscriptions, contact him at[email protected]