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.