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Farrell: Bernanke And Hoenig


Kansas City Federal Reserve President Hoenig said that due to the funding needs of the Treasury "it is clear that interest rates must rise." Our dear Uncle Ben said quite clearly in testimony on Wednesday that the "Fed will not monetize the debt."

So if we interpret the statements - made separate and independent from one another - the Federal Reserve is not going to accelerate its purchases of Treasuries and/or agency and mortgage backed paper. The Fed has bought about $130 billion of the $300 billion in Treasury paper it pledged to buy. It has bought $500 billion or so of the $1.25 trillion mortgage backed stuff. It looks and feels like the Fed will say that the back up in yields is more a sign of an improving economy and not an indication the world is demanding higher yields due to the glut of paper that needs to be sold (the size of next week's 10 year and 30 year auctions will be announced Thursday.) Even the Fed's checkbook can't withstand the market forces when they shift in one direction so I would look for the ten year to approach 4% fairly soon and the Fed can't try to slow it.

4% is historically low and would not cause worry in normal times. But if the normal spread between the 10 year Treasury and the 30 year fixed rate conforming mortgage were to hold (the historic spread is about 160 basis points) then we would have a 5.6% mortgage interest rate, and I think that is overly optimistic and the "new normal" might require a slightly wider spread. 5.6% would slow down mortgage applications appreciably since so many mortgage aps are for refinancings and at 5.6% the arithmetic doesn't work. Applications were down 16% last week as the impact of the back up in rates started to be felt. I would expect a steady stream of negative weekly mortgage application numbers.

That doesn't help the bank business. In the first quarter nine of the largest banks saw $4.5 billion in mortgage production income which is equal to 86% of the income for this category for all of 2008. The NY Times had an article recently that stated of the total of $7.7 trillion in loans and leases outstanding in the banking system, 7.75% show some signs of "distress." That surpasses the prior high of 7.26% in the 1990-1992 time frame. The banking system can ill afford to lose an attractive source of "easy" income, but if rates back up it is inevitable. Total corporate profits were up nicely in the first quarter when the horrible environment is considered. The $43 billion gain was led by a 94% increase in financial company earnings. Non financial earnings were down versus a year ago and not likely to turn up until the auto company debacle is washed through the system (at the least.) It would be nice if financial earnings took on some consistency.

The macro data on Wednesday ate up some of the green shoots we have been enjoying. Factory orders were up less than expected and March orders were revised down by a good bit (to -1.9% from an originally reported -.9%.) The ADP guess at job losses for the month was in line with expectations at -532,000, but the prior month was revised considerably to -545,000 from -491,000. The Institute of Supply Management index for service jobs was reported at a punk 44 which is still contractionary. Finally, the Reuters/Jeffries CRB commodity index was slammed a big 2.7% from the 260 level to 253. At least for a day the theory that commodities were rising in price due to a better economic outlook was set back.

The size of next week's 10 year and 30 year auction will be announced Thursday as I said, but the big news will be the jobs number on Friday. If the ADP number is directionally correct look for a negative 550,000 and a jobless rate of 9.2%.

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