Monday, July 19, 2010

Warning from Weird Financial Markets

The financial markets are getting weird (as if they weren't already). Interest rates for mortgages are at or near all-time lows, but home buying interest is dropping. Stocks are trading in tandem with each other more than ever, seemingly in disregard of the fortunes of individual companies. The dollar and U.S. Treasury securities have improbably rallied, in spite of already low interest rates. When markets behave strangely, it's prudent to check if any canaries have stopped chirping.

The decline in home buying interest stems from two factors: (a) the end of the $8,000 first time buyers credit (and $6,500 repeat buyer's credit), and (b) the large quantities of foreclosed homes and homes with defaulting mortgages sitting in bank inventories. Buyers know that home prices are likely to stagnate or drop, because banks will have to offload their moribund inventory eventually. There's no point rushing to buy now. Lower interest rates may reduce monthly payments, but buyers have learned that monthly payments aren't the only problem. They realize that a loss of equity can be devastating. Something like a quarter to a third of all homes with mortgages are now underwater. Whether the owners of those homes can still afford the monthly payments is becoming a less important question than whether a strategic default makes sense.

Today's stock markets are dominated by powerful hedge funds and other institutional traders. Many use high speed trading strategies. These big boys frequently trade the stock market as if it were a commodity. The notion of stocks as ownership of a piece of a continuing business enterprise is becoming outdated as computerized trading techniques treat the stock market like a bulk commodity to buy or sell alongside oil, copper and pork bellies. Individual investors see their modest portfolios gyrating for no reasons relating to the companies they hold. It's tough to ride a bicycle among tractor trailers, and lots of Moms and Pops are stepping back from the chaos.

The dollar and the U.S. Treasuries rallies were flights to safety at a time when the European Union seemed about to fall apart. It's still shaky, and may get shakier if there's a lot of grade curving on the bank stress test results to be announced this week or next. That the dollar would be seen as a safe haven in a time when the U.S. economy's running on flat tires doesn't bode well.

The markets are mispricing assets. Real estate prices are too high to compensate buyers for the risks of the inventory dump that's coming. But a host of government subsidies, policies and programs buffers home prices from market forces. So buyers hold back, reluctant to pay a non-market price.

Stock prices are too high to compensate individual investors for the stomach churning volatility created by the big boys. But the stock markets today are of, by and for big traders. Volatility is profitable for the short term, high speed strategies many of they employ. These big dogs don't care which way the market moves as long as it moves somewhere because they can't make a profit if prices don't change. Small investors are removing liquidity from the market and finding tranquility in bank CDs.

The dollar and U.S. Treasury securities are issued by a politically unified nation (okay, so bipartisanship ended about 2.04 seconds after Barack Obama was sworn in as President, but compared to Europe the U.S. is as solid as a rock). The Euro is backed by a loose confederation of separate nations that are devoted to passing the buck to someone else. The financial markets undervalued the dollar, not adequately factoring in the value of political cohesiveness. But a rising dollar impairs America's ability to increase exports, foreclosing one path to economic recovery.

Then, there is the biggest market dysfunction of all. For over one and a half years, the Federal Reserve has held short term interest rates to near zero. Bank profits have rebounded sharply but the stimulative effect of this policy has been disappointing. Banks aren't lending. They invest excess reserves in U.S. Treasury securities, mortgage backed debt guaranteed by the U.S. Treasury, and accounts at Federal Reserve banks (in effect, investing in the federal government). The credit markets for banks now operate smoothly. But the credit markets for everyone else are discombobulated. This massive dysfunction remains an enormous barrier to recovery.

While the reasons for these problems vary from market to market, they each impede America's long term economic prospects. Their simultaneity only exacerbates things. When so many important markets are mispricing assets and discouraging participants, canaries may fall quiet.

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