In the last year, M3 has been growing by approximately 15%. This is a basic measure of money supply and liquidity—and this is huge. While the focus has been on the Federal Reserve and how much they will/would drop interest rates to help the real estate market and general economy—what’s been going on behind the scenes speaks volumes. They are increasing the money supply at an enormous rate to stabilize the housing market throughout the USA. It is important to note that interest rates certainly have not been high—it has been a major problem that banks have stopped lending, tightening terms, etc.

I suspect mortgages will be in the 5-5.5% range in the spring—and this–along with the lower prices—should finally put the floor under prices. As this occurs–the risk premium will dissipate, interest rates on mortgages will become cheaper—and housing will begin its normal recovery. There is no question that the Fed is doing everything they can to stabilize the housing markets—and once they turn up ever so slightly—you can expect lower rates as the risk premiums dissipate.

While housing fundamentals are certainly improving—they will continue to do so against the backdrop of continued price declines. This is simply the opposite part of the cycle—remember when housing prices soared even though rates were going higher and inventory was growing? at THAT time—prices increased DESPITE declining fundamentals.

Inventory has been declining now for 3 months—and this is extremely important. This, along with lower interest rates, are the fundamentals that will eventually bring the supply and demand into balance. At some point—due to a drastic reduction in new homes started over the past 2 years—will result in higher prices for real estate as inventory will continue to shrink and shrink—-and let’s not forget—we basically have 3 years of pent-up demand by home buyers.

Combining all of this with expected government action to hold off foreclosures, could bring the real estate market back a lot sooner than most expect.

It is becoming apparent that the Fed will lower 1/2% on Tuesday. There would have been no other reason for the Kohn and Bernanke speeches last week.

The 2 yr note is down to 2.97—-while the 10 yr bond has risen in yield to 3.99% from 3.85%. I think it is safe to say that the speeches were done to stop the stock market slide–and to give the market the assurance it needed about the cuts. I believe that the rise in the 10 yr bond is EXACTLY because the bond market is saying that the Fed is finally starting to catch up to the declining economic fundamentals—

Assuming the Fed does lower to 4%–and the 10 yr bond stays where it is—then it will be the 1st time in a very long time that the fed funds were NOT above the 10 yr bond—and this usually signals the end to any market decline. I have very little doubt that the fed will need to continue to lower—i think right now the only debate is whether they go to 3.5 or 3.75% on Jan 30th—and we’ll need to see the data. As I have said all along—I expect fed funds to be nearer to 3% when the cycle is finished.

The housing party was a big one. everyone got drunk. the vomiting is almost over—but the headaches and malaise will linger and linger. I suspect that mortgages will no longer trade just 1.25% above the 10 yr bond in normal circumstances—not when the Fed is prepared to renegotiate the mortgages. no one would take the risk without more premium. This will probably lead to lower rates than people expect—and that these lower rates could stay with us a lot longer than people expect.

We have just experienced back-to back declines in monthly inventory for housing. As I spoke about before—the fundamentals for housing are now starting to improve dramatically. Inventory drop not too big—but interest rates are coming down a lot—and will come down more—not only because the fed is lowering rates—but because the spread between the 30 yr fixed mortgage and the 10 yr bond will continue to shrink after getting to be about 2-2.5% above the 10 yr bond—instead of the normal 1.25%

i suspect mortgages will be in the 5-5.5% range in the spring—and this–along with the lower prices—should finally put the floor under prices. as this occurs–the risk premium will dissipate—-and housing will begin its normal recovery [do NOT–for a second–think “this time it’s different”—-those are famous last words!].

While housing fundamentals are certainly improving—-they will continue to do so against the backdrop of continued price declines. This is simply the opposite part of the cycle—remember when housing prices soared even though rates were going higher and inventory was growing? at THAT time—prices increased DESPITE declining fundamentals.

Evaluating the stock market now—i think the market has priced in a fed cut of 3/8ths—-and by that I mean that if the fed lowers only 1/4% [doubtful] expect a pretty good sell-off. if they lower 1/2%—expect a nice rally. 

Expect a strong stock market throughout 08. it may be starting now—but i suspect that it might take until February. Expect the hardest hit–but QUALITY financials to recover and lead the market higher. everything the fed is doing is about finacials. Please note that the yield curve has risen to 40% [2yr-10yr bonds]—and that the DIRECTION [widening] and the % amt—are bullish. bullish. bullish. That said—we face the last amount of turbulence until everyone buys in to this.

With the Federal Reserve meeting again this week, it is now time to update our market expectations.
 
As many of you know, I have been expecting a major move down in interest rates, caused by the biggest housing decline since the Great Depression. While many pundits on television have been talking about the problems in the housing market being “contained”, I have maintained that this is simply impossible—-and with price declines of 5-45% depending upon the region—not only are we seeing economic weakness, it would be hard to argue that places like Florida are not in a pretty deep recession.
 
The problems created by having mortgage money too easy at the end of the last cycle—with “no down” no doc” “no credit” etc loans fueling the last run-up in prices have certainly come back to bite everyone with foreclosures rapidly rising throughout the USA, and with price declines across America. These declines [ignore what the media reports] have been anywhere from 5-10% in the “strongest” markets like Los Angeles coastal areas to as much as 45% in many areas of Florida. Las Vegas, Inland California, and Phoenix are also amongst the hardest hit.
 
Declines in prices have varied based on the amount of new home building in any particular area, as wherever there is a large inventory of tract housing or condominiums there has been the greatest decline in price. Much of this has to do with speculators who created an artificial housing “shortage” by buying 5-10 homes a piece with the idea of simply flipping them at higher prices to the next person to come along. As soon as mortgages got tighter, and the inventory of new homes started to manifest itself—the “music stopped” and inventory grew rapidly.
 
There is no question in my mind that Fed Chairman Bernanke is completely aware of the problem, and has come to grips with the fact that unless this is headed off quickly, we may not only be using the “R” word for Recession—but would have to think about the “D” word–for Depression. It must be kept in mind that the last time we had a housing decline like this WAS around the time of the Great Depression of 1929-1933. This HAS to be the reason behind the 1/2% cut in rates at the last meeting
 
I do NOT say these things to scare you–because I think the worst of the housing market decline is behind us—and I expect the market to start its recovery early next year.

I expect the Fed to lower interest rates on Wednesday—and the only issue is whether it will be by 1/4 or 1/2%. Hopefully, it will be by another 1/2%.

I also expect them to lower rates Dec 11th, the end of Jan and March—-bringing Fed funds down to the 3-3.5% range from the 5.25% it was until this past summer.
 
The Fed will be putting the “pedal to the medal”—NOT to bring prices of homes back to their July 2007 peaks—but in order to create a “bid” under the market.

They simply MUST create an environment whereby people can see that houses will resume their normal appreciation levels alongside inflation. At the moment, we sit with 3 years of buyers sitting on the sidelines waiting for the market to stabilize before THEY buy. Once the PERCEPTION of housing weakness passes, expect the market to regain its health—fed by these interest rate declines.
 
Along with the decline in interest rates—and along with the stabilization of the housing market—will come the elimination of the “risk premium”. Historically, 30 year fixed mortgages have tended to be whatever the 10 yr bond was paying [now at 4.40%] plus 1.25%. That would translate to a fixed rate of 5 5/8% and the jumbo at 6%.

However–because of the perceived risk—banks are charging about 1/2% more—which may not sound like much–but it is making mortgage payments 10% higher than they would be—and this has a bad influence the housing prices and the market itself.
 
I’m expecting the 30 yr mortgage to get back down into the 5.25-5.5% area—with the jumbo about 1/2 point higher.
 
The continuing of interest rate reductions have helped to keep the stock market at or near record levels—and I expect the stock market to rally strongly at least until the Presidential election. Since this tends to happen every 4 years anyway–I’m hardly going out on a limb here. This stock market advance will help to bring the more affluent home buyer back into the market along with lower interest rates. This housing recovery will be led by the HIGH-end buyer—-and this is normal, with the last cycle being led by the 1st time home-buyer being the anomoly.
 
The Fed lowering rates will also make mortgages a lot cheaper for anyone willing to get an adjustable rate mortgage and will help to bail out those people who bought homes with adjustable rate mortgages that are–or are about to–reset at much higher rates which could lead to more defaults. I have little doubt that the Fed will be moving quickly to help this group along.
 
While much will be said over the next couple of years about the Fed bailing out the speculators—this will NOT be the case. Those investors/speculators who bought homes at $700k in inflated markets–only to see prices drop to $475k—will be forced under—-but the housing market WILL start its recovery from this $475k level gradually as people realize that prices have gotten back to $500k—and that prices are heading higher. Since full price recovery might take years—the speculators will be in deep trouble, and not bailed out. For the individual homeowner who stays in their home—eventually they will get their money back.
 
The Fed also remembers what happened after the Tax Reform of 1986 which caused real estate to decline—the banks ended up with the real estate–and then YOU and ME had to bail out the Savings and Loans through our tax dollars.

The Fed will be moving quickly here to try to have that not happen—as we have seen disturbing news from companies like Merrill Lynch, Countrywide, Citibank, Washington Mutual etc—the high quality institutions—while we have also seen scores of mortgage companies fail and file chapter 11.
 
I think they will be successful—-and I feel that housing prices will begin its recovery in late 2008—after the actual sales recovery starts this spring when new home builders will be ending their price slashing to clear out unsold inventory. Once we start to see noticeable reductions in homes for sale, we know that we will resume a more normal real estate market with normal levels of appreciation.
 
One thing needs to be kept in mind—-we had a real estate market that was “overvalued”.

After the decline—it is more normal to swing to “undervalued” and then begin a recovery. It is rare for a market to go from “overvalued” to “fairly valued”—so there is probably some catch-up appreciation to be had in this recovery as we eventually get back to a normal market.
 
Those people buying homes this spring should be handsomely rewarded over the years to come.