Daily Insight

U.S. stocks were headed for their worst session since mid-November until a little afternoon rally eased early-session weakness. Speculation coming out of China that they’ll rein in bank lending, along with an IBM earnings report that failed to confirm private-sector orders are rebounding, started things off on a bad note yesterday.

Additional data on housing starts was also portrayed as putting pressure on stocks, but I’m not so sure about that one. While housing starts fell more than expected, the permits data showed a bounce back will take place in the subsequent months. Besides, does the market really believe that residential construction is making a comeback anytime soon? Doubtful, it’s hardly a secret that we continue to see 300k-plus in foreclosure filings per month, that’s a lot of supply on the horizon. The point is the market shouldn’t be caught off guard by weak home construction data. Besides, it means ZIRP’s longevity is extended and I haven’t seen a shift back to market fundamentals; the liquidity trade remains in play, so I doubt the housing number played a role.

If we’re going to base what drove the market lower on any single day you have to look at the internals. Since the commodity-related areas (such as basic material and energy sectors) along with tech led the decline, you’ve got to surmise that the weakness was about China and IBM’s results. (And the China story is getting interesting. Concerns that they really will begin to rein things in have increased this morning after a fourth-quarter GDP print of 10.7% -- the growth appears to be largely driven by the construction sector, fueled by significant credit expansion. How many times are we going to watch this trainwreck? First in Japan, then the U.S. – now China?

While the financials were the best-performing sector (health-care was the next best, although both were down), earnings reports out of Bank of America and Wells Fargo showed loan losses remain elevated and “will continue so for the next several quarters,” according to BofA’s Moynihan. Mortgage and credit-card delinquencies continue to present a problem – a problem that only a stronger job market can fully fix. BofA’s charge offs fell 12% from the previous quarter (that’s good), but Wells’ charge offs increased 6%. Both banks reported an increase in non-performing loans (payments late by 90 days), up 5% for BofA and 18% for Wells.

Market Activity for January 20, 2010
Mortgage Applications

The Mortgage Bankers Association reported that applications rose 9.1% in the week ended January 15, after a 14.3% increase in the week prior. But while the prior week’s rise was all due to refinancing activity, this latest week did have some purchases in it. Purchases were up 4.4% after a paltry 0.8% rise for the week ended January 8 – the chart below shows purchases continue to muddle around the cycle low. Refi activity rose 10.7% after up 21.8% in the previous week. The rate on the 30-year fixed mortgage fell to 5.00%.

Housing Starts

The latest housing starts figure dovetails that very low homebuilder confidence reading we mentioned yesterday. Builders broke ground on just 557,000 units at a seasonally-adjusted annual rate (SAAR) in December, which amounts to a 4% decline from November’s activity – the expectation was for starts to come in pretty much flat relative to November.

This latest data moves the figure back to the level that is just a tier above the all-time low of 479,000 units hit in April – the data goes back to 1959. Surely, the weather played a role in the decline. The permits data seems to confirm this, which we’ll get to below However, most of the new-home construction occurs in the West and South regions. While temperatures were below normal in the South (the largest new home market by region) and they did get some snow, it may not have been a large effect on overall starts.

The permits data, an indicator of future building, jumped 10.9% month-over-month to 653,000 units SAAR. That’s the highest reading we’ve seen since October 2008 and suggests that we’ll get some bounce in homebuilding activity in the current month and into February.

Regardless of whether the December building numbers were adversely affected by the weather or we get a two-month bounce back, builders will be forced to keep activity to a minimum for an extended period of time. The supply of foreclosures may just double the current amount of existing homes available for sale – and that’s using the low end of estimates.

So try as you will boys and girls of the Beltway, but even rock-bottom interest rates, tax-credit extensions and the Fed’s foray into the mortgage market will only delay the inevitable. You’re barking up the wrong tree, for until the job market comes rocketing back housing is going to remain on the mat – that’s what policy should be targeting, the job market.
(And I’m not talking about some short-term public works program or this monetary fantasy currently wandering through the blogosphere that recommends a quantitative-easing orgy, calling for the Fed to buy an additional $2 trillion in Treasury securities. As explained yesterday, I’m referring to elimination of the corporate income tax. And, as mentioned on several occasions, a winning energy strategy that creates high-paying manufacturing jobs in order to fill the gap from the 840,000 permanently lost auto-assembly jobs and most of the 1.3 million construction jobs that have been eliminated for a very long time.)

Producer Price Index

The Labor Department’s gauge of producer prices rose 0.2% in December (the expectation was for no change) basically all on the food component. Energy fell after a large increase in November. Prescription drug prices rose 0.8% for the month after a series of very tame monthly readings.

The year-over-year figure jumped to 4.4%, a big turnaround just two months following what was an eleven-month streak of decline. But these latest figures are against very easy year-ago comparables. The PPI figures should ease about six months out, before they eventually shoot higher, as the comps are not so easy by June. This is similar to the declines we saw for the eleven months that ran December 2008 through October 2009. Many people were calling this deflation; it was not in the specific sense of the term. It was just that the figures were being compared to very high year-ago levels that resulted from the commodity-price spike of summer 2008.

Overall, even though the Fed likes to minimize the food and energy components, these will be the ones to watch for signs that inflation will become a problem down the road. The Fed is so wrong. Their recalcitrance is going to get them, and the rest of us, into trouble again. They continue to believe that so long as the unemployment rate remains well above average, there is little to no chance that inflation can occur, particularly their core rate look – which excludes food and energy. But the inflation that will take hold over time will be of the commodity-push variety, not the wage-push that the Fed myopically watches for. Therefore, the core rates are not the measures to focus on. Again, it is food and energy prices. The core rates become much less meaningful in an environment such as the one we find ourselves.

I must make it clear that it may take some time for the official inflation gauges to move meaningfully higher in a consistent manner, remember credit is still contracting and that means trillions of dollars the Fed has pumped into the system remains fallow. When credit begins to expand, which I suspect is still a ways away, that money will move into the system and if the production of goods isn’t there in a commensurate way to absorb this money (which I think is unlikely) that’s when inflation begins to become a major problem. We’ll continue to very closely watch credit activity.

Some Common Sense

The Federal Housing Authority (FHA) is struggling with a 14% delinquency rate and is in the process of making some changes to deal with this. They’ve been leaned upon, along with Fannie and Freddie (the three accounted for 90% of home loans during most of 2009), to resuscitate the housing market as the FHA has guaranteed more than 30% of new home loans.

As a result of these default rates, the FHA is raising the premium charged to insure mortgages to 2.25% from 1.75%. They will also raise the down payment requirement to 10% for those with credit scores below 580. Borrowers with FICO scores above 580 will still only have to put down 3.5%. Subprime is defined as a credit score below 650, so this new rile isn’t exactly stringent

Frankly, I would argue that sub-580 FICO shouldn’t even qualify for an FHA backed mortgage and they should boost their down-payment requirement to 10% for all – I know, cruel thought. But look, down payments are necessary and if you don’t have at least 10% then sorry you’ll just have to take some time to save it – like most people used to do before all common sense was thrown out the window. A return to common sense would put the market on a more solid foundation as borrowers are able to withstand home-price declines and still have some equity in their home.

The FHA change is a minor one, but should help their solvency. It will have some level of negative effect on the housing market in the short term, but sometime you just have to deal with reality. When we mask problems, history continues to show that more result – and the economic damage that everyone must endure becomes increasingly acute.


Have a great day!

Brent Vondera, Senior Analyst