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This arti­cle is a guest con­tri­bu­tion by David Rosen­berg, Chief Mar­ket Econ­o­mist, Gluskin Sheff.

MARKET COMMENT

Per­haps it wasn't unusual to see new home sales trail off in the after­math of the expiry of the hous­ing tax cred­its but the mag­ni­tude was very sur­pris­ing. More­over, since mort­gage appli­ca­tions for new pur­chases through the first three weeks of June are a huge 15% below May’s tally, this mas­sive slump in home sales is not exactly a one-month won­der either. New home prices are down 10% year-to-date and one has to won­der whether yesterday’s mes­sage in the post FOMC press state­ment was the first hint of an even­tual return to quan­ti­ta­tive easing.

As for the mar­kets, every­thing seems to be bounc­ing off the 50-day mov­ing aver­age – the S&P 500, oil, and the U.S. dol­lar. The stock mar­ket is down 2% for the year in what looks to be a very impor­tant top­ping for­ma­tion. That was not expected at the start of the year, that much is for sure.

The really big story is in the bond mar­ket. The yield on the 10-year T-note yield and the long bond, after yesterday’s rally, is down to lev­els that are below those pre­vail­ing when the Fed was busy build­ing the fire­wall against defla­tion back in mid-2002. Back then, the Fed cut rates (75 basis points dur­ing that bor­der­line double-dip), the gov­ern­ment could cut taxes, and for good stim­u­la­tive mea­sure, go to war. And of course, we had Con­gress turn a blind eye towards the credit excesses that pro­vided fur­ther juice with lever­age ratios among Wall Street banks and the GSEs that ranged from 30% to 70%.

Look at what we have today: No room to cut rates. No room – let alone ide­ol­ogy – to cut taxes. And, in con­trast to start­ing a new war, the U.S. is going to be pulling troops out of Afghanistan, which is a good thing for the troops and their fam­i­lies, but in terms of GDP impact it does rep­re­sent fis­cal with­drawal. The options to resus­ci­tate the econ­omy when it – no longer an if – enters a 2002-03 style growth col­lapse are extremely thin. And, they prob­a­bly lie on the Fed’s bal­ance sheet, which means the bond-bullion bar­bell will likely remain a viable strategy.

At cur­rent yield lev­els (1.9% on the 5-year?), the Trea­sury mar­ket is scream­ing defla­tion. If it is right, not only is the con­sen­sus esti­mate of a new peak in cor­po­rate earn­ings in dan­ger, but so is the key 1,040 tech­ni­cal thresh­old on the S&P 500.

WE’RE NOT JAPAN?

Well, rates are at zero. The cen­tral bank bal­ance sheet is preg­nant. All the fis­cal good­ies have had no last­ing effect. The gov­ern­ment is increas­ingly unpop­u­lar (the President's approval rat­ing in a new poll is at a record low). And now, in the lat­est tale of account­ing gim­mickry, a House-Senate con­fer­ence is mov­ing to estab­lish new rules for all but the largest U.S. banks (who have already been bailed out) that will basi­cally allow them to pre­tend that the bad loans on their books are actu­ally still good (allow­ing them to spread their losses for up to 10 years instead of rec­og­niz­ing them imme­di­ately). See page A2 of the WSJ. Japan kept zom­bie banks alive ... and so are we (the U.S. that is).

Oh, but I for­got. The demo­graph­ics are far supe­rior in the U.S.A. As far as I can see, that’s the last final dis­tinc­tion in our favour is labour mobil­ity. How­ever, the huge num­ber of Amer­i­cans upside-down on their mort­gage has ren­dered that obso­lete, and our polit­i­cal sys­tem is stand­ing in the way right now of good decision-making. So, if this is turn­ing out to be more Japan­ese than any­one would have liked or wanted, draw the chart of the Nikkei and JGB yields to get a sense of where mar­ket prices are likely headed. Trea­sury yields at 3% may be as attrac­tive as the 4% yield we had at the turn of the year.

DARING TO COMPARE TODAY TO THE 30’S

Com­ing off a crash (‘29) and rebound (‘30); after­math of an asset defla­tion and credit col­lapse banks fail (Bank of New York back then, Lehman this time around); nat­ural dis­as­ter (dust bowl then, oil spill now); global pol­icy dis­cord (with the U.K. then, with Ger­many now); geopo­lit­i­cal threats; inter­ven­tion­ist gov­ern­ments; ultra low inter­est rates (long bond yield fin­ished the 1930s below 2%); chronic unem­ploy­ment (25% then, 17% now); defla­tion pres­sures; com­pet­i­tive deval­u­a­tions; gold bull mar­ket (dou­bled in Ster­ling terms in the 30s); debt defaults; sput­ter­ing recov­er­ies and ral­lies; onset of con­sumer frugality.

FED TAKES DOWN GROWTH AND INFLATION VIEW

At the mar­gin, the Fed changed just enough of the word­ing in the press state­ment from the April 28 release to sug­gest that it is in the process of tak­ing its growth and infla­tion fore­casts down. What­ever anyone’s time hori­zon was on the Fed’s first funds hike, at this point, it can safely be pushed even fur­ther into the future. Per­haps even as far out as 2016. A recent San Fran­cisco Fed study strongly hinted that we will be past 2012 by the time the Fed raises the funds rate. The study also made the point that even with the funds rate basi­cally at zero and the Fed’s bal­ance sheet bloated at over $2.3 tril­lion, over­all pol­icy is still 300 basis points too tight in light of the pace of eco­nomic activ­ity, the size of the out­put gap and pre­vail­ing trends of under­ly­ing infla­tion. That is what we are pen­ning in; under­stand­ing that we are in uncharted ter­ri­tory and that fore­cast­ing the Fed is more an art than a sci­ence, even at the best of times.

The Fed no longer sees the recov­ery as a “con­tin­ued to strengthen” back­drop but that it is “pro­ceed­ing” (growth but it is slower) and the labour mar­ket is no longer in “improve” mode but is “improv­ing grad­u­ally” (that is not good in the con­text of a double-digit unem­ploy­ment rate). Note that back in April, it was “growth in house­hold spend­ing” that had “picked up”, which is an improve­ment in the sec­ond deriv­a­tive; now it is merely “spend­ing is increas­ing”. Again, the sub­lim­i­nal mes­sage here is that we are in decel­er­a­tion mode.

Back in April, hous­ing may have been “depressed” but was deemed to have “edged up”. Six weeks later, it is just plain “depressed”. And, the Fed made two other very impor­tant remarks: “Finan­cial con­di­tions have become less sup­port­ive of eco­nomic growth” and marked its infla­tion view down too by acknowl­edg­ing, which it did not do last time, that “prices of energy and other com­modi­ties have declined some­what in recent months, and under­ly­ing infla­tion has trended lower.” Then again, the six-month trend in the core CPI is run­ning at the grand total of a 0.45% annual rate and the head­line CPI at a 0.34% pace.

The Fed left in “infla­tion is likely to be sub­dued for some time” and that “that eco­nomic con­di­tions, includ­ing low rates of resource uti­liza­tion, sub­dued infla­tion trends, and sta­ble infla­tion expec­ta­tions, are likely to war­rant excep­tion­ally low lev­els of the fed­eral funds rate for an extended period.” It’s hard to believe that just three months ago, there was debate over whether “extended period” would be removed. Now the eco­nom­ics com­mu­nity is debat­ing whether or not the Fed will ulti­mately be forced to re-engage in quan­ti­ta­tive eas­ing. We think it is very likely.

Oh yes – did we men­tion that Tom Hoenig dis­sented for the fourth straight time? Then again, does any­body really care?

The futures pit is now pric­ing in the first Fed rate hike in mid-2011. It was only at the turn of the year that the mar­kets were pricing-in rate hikes in the sec­ond half of this year and for the funds rate to reach 2% by next sum­mer. How the times have changed.

THE ROOF COLLAPSES ON THE HOUSING MARKET

New home sales cratered a record 33% in May, to a record low of 300,000 units at an annual rate. This breaks the prior all-time low of 341,000 set back in April 2009 when the econ­omy was knee deep (more like six feet under) in reces­sion. There must have been a wave of can­cel­la­tions too because April was revised down to 446,000 from 504,000 and March to 389,000 from 439,000. The only other time when new home sales made a new low 11 months after the end of a reces­sion was dur­ing the dou­ble dip of the early 1980s – assum­ing that the pun­dits are cor­rect on this assess­ment of when the econ­omy bot­tomed out.

On aver­age, home sales at this junc­ture (11 months after the end of a reces­sion) are up nearly 60% – this goes to show that com­ing off an unpre­dictable credit-induced reces­sion, what we get is an extremely ten­ta­tive recov­ery. If new home sales behave the same way as they did in the 1980 and 1982 reces­sions, who can say that the econ­omy can­not suf­fer a double-dip? The only answer is that the way to pre­serve your job on Wall Street as a research ana­lyst is to play it safe and tell peo­ple what they want to hear.

This wasn’t just an oil spill or weather story either as every region posted a huge decline. All the tax cred­its did was play around with human nature – all the gov­ern­ment inter­ven­tion could really do was dis­tort the data and delay, but not derail, the fun­da­men­tal sec­u­lar down­trend in res­i­den­tial real estate activ­ity. The inven­tory back­log, which had taken a dive in April as the tax cred­its were about to expire, soared from 5.8 months to an 11-month high of 8.5 months. And, this excess sup­ply is exert­ing more down­ward pres­sure on pric­ing – the median price of a new home fell 1% MoM in May to $200,900 and is now down nearly 10% for the year (was $222,600 in Decem­ber). Home prices have not been this low since Decem­ber 2003 and are light years away from the $257,000 peak estab­lished in mid-2006.

Despite all the stim­u­lus aimed at the hous­ing mar­ket, it took builders a record median 14.2 months to find a buyer for a com­pleted home in May. This sec­tor is bro­ken. Peo­ple don’t want to buy an asset they see will depre­ci­ate in value. And peo­ple don’t want to pur­sue the dream of home­own­er­ship if it means tak­ing out a mort­gage – the scars from the credit col­lapse are obvi­ously lin­ger­ing if not accelerating.

© Gluskin Sheff

www.gluskinsheff.com

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