The fundamental dilemma we face on June 24th 2009 is how to effectively keep mortgage rates at a low level to encourage refinancing, which will drive home purchases and put a floor to home prices, while simultaneously the Fed monetizes deficits, pushing nominal rates up
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(On yesterday’s letter, there was an error. On the first sentence, I meant to say that the Treasury was auctioning $104BN in T-bills and coupons this week. Instead, I said the Fed was. This is what happens when I write at midnight!)
I don’t usually follow macro statistics, but monetary aggregates and cash flows. However, two metrics left me thinking yesterday. First, it was the May release of Existing Home Sales. After reaching record lows for 30-yr mortgage rates in May, the months’ supply of unsold homes fell only to 9.6 months, from 10.1. With mortgage rates going up since then, further improvement in residential real estate is only a leap of faith away!
Secondly, I suddenly remembered that at the Facultad de Ciencias Económicas, in Buenos Aires, one learned that, as a rule of thumb, an ongoing government deficit that represents more than 5% of GDP is only a time bomb. Now, if only the gross US Federal debt is supposed to reach $10 trillions by 2010, it may be licit to think that servicing the US aggregate fiscal debt (federal + state + municipal + agencies) should easily represent more than 5% of GDP…I say “should” because unfortunately I could not find in any website precise data on this. Interestingly enough, this issue is altogether ignored in research reports, which usually make reference to fiscal deficits of other countries…
In summary, the fundamental dilemma we face on June 24th 2009 is how to effectively keep mortgage rates at a low level to encourage refinancing, which will drive home purchases and put a floor to home prices, while simultaneously the Fed monetizes deficits ($300BN scheduled for 2009), pushing nominal rates up (ref. www.sibileau.com/martin/2009/06/03 ). See, the problem lies in the deficits. We should not be focusing on what the Fed will say tomorrow at the close of its FOMC meeting. They cannot change the bottom line. Instead, we should be demanding from Mr. Geithner a healthy budget. Now, investors don’t think that will happen (and I agree) and therefore have retrenched, trying to defend every penny they made in this “rally”. Equity and credit markets managed to keep relatively flat yesterday: S&P 500 up 0.2%, while CDX IG12 was 1 bp tighter at 144 bps. If you have been following the letters, you should not be surprised. Since day one, our thesis has been that as long as the Fed and all the other central banks keep flooding us with liquidity and feed us with daily announcements, we can see prices NOT falling (See www.sibileau.com/martin/2009/04/14 ), which would suggest that, in order to solve the aforementioned dilemma, in the continuous presence of deficits, asset prices NEED to fall, to make room for the government deficit. How do you think will this be sorted out? In the meantime, I thought I would show the “evolution” of the on-the-run UST yield curve, from June 8th, when we first sensed the current plateau, until yesterday. As we’ve been proposing, a sell off in equities should not bring an inversion of the curve, because the sell off would not be caused by illiquidity: 3-month LIBOR is at 0.6075%.