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Higher Interest Rates Mean Trouble Ahead

Higher Interest Rates Mean Trouble Ahead

When I last commented on the bond market on December 5th bond prices were inexplicably rallying, sending yields on ten year Treasury bonds to 4.4%. At the time, Wall Street was offering a variety of half-baked explanations as to why the market had moved beyond the cause and effect stimuli that had ruled for generations. My advice to investors was simply to sell into the rally and ask questions later. Since then, bonds have reversed course, with ten year treasury yields hitting 4.9% (a five-month high). Just as Wall Street’s explanation for falling rates was way off base then, so too is their explanation for rising rates now.

The consensus asserts that yields have turned around because new “evidence” of a bottom in the housing markets will keep the economy from tipping into recession, which in turn will diminish the likelihood of a Fed rate cut. The problem with this explanation is that there is no evidence of a bottom in the housing market. Despite the self-serving rhetoric of biased real estate industry spokesmen, a bottom is nowhere in sight, both in terms of price and time.

Although 2006 saw existing home sales decline by 8.4% (the biggest drop in 17 years) and new homes sales fall by a stunning 17.3% (the largest in 16 years), Wall Street Pollyannas stressed that opinion and sentiment trumped data. For example, based solely on a 7.9% decline in existing home inventory, perennial real estate shill David Lereah (chief “economist??? for the National Association of Realtors) claimed “It appears that we have established a bottom.??? (Mr. Lereah has seen more bottoms than a diaper attendant in a hospital nursery.)

However, the drop in inventory in existing homes is most likely the result of discouraged sellers taking their homes off the market with the intention of re-listing them in the spring. This is a common tactic among realtors as spring is traditionally the strongest home buying season and stale listings are a turnoff to potential buyers. Also, my guess is that lots of other potential home sellers are planning on listing their homes for sale for the first time come spring, and many more would list their homes now if they thought they could actually get their “appraised values.???

New home sales figures are even more misleading. Although the headlines trumpet that inventories dropped in December, the figures ignore cancellations which are running at record highs. So while cancelled contracts are excluded from the “official??? inventories, they are definitely part of the real inventory that will ultimately exert additional downward pressure on prices. Also, while new home prices “officially??? fell by a modest 1.8% in 2006, the real decline is likely far more substantial. That is because the sales incentives now typically offered by developers, such as paying closing costs, free upgraded floors and countertops, free appliances, free swimming pools, free plasma TVs, free landscaping, decorating allowances, health club memberships, vacations, etc., are not reflected at all in sale prices. However, they are reflected in recent home builders’ earnings reports, which have been universally dismal.

The elephant in the living room is that the recent jump in bond rates suggests that things are about to get much worse for the housing market. Since January 5th, interest rates have risen by over 30 basis points and gold has risen by over $40 per ounce. When rates and gold prices rise together the most likely explanation is escalating inflation fears. Indeed, my guess is that rather then sensing a bottom in the housing market, bond investors around the world are beginning to appreciate the inflationary implications of a real estate crisis.

A substantial decline in real estate prices will either produce a severe recession on its own or exacerbate one that arises from other factors. In either case, the result will likely be the Fed coming to the “rescue” with inflationary monetary policy. Inflation will push long-term rates even higher, causing more loans to default. With credit destroyed and home equity and jobs lost, foreign creditors will rush for the exits sending the dollar into a tailspin. The Fed will be forced to buy all of the paper foreign lenders no longer want and that savings-short Americans cannot afford. Domestic money supply will explode sending consumer prices soaring.

As is so often forgotten, interest rates are merely the price of money, which like any price is determined by supply and demand. In the United States, where hardly anyone saves and almost everyone borrows, that price should be very high. Our low interest rates are a temporary fluke, once made possible by naïve foreign savers but now mainly a function of misguided foreign central banks.

Instead of trying to fabricate benign explanations for why interest rates are rising, Wall Street should instead prepare investors for the unpleasant consequences to their portfolios should this trend continue. The true mystery is why long-term rates have remained this low for so long. Unfortunately by the time Wall Street solves the riddle many of their clients will be broke.

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