Today’s bland FOMC statement sounded as if it were coming from another world—a world that was not witnessing a severe housing recession, turbulent financial markets, rising credit spreads, declining consumer confidence, flagging retail sales and dropping durable goods orders. Despite the Street’s efforts to parse every word, the Fed is largely irrelevant at this point as monetary tightening is already happening on its own while the seeds of a hard landing or recession have been in place for some time. The Fed’s decision to remain on hold indefinitely is more an admission of paralysis than an act of definitive policy.
The fact that credit is tightening is hard to deny. Ten-year bond yields are up to 5.12%, close to their highest level in five years, and up from 4.62% in early May. The Bear Stearns hedge fund problems have raised the awareness of risk across the board, and loans for LBOs, junk bonds, corporate buy-backs and mortgages will be harder to get. We’re already aware of three major debt deals that have been pulled, and there are sure to be many more. It is also noteworthy that global interest rates are rising almost everywhere. In addition, mortgage regulators are probably only days away from issuing much tighter mortgage standards that would disqualify a large number of applicants who would have been approved in recent years.
The Bear Stearns $3.2 billion bailout of one of its funds is leading some investors to hope that the turmoil is just a temporary phenomenon that will pass in a short time. We think that is highly unlikely. With its infusion of cash, Bear was able for now to avoid writing down the funds’ assets to their true market value, but this is only covering up the problem. CDOs containing major amounts of sub-prime loans are widespread, and now there is the sudden realization that they are worth far less than their stated value. One recent attempt at auctioning CDOs drew bids amounting to only 60% of stated value.
Not only is the sub-prime situation getting worse, but the malaise is spreading to Alt-A mortgages as well. Alt-A mortgages issued in 2006 are now showing a default rate of 4.21%. Whether the huge inevitable write-downs are made now or at some later date, the reality remains the same—a lot of hedge funds are worth a lot less than their stated value. It is no wonder that Goldman Sachs CEO Lloyd Blankfein stated this week that he is in a "high state of nervousness."
In addition to the financial turmoil, the housing situation is having a direct impact on the economy. Both new and existing housing sales have continued to fall while inventories are soaring and house prices are declining. Chain store sales have declined for five of the last eight weeks and year-over-year sales are up only 1.7%. Anecdotally, we have seen numerous retailers downgrading their forecasts for the period ahead. Non-defense durable goods orders ex-transportation have declined 8% over the past eight months, indicating a weakening outlook for capital goods expenditures. Although 2nd quarter GDP growth will likely be somewhat higher than the 1st, the outlook for the second half looks bleak as the monetary situation appears to be tightening significantly despite the Fed’s neutral policy.
