Interest rates and housing

Bloomberg columnist Caroline Baum's latest piece. Caroline is a firm believer in the predictive abilities of the yield curve. And it's true, the yield curve, over time, has proved to be the most accurate of the leading indicators.

Think about this -- the current yield on the 10 year T-note is 4.76%. The yield on the 91-day T-bill is 5.02%. Why would a sophisticated investor buy a 10 year T-note with a 4.76% yield when he could buy a T-bill with a 5.02% yield? The answer is that investors don't think the 5.02% yield will be around for too much longer. Therefore, lock in the 4.76% yield for the next ten years. But question -- why wouldn't the 5.02% yield be around?

First, you have to remember that the bill yield is closely tied to the Fed Funds rate, which is an artificial rate chosen by the Fed. But the yield on the 10 year note is a free market rate, arrived at by the consensus of market opinion -- it's a rate created by investors who've put their hard-earned money on the line.

Now suppose the free market yield is correct, and it's below the Fed's arbitrary Fed Fund yield? The yield curve is then inverted, and that tells us that the market thinks the Fed is wrong and that short yields will soon be heading lower in line with the market's opinion.

And that's where we are now, the inverted yield is saying that the bond market along with the PIMCO crowd believes the economy is going to "soften" in coming months and as a consequence yields in general will be heading lower.

I wouldn't argue with that opinion or "forecast" at all. So let's just suppose that the economy does soften in the months ahead. My first thought is that housing is going to get hit -- and hit probably harder than it has been hit so far. If this happens, the Fed is going to "freak out," because a "hard landing" in housing is the one thing the Fed does not want to see.

What would be the Fed's reaction be to a softening economy and a further unraveling of the housing situation? The Fed's reaction would be to bring rates down and keep the money spigots wide open.

This in turn would impact on the dollar while sending gold higher. And I'm wondering -- is gold sensing that scenario now? Is this why gold has been moving up along with silver and platinum?

As far as the stock market is concerned, that there are few signs of downside pressure. Keep you eye on the new lows, which have not been higher than 30 all year. So far, nothing's breaking to new lows.

Interestingly. all three D-J Averages hit record highs last week. But by the end of the week, Industrials and Transports had turned down (but not the Utilities), thus creating what technicians term "key reversals." These reversals are usually distribution phenomena, and as such, they tend to be followed by lower prices.