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Howe Street: Interest rates: the Fed Conundrum

Fed Decision October 31st

All eyes will be on the U.S. Federal Reserve 13 days from now when possibly the most important interest rate decision of the year will be announced.

The Fed has a real conundrum as we related earlier this week. On one hand there is a weakening economy that is getting pilloried by the credit crunch caused by the failing U.S. real estate market; on the other inflation, which is now 1.6% over the Fed target of 2%.

The news on the real estate front just keeps getting worse as the stats come in almost on a daily basis. It is not just new homes as reported by the National Association of Homebuilders yesterday who saw their overall index fall to an 18, (50 is considered the benchmark when sales turn poor, and it was up in the 70's earlier in the year). This is the lowest it has ever been since the gathering of stats started in 1985. Not only that, but actual housing starts were down 10.2% in September.

It is also resale homes that are piling up where mortgage defaults are not only being felt in the subprime arena, but now with adjustable rate mortgages that were initiated 3 years ago at interest rates 3% lower than today's levels, even qualified buyers are dropping from the market.

Today, in just two markets, the figures are astounding. Phoenix has over 50,000 residences for sale and Las Vegas, where earlier this year the market was on an absolute tear, there are over 35,000 houses for sale. In both venues, the approximate selling time for a home once it is listed is over 9 months.

New figures for Southern California released yesterday show that sales plunged to their lowest level in more than 10 years, with prices falling in tandem with sales in most regions and sales in Los Angeles proper down a whopping 50% year over year. (LA home values actually gained 1.2% year over year where the average drop in prices for Souther California was 4.0%).

On the other hand, the rising cost of energy is driving inflation to levels that are way beyond Fed tolerance. In fact, yesterday's CPI figures for September were above analysts' forecasts, and that was before the price of oil and natural gas really took off.

In fact, to yesterday's high of $89, oil is up over $10 per barrel in just the last 8 days, an impact that will surely be felt in next month's inflation numbers, and one that has to be dealt with by the Fed when it sets rates on the 31st.

But it is just not the price of oil that is up for Americans, for as the U.S. dollar continues to plummet, the price for all commodities have been compensating for the lower greenback, as all commodities world wide are priced in U.S. dollars.

Where Canada and the European nations have been somewhat buffered by the increasing cost of commodities because of the rising CAD and Euro, the U.S. has felt the brunt of higher prices for everything from precious and base metals to energy and foodstuffs.

Even today, the USD is flirting with recent lows with the U.S. dollar index falling earlier this week back under 78 and threatening today to take out its all time low set the 1st of October.

This fall in purchasing power of the Dollar just fuels the inflationary monster. If the Fed raises rates it could be a crunch that the U.S. economy could not stand and could be the actual catalyst that pushes America into recession.

If they lower rates to accommodate the flagging economy, (economic growth for 2009 is estimated at 1.8% which is half the rise of inflation at today's numbers), then the inflation figure could really jump to the upside and the Fed could lose control.

The Fed has stated in every which way that fighting inflation is their primary goal, but with the situation as it is today, how can they dare to raise rates?

Their only hope, and listening to both Fed Chair Ben Bernanke and Treasury Secretary Hank Paulson earlier this week one has to doubt this will be the solution, is that the market will work its own way through this ever deepening housing crisis.

There is still about 15 months to go of subprime mortgages that are in deep trouble coming up for renewal. The big crunch comes next March, and then the numbers start to wane from there on a monthly basis.

We expect that the Fed will do as the Bank of Canada did earlier this week and stand aside on rates; but what they have to say along with the rate announcement will probably fuel the markets, one way or another, right through the important fall and Christmas season.

We see the U.S. economy on a knife's edge, and to keep it from bleeding profusely will take some masterful work and cooperation from the U.S. consumer who will be looking with more than mild interest at what the Fed decides on Halloween night.

CAD fails to follow Euro higher
After hitting $1.03 late last week, the Canadian dollar seems now to be back into a bit of a trading range, even though the Euro this morning made all new record highs and the U.S. dollar index is flirting with record lows.

Part of the fact that the CAD seems to be stuck temporarily has to be its meteoric rise of late, and it could just be stopping for a breather before the next assault of higher levels.

However, and this is where we put our money, there is a bit of negative North American sentiment starting to build and the CAD could be reacting to the weakening situation in the U.S.

The 'sell North America' syndrome may be closer at hand than some traders realize, and although Canadian fundamentals are much better than American, the fact is our economies are closely linked.

If in fact if the U.S. does falter badly, whether it goes into recession or not, the impact on Canada could be neutral to mildly negative depending on the severity of the U.S. slowdown.

This is not to say that we bet against a dollar (ours) that is in a definitive uptrend, however caution may be the word here as we watch the Euro go over $1.43 and gold climb back up over $760 while the CAD struggles at $102.50, yesterday's close.

The U.S. interest rate front will also come into play with the CAD and any hint that the U.S. might take the bull by the horns and raise rates would send not only the CAD much lower, but could be the catalyst that turns the U.S. dollar trend around.

By Michael L. Levy, Executive Vice President, Financial Analyst

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