Today, there is speculation that the US housing bubble might deflate next, bringing on a recession in 2008, and an easier Fed policy in the second half of this year. At its peak in February 2007, the yield on the three-month T-bill rate was roughly 60 basis points above the benchmark 10-year yield. At that time, many analysts predicted the inversion would at least signal slower economic growth, yet few were convinced it would spell a contraction of gross domestic product for two consecutive quarters, the typical definition of recession. But since mid-July, the odds of a US economic recession have been mounting, led by sliding home prices, a global credit crunch, and the first loss in employment in four years in August. US retail sales stagnated last month, and the glut of unsold US homes reached 10 selling months, its highest in 18-years. Forced to choose between defending US home prices or the US dollar, the Bernanke Fed decided to sacrifice the greenback, and lowered the fed funds rate by 50 basis points to 4.75% on Sept 18th.

During the three previous Fed easing campaigns, whenever the two-year Treasury yield fell to more than -50 basis points below the fed funds target, the Fed lowered its target rate each period. In August 2007, the 2-year T-Note yield fell to -110 basis points below the 3-month T-bill rate, persuading the Fed to slash the fed funds rate by a larger-than-expected 50 bp on Sept 18th. The longer the spread between the two-year T-Note yield and the fed funds rate stays below -50 basis points, the greater the likelihood of more Fed rate cuts in the months ahead.  Most interestingly, the Bernanke Fed is lowering interest rates at a time when the  US M3 money supply is expanding at a 14% annualized rate, its fastest in 35-years, gold is trading at $730 /oz, its highest in 28-years, and crude oil is flirting with the once unthinkable $80 /barrel. Soybeans and wheat are surging to record highs, and the Baltic Dry Freight Index, a key measure of the health of the global economy, is 300% higher from 18-months ago.  Other central banks in Australia, Canada, China, the Euro zone, England, and India are inflating their money supply at double digit growth rates, and might have to permit faster monetary expansion at home, in order to prevent a freefall in the US dollar. The fear of explosive money supply growth around the world has now touched off a frenzied craze for anything that can’t be printed by central banks, including agricultural and industrial commodities, and stock index futures.   Fed Spooked by Severe weakness in US Housing Sector Why did the Bernanke Fed slash the fed funds rate by a larger than expected half-point on Sept 18th, at a time when inflationary pressures are elevated at dangerously high levels in the global economy? Robert Shiller, a Yale university economist, told a US congressional panel on Sept 19th, “The collapse of US home prices might turn out to be the most severe since the Great Depression. The decline in house prices stand to create future dislocations, like the credit crisis we have just seen.” According to the S&P/Case Shiller national home price index, US home prices in the top-20 metropolitan areas fell 0.4% in July from June, to stand 3.9% lower from a year earlier. The index for the top 10 metropolitan areas fell 0.6% in July, for a 4.5 % annual decline, the worst rate of decline since July 1991 as the economy was emerging from recession, S&P said. Home builders are under enormous pressure to pare down unsold inventories, and are lowering prices.

Meanwhile, existing US home sales fell 4.3% in August to a 5.5 million-unit annual rate, swelling the inventory of homes and condos for sale to 4.58 million units, to a record supply of 10-months. Former Fed chief “Easy” Al Greenspan said on Sept 16th, the he would not be surprised if US home prices fell by double-digits into 2008.

A fall in home prices on that scale would be unprecedented in US history and could tip the world’s largest economy into recession. US residential real estate has an aggregate value of about $21 trillion, and is the single biggest source of US household wealth. If home prices fall roughly 15%, it could wipe out $3 trillion of household wealth, and deal a huge blow to consumer spending.

A double-digit decline in US home prices could spark big job losses. Construction employment fell about 15% in both the 1990’s and 1980’s recessions, and it dropped 18% in the recession of the mid-1970’s. In each case, the sector’s declines were far steeper than job losses in the overall economy, and the recovery took longer. About 7.6 million Americans workers are employed by construction companies, so a 15% decline would translate into the loss of 1 million jobs.

The yield on the Treasury’s 2-year note is closely tracking the slide in the Dow Jones Homes Builder Index, which tumbled to the 350-level today, or 68% below its all-time high set in August 2005. Adding to the gloomy outlook for the home builder sector, Lennar (LEN.N) posted a third-quarter loss of $514 million, compared with a year-ago profit of $207 million, and reduced its workforce by about 35 percent. New orders during the quarter fell by 48% to 5,804 homes.And it’s the direction of the 2-year note yield, which is influencing the Federal Reserve’s monetary policy these days. With the US 2-year T-Note yield hovering at 3.90%, traders are projecting at least 75 basis points of Fed rate cuts to 4.00% in the months ahead. And according to the chart below, the US$ Index usually tracks the direction of the two-year US T-Note yield. 

The Fed’s decision to devalue the US dollar, by unilaterally lowering interest rates, carries big risks, since it could evolve from an orderly decline into a speculative rout. Foreign exchange trading has mushroomed by 65% over the past three years to a record $3.2 trillion a day on average, led by hedge funds and foreign investors. The sheer volume of FX trading would make central bank intervention less effective in trying to control a crisis situation.The Euro has emerged as the top challenger to the US dollar, and is involved in roughly $1.2 trillion per day of currency transactions. The Euro moved above the psychological $1.400 level after the Bernanke Fed slashed the fed funds rate. Meanwhile, the European Central Bank signaled that it won’t follow the Fed in cutting its interest rates, with inflation risks pointed to the upside in the Euro zone.

With G-7 central bank monetary policies out of sync, unilateral Fed rate cuts to 4% and a further devaluation of the US$ Index below the 80-level, could open the door for an upside break-out for the Dow Jones Commodity Index, which has been trapped in a sideways range between the 160 and 180 levels for the past two years. There have been numerous rotations among its major sectors, energy (33%), grains (21%), industrial metals (18%), and precious metals (8%), but until now, a steady Fed policy had kept the “Commodity Super Cycle” in check.In 2001, the Fed tried to prop up the Nasdaq bubble by slashing the fed funds rate from 6.50% to as low as 1%, but instead, created a bubble in the housing sector. Nowadays, the Bernanke Fed aims to cushion the decline in US homes prices by slashing the fed funds rate, but might end up inflating a bubble in the commodities markets, led by the top-4 sectors in the Dow Jones Commodity Index.

If a weaker US$ ignites a rally for base metals, such as copper, it could add to the bullish enthusiasm for the Australian dollar, which also carries a big interest rate advantage over the greenback. The Aussie dollar is closely tracking London copper these days, and has recouped its losses from the violent shakeout in August to as low as 77.50 US-cents. The Aussie is in strong demand, as the Bank of Australia has ruled out reductions in its cash rate anytime soon, due to a booming mining sector.The Australian Stock Exchange touched record highs of 6,500 this weak, led by strong demand for BHP Billiton, the world’s largest miner, who said on Sept 26th, that its giant Olympic Dam site holds about 79 million ounces of gold, making it the biggest gold resource in Australia and the fifth-largest in the world. The Aussie dollar might also begin to exhibit a greater correlation with the yellow metal.

What could go wrong with the bullish outlook for the “Commodity Super Cycle”? If the US economy sinks into recession, it could weaken demand for Chinese exports and industrial commodities. And 25% of Chine’s juggernaut economy is linked to exports to the USA. Therefore, traders should keep a close eye on the Shanghai red-chip market and the Dow Industrials, for any signs of a slump or worsening investor sentiment. If either market turns sharply lower, it could rattle stock markets in Asia and Europe and undermine the “Commodity Super Cycle”. On the other hand, if global stock markets can stay elevated near record highs, or move higher in the fourth quarter, alongside a weaker US dollar, and massive monetary inflation by central banks, then it would alleviate fears of a global economic downturn, one can expect to eventually see a 10% upside rally for the DJ Commodity Index to the 200-level.

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