Almost a Negative Real Interest Rate

By: Chad Hudson | Wed, Jun 27, 2001
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With today's 25 basis point cut by the Fed, the real interest rate got a little closer to negative. With the latest CPI running at 3.6% and Fed Funds now at 3.75%, the Fed continues to rescue the wildcat financiers, with little regard for the prudent savers. Economists were quick to point out that the sudden moderate action signals that the economy must be showing signs of a recovery and is close to bottoming. This current string of easing is still the most aggressive since the cuts in the second half of 1982. The timing of the National Bureau of Economic Research announcement that "data normally considered by the committee indicates the possibility that a recession began recently" seems a bit ironic. However, the NBER did say "the economy has not declined nearly enough to merit a meeting of the committee or the determination of a peak date." It is very unlikely that the Fed's aggressive easing will solve the underlying problems of the economy. There is simply too much capacity and too much debt.

The Fed easing has not benefited companies that need financing. As Greenspan pointed out before the Senate last week, banks have tightened lending standards during the current period of economic slowdown. So far the easing of the Fed has only affected the short end of the curve. Corporate bond yields have actually increased since Greenspan started cutting rate back in January. Ten-year AAA bonds have moved from 6.2% at the beginning of the year to just over 6.4%, while 10-year BBB rated bonds have moved from 7.65% to 7.8%. Not only are yields up for corporate bonds, but more companies are getting their ratings lowered. Moody's lowered the ratings of 23 companies to junk in the first quarter this year verses only 12 in the previous quarter. This was the highest number of companies declining to junk status since 1990. The frightening aspect of this is that this new junk includes a wide range of large companies: J.C. Penny, Lucent, Interstate Bakeries to name a few. Defaults have also soared. Earlier this year, Fitch reported that defaults on junk-rated bonds totaled almost $24 billion in the first quarter, which is close to last year's total of $28 billion. Fitch also said that the average recovery value on defaulted telecom debt is only 8%, down substantially from the 33% last year.

Edison International will not benefit from the lowered interest rates. The company created to issue the bonds for Edison, Mission Energy Holding Corp, is expected to price the 10-year bonds to yield between 13.25% to 13.5%. This compares to a yield of about 5.25 for a 10-year Treasury. If this is what the final pricing actually is, it will be 100 basis points higher than anticipated. The yield was increased to help drum up interest.

With DRAM sales expected to be down around 50% this year there is plenty of excess capacity. In fact, most of the semi fabs are running capacity utilization rate around 50%. Plus, there are new fabs currently being built in South Korea and Germany. How anyone sees that as a good business is beyond me, but Micron has a following that most cult leaders would die for. Looking out longer-term, IDC predicts that the DRAM market will get back to last year's levels in 2005. Looks like there will be plenty of capacity for a long time.

Commercial real estate continues to deteriorate. Bad news in Silicon Valley is it spreading throughout the country like a wildfire. In Denver, office-vacancy rates have soared in its high tech, the U.S. 36 corridor. Since the beginning of the year vacancies have moved from 1% to 28%. Commercial real estate broker, Chris Phenicie, noted that including new construction there is 1.5 million square feet of available office space available. This is more than the total amount of space that even existed just a few years ago. A substantial amount of this space is from technology companies that have put up unused space for sublease. Sun Microsystems is one example. It was ready to move into 133,000 square feet building, but decided to move the group to Austin to take advantage of their labor pool available due to the dot-com fallout. Level 3 has also abandoned a 300,000 square foot building that is still under construction. The increased amount of available space has caused rents to fall almost 20% just since the beginning of the year.

The situation is similar in the Boston suburb of Cambridge. Last year vacancies ran about 4%. Estimates for the end of the second quarter are calculated to be 18% by Debra Gould, principle of Spaulding & Slye. Technology companies, fueled by aggressive expansion plans often "took more than they need in anticipation of growth," said Gould. Now this extra space, along with space made available after layoff, is coming to market all at once. On a national scale, real estate firm Torto Wheaton Research found that 20 million square feet of space has been put back on the market.

At the epicenter of the real estate boom, residential weakness is starting a slow creep to the outlying areas of Silicon Valley. In Tracy, California, which is about two hours away from San Francisco, there are over 400 properties for sale. This compares to only 214 at the end of March and 130 last year. Another problem that surfaces in a slow real estate market is that most houses are sold on the condition that the buyer's existing house is sold first. One real estate agent in Tracy has "been in contract twice and it's fallen through because of the buyers not being able to sell their homes."

However, nationwide home sales continue to defy experts. During May, home sales increased 2.9% to an annual rate of 5.37 million units. For the first five months of the year, more homes have been sold than ever before during the same time. Durable goods orders also surprised economists as orders actually rose in May, however orders are 11.5% below year-ago levels.

The buoyant consumer was confirmed by the latest consumer confidence reading. The June reading of 117.9 was the highest the index has reached all year. This is most likely explained by the overall health of the labor market. While announced layoffs are filling the headlines, unemployment still remains well below 5%. However, this confidence might be ill placed. While many see the economy starting to bottom, chief financial officers expect to see layoffs and lower capital spending to continue. A survey conducted by Financial Executives International and Duke University's Fuqua Business School found that more than 33% plan on cutting jobs, and 39% expect to reduce overtime. Twenty-five percent of CFOs expect to reduce capital spending. Capital spending is expected to drop 1.3% compared to last quarter's survey that still forecasted capital spending to grow 5%. It also indicates that inventory level are still high with 51% of respondents saying they plan on reducing inventories, with 30% planing to maintain the current level. Inflation rears its ugly head in the survey with 59% of firms hoping to raise prices by an average 3%. Overall CFOs expect prices to rise 1.3% in the next 12 months, double the 0.6% expected just 3 months ago.

There has been a lot of discussion about how bad the savings rate really is. The Economist is the latest to declare the savings rate has not declined substantially, American savings. Under the methodology used by the government, taxes paid on capital gains are taken out of income, while the actual capital gains are not included. Paul Kasriel, Director of Research at Northern Trust, did a superb job in rebutting the article in the Economist, - Are The Finances Of Americans In Better Shape Than Feared? I would only add one small item. In the Economist article, the economist smoothes out durable goods purchases by spreading the cost over ten years since these items are long lived. First, ten years? I would like to know how old the economist's car, TV, and computer are. And, this is the whole point. Consumers have been buying too much stuff recently, this is what has pushed the savings rate down. In the future they will not be purchasing the amount of goods that they have during the last few years. This will have a dramatic impact on the economy, since the consumer drives about two-thirds of it. I offer one more piece of evidence, the number of self-storage places popping up all over the place.

MGIC Capital Markets Group conducted a study on recent refinancing that revealed some startling results. The study found that the average loan was $41,000 larger with an interest rate 0.6% higher than the loan it replaced. The spin on it was that consumers are using their built up equity as a way to better finance their debt. While I would agree that it is better to carry one bigger loan at a lower interest rate, than a bunch of smaller loans at higher interest rates, I'm not sure the credit cards are not put in the drawer and not used anymore. Additionally, a lot of home equity loans are used to purchase items and not consolidate other debts. This way of financing seems almost too good to pass up, and is symbolic of an economy that prices everything by its monthly payment. The study also found that 15% of borrowers that were not paying private mortgage insurance (PMI) before refinancing were paying it after the refinancing. Most lenders require PMI if the equity is less than 20% of the loan.

During the 1998 refinance boom only 28% of "cash-outs" were used to consolidate debts. If the current refinancing boom has similar characteristics, there leave little doubt on the source of the consumers confidence and buying power.

For trivia buffs: California ($1.33 trillion GDP) has replaced France ($1.28 trillion GDP) as the fifth largest economy in the world, mainly due to the weakness in the Euro.


Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis

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