"It's Hurting and It's Working"

It's a funny thing right now, but no matter where you start your logical investment discourse, no matter how hard you try to avoid it, somehow and some way you end up wriggling your way back to a discussion about the US and the US housing market.

The reason for this is very simple; it's possible to view everything that has gone on in the bond, currency and even equity markets this year, not as the result of some great series of economic events, but as a single one. The Japanese want their money back and everything else follows from there. Take a look for instance, at how fast the Bank of Japan (BOJ) have been draining money out of the bank account of Japan PLC (see first graph). This is a clear signal that the BOJ could be preparing for a rate rise and everything that any official has said in the past two weeks says to you that they have given themselves the option (at least) to do it in the second week of July.

If you raid someone's bank account they are apt to start selling their investments. Sequentially, we have seen western bonds, commodities and the emerging markets suffer from this withdrawal of Japanese capital. The intricacies and backwaters of global finance are probably too complicated to work out all of the linkages from Japan to these markets, but if we concentrate on cause and the effect the cause is the BOJ and the effect is declining markets some of which have looked like bubbles for a long time.

The one place that remains untouched, the final bubble to be popped, is the global real estate market. In particular you end up looking at the US housing market because it is there that the worst excesses exist. To justify their interest rate increases the US Federal Reserve has hidden behind a smoke screen of "inflation busting" which has been meant to pacify The New Inflationists who see 1970's style price increases lurking around the corner like a Victorian villain; apparently we are supposed to believe that China is now an exporter of inflation whereas until a few months ago it was the biggest source of deflation seen since the Ming Dynasty.

The reality is that all this inflation vigilance is a cloak to hide the real intent of the Fed - to curb borrowing (ultimately from abroad) and stop the real estate market in its tracks. It has to be said it has taken some doing, but if you look at the number of homes currently available for sale (both new and existing - see second graph) you will get a big shock and begin to understand why this writer believes they have already gone too far. There are now over 3,500,000 homes available in the US and the number has climbed at an alarming rate in recent months. To put this into perspective, things appear now WORSE than the early 1990's and many of us remember what meant: years of balance sheet reconstruction and low interest rates to sponsor it.

The transmission mechanism between the US interest rate policy and the real economy has clearly re-established itself with an 8 month lag between the start of the interest rate cycle and the onset of the effects (see third graph). Both mortgage costs and the number of homes for sale began to increase about 8 months after the Fed started to increase rates from the historic low of 1%.

As we pointed out in a recent piece ("Playing Golf with Ben Bernanke ") interest rates just aren't subtle enough to control an economy as vast and complex as the US. The Fed usually gets it wrong and there is no reason to believe it will be different this time around. In fact they may already have got it wrong. Clearly, from evidence like the third illustration it's hurting and it's working. On this basis alone we should be preparing portfolios for a coming bond market rally as the Fed stops its rate increases dead in their tracks and prepares for the first rate cut maybe as soon as the fourth quarter of this year.