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Farrell: Sounds Crazy, But Ben Says It's OK

Thursday, 28 May 2009 | 9:57 AM ET

On Wednesday, the Treasury auctioned $35 billion in five-year bonds(more on that in a second), with a seven-year auction to be held on Thursday. The Federal Reserve at the same time bought three- to four-year paper, as Ben has promised to do.

Sounds nuts, but it's how we financed World War II, and I do trust Ben.

But if Fed Vice Chair Kohn was directionally correct when he said Tuesday that the Fed action has kept interest rates lower by 100 basis points, what happens when the Fed spends its targeted funds? I guess since they are the Fed and have a magic checkbook, they could keep on buying.

The issue is: what does the dollar do? If we are spending freely to buy debt while we are issuing debt, we better hope the stimulus of a trillion dollars works and the issue becomes draining reserves out of the system.

The aforementioned auction went well enough, with an in-line yield of 2.31% and a normal bid-to-cover ratio of 2.3 to 1. But apparently some mortgage guys felt the need to hedge, and their actions caused the 10-year bond to go from 3.53% in the morning to over 3.7% at one point. That is a big move for the bond market. It could also have been that the market said, "Whoa! — we have a 7-year auction scheduled for Thursday to get through and then a 10-year and 30-year auction next week." The rise in the 10-year yield today is not a good intro to the 7-, 10-, or 30-year auctions.

Bummer: yields are on the rise.

Existing home saleswere a bit above expectations, at a 4.68 million annual rate, but only a bit. 45% of the sales were "distressed" sales, and 40% of buyers were first-timers probably encouraged by the $8,000 tax credit. Inventories of unsold homes jumped to 10.2 months from 9.6 months. There are two ways to look at the inventory increase. One is to bemoan it and worry when we will ever work through it. The other is to acknowledge that there is a large "shadow inventory" of foreclosed homes being held back from the market by banks. There is also some undetermined number of discouraged homeowners who have taken their homes off the market. The fact that the inventory rose indicates some of this shadow inventory is being put on the market and could imply a rise in optimism that the markets are improving. I choose the latter explanation. It doesn't mean home prices will rise anytime soon, but since the inventory is there and can't be wished away, better to have it come out and deal with it.

Mortgage applications were also announcedWednesday morning and were down 14.2% to the lowest level in 11 weeks. The average interest rate on a 30-year conforming loan rose a bit, to 4.8% from 4.68%. Being below 5% still strikes me as an attractive enough rate, and I am a bit perplexed that applications should move down. I voiced suspicion at Tuesday's consumer confidence report that was so strong compared to prior readings. The "expectations" section noting confidence in employment and housing prices struck me as questionable. People often say one thing and do another (except on Wall Street, where the truth always holds!). The fall in mortgage applications might be more indicative of what is going on.

The stock market's rise on Tuesday on light volume supposedly encouraged by the confidence survey couldn't stand up for a second day, and the rise in yields spooked investors to sell the market off. I continue to see more downside ahead.

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