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Economic Zugzwang: Whoever Moves Loses


The irony of the situation is that the only way oil prices are likely to sink is if the U.S. heads into a recession and/or the dollar strengthens considerably.

Curve Watcher's Anonymous is once again eying the yield curve and mortgage rates following yet another set of horrible existing home sales and news home sales numbers.

See Housing - The Worst Is Yet To Come for my take on future home sales, prices, and a possible hint at where the bottom might be.

See Five Things: New Home Sales; Price Capitulation? for Prof. Depew's take on the magic of reporting new home sales.

Yield Curve As Of 2007-10-24

Click here to enlarge.

There has been a strong rally in treasuries (lower yields) in conjunction with consistently weak economic data. However, in spite of a 100 basis point (1%) cut in the discount rate, and a 50 basis point (.5%) cut in the Fed Fund's Rate as compared to a year ago, Curve Watchers are noting that 30 year mortgage rates are almost exactly where they were a year ago, and 1 year ARM rates are substantially higher than a year ago. 15 year fixed rates are lower than a year ago, but only by a mere 11 basis points.

The picture is even worse than it looks, however, because the above rates are for prime borrowers with a reasonable down payment. Subprime borrowers are facing resets substantially higher. Someone struggling to make a home payment at a teaser rate of 3% is going to be in serious trouble at 9%.

So the idea that these rate cuts are going to do anything to help borrowers in trouble is seriously misguided. However, that is not stopping Bernanke from trying. Certainly the market is now expecting the Fed to cut rates.

With that in mind, Curve Watcher's Anonymous is noting a striking similarity between recent yield curve action and that in 2001. Let's take a look.

Yield Curve 1999-2007

Click here to enlarge.

$TYX is the yield on the 30 year long bond.
$TNX is the yield on the 10 year treasury note.
$TYX is the yield on the 5 year treasury note.
$IRX is the discount on the 3 month treasury bill.

Take a good look at the above chart. Haven't we seen this series of plays before?

There's only three small problems. The last time the Fed embarked on a slash and burn campaign lowering interest rates, the U.S. dollar index was sitting near 120, gold was near $300, and oil was near $20. Now the dollar index is under 80, gold is over $700, and oil is over $80.

The second problem is the Fed created a housing bubble (and lots of jobs) the last time they tried slashing interest rates. Who needs a house now that does not already have one (or two or three)? Should the Fed dramatically lower rates again, where are the jobs going to come from?

The third problem is that drug-induced highs need stronger and stronger doses to maintain the same high. There is not much room below interest rates of 1 to even think about a higher high.

The Irony of Bernanke's Predicament

High energy prices and falling home prices are two things of concern to consumers. The irony of the situation is that the only way oil prices are likely to sink is if the U.S. heads into a recession and/or the dollar strengthens considerably.

Bernanke is acting to prevent said recession by cutting rates. Good luck with home heating season coming up. If Bernanke does not cut rates, it will hasten the recession. A recession is badly needed, I might add, but Bernanke does not see it that way.

In addition the U.S. Dollar is likely to rally if the Fed pauses because rate cuts are priced in. Given that the dollar and the stock market have been inversely correlated for quite some time, if Bernanke acts to shore up the dollar by failing to cut rates, the stock market is likely to take a big hit.

I call this situation Economic Zugzwang. There are no winning moves.

Trébuchet. Bernanke, it's your move.
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