Rates closed somewhat higher Friday afternoon. There was a moment around 11:45 EDT when it looked as if the Iranian act of war may push rates lower. There was a rumor that situations were heating up and it may have even appeared that military or at least very strong action would have been taken. The rumors proved to be false, but it still caused a large momentary drop in rates. Rater recovered, unfortunately. The 10-year Treasury closed on Friday at 4.648% which was +.016% higher than Thursday’s close.

Friday’s trading gave us some lessons in how the bond market ‘thinks’. When

We say that the market ‘thinks’, we are really referring to the millions of investors and traders that influence rates every day. They ‘think’ about rates and bond prices the same way that voters ‘think’ as a group. Some vote for one candidate, some for the other. Investors and traders buy, sell, hold in or stay out based on their belief of the direction of rates and the economy. Rather than one man, one vote, one dollar, one vote.

In contrast to paranoid belief, here is no one person, agency, or evil corporation setting bond prices and interest rates. Interest rates are a function of an auction. Stock prices, bond prices and yes, even oil prices are set the same way.

That is not to say that the FED Reserve does not influence interest rates. The FED does influence interest rates, and time impacting rates, by setting the very short term FED Funds rates. The FED Funds rates are an overnight loan to banks.

To those who still believe that the FED controls interest rates, kindly explain why long term bond rates reflected in the 10-year Treasury have been below the FED Funds rates for nearly two years.

When interest rate voters are determining interest rates they are looking primarily at one thing, inflation. Inflation eats away at the underlying value of the money invested in the bond. One of the dominant theories of inflation is to watch how the economy is growing. As the theory goes, a hot economy MUST produce inflation. The theory is only partially true. If production of goods and services grows as fast as the economy things are ok.

Investors watch economic data to see how the economy is doing. That is why we report on them every day. Some of the data are forward looking, others are lagging’ they look back in time. Some mix the two. All thinks being equal, a forward looking indicator has more persuasion than a lagging indictor. But all things being equal are a rare event. The MBA Purchase Application Index is forward looking, but if GDP is out o the same day it will overwhelm the MBA Purchase.

They will also be watching critical sectors of the economy. Right now, everyone is most concerned with the housing sector.

Friday gives a living example of how traders and investors think. Personal Income and Spending are lagging indicators. That had a momentary effect on rates. The bond market was waiting for Chicago Purchasing Managers Index. It came out at 09:45 EDT. As a forward looking indicator it had more influence. The bond market did respond some after its release. Unfortunately it responded the wrong way.

Construction Spending rarely surprises the market. It did on Friday, at 09:00 EDT. As a portion of the real estate sector it currently has a big impact on rates.

So, the final question, why didn’t Consumer Sentiment pull rates back down? Economists and to a greater degree, bond investors know that consumers are often swayed by the media. They may be the first to know when the economy is dropping, but they are often the last to know when it recovers. This is especially true when a Republican is President given the main stream media’s 2.2% scenarios.

The 2.2% scenario is something that we commented on quite some time ago. It happened in 1992 and 1993. President Bush #41 and then Governor Bill Clinton were battling for Air Force One. In April of 1992 the 1^st quarter GDP was reported. The media reported it in dire terms as if the world was ending. The word anemic was used.

Flash forward 18 months and the word anemic was dropped. The GDP report was described as ‘a fast clip’. Funny thing was, the GDP grew at the same rate, 2.2%.

Rates were pretty good as we end the 1^st Quarter. But we need to caution that they may not drop much further. That is, unless the 10-year Treasury goes below the 4.500% level for more than 5 trading sessions. That is the next “psychological floor”. The market has toyed with going below that level, but never for more than a few trading sessions.

[Publisher’s note: In an attempt to clean up our blog, we will post all three outlooks on Monday only. We will post an outlook on days when one is modified.]

SHORT-TERM OUTLOOK [28 March 2007]

Friday is the big day for economic events with last month’s employment situation report. Monday does have the ISM report. Wednesday has the ISM Services report. Other than those, it should be a pretty quiet week.

There are still problems on the international situation.

As we posted earlier:

On Friday, the Iranians captured 15 British Sailors and Marines. The Iranian capture of these 15 British was clearly an act of war. Even if the British had briefly been in Iranian water the normal procedure would have been for Iran to question then release them with a stern protest.

It is our opinion that this event has the potential to turn into an international crisis. If it does, the impact on World Stability and peace is obvious. Let’s hope that the Iranian provocation does not escalate. At the same time, this blog is about economics and interest rates and we will examine this event with that in mind.

If the Iranians cause this to escalate the impact at the gas pump will be dramatic. It is possible that gas prices will spike about +$1.00 per gallon. The only silver lining will be the initial impact on rates as money makes a flight to safety. Rates could go as low as 4.000% on the 10-year Treasury. Again this assumes that the situation escalates.

That drop will last only a short time, 2 to 6 weeks. The increase in Energy costs will flow through and spark inflationary fears. Bond holders fear inflation more than they fear WW III.

A similar situation occurred in 2004 and was soon resolved. Still, the Britts (and the world) are growing tired of Iranian obstinacy. That could move this even to the forefront. That would not happen until late in the week.

As of this date, there has been more evidence offered that the Britts were in Iraqi water, and therefore innocent. Even the French – who never shy away from a chance to stab the Anglo-Americans in the back – are taking the side of the Brittish.

Iran is not backing down, neither is the UK. At this time it has not impacted rates. If it had rates would be lower. IT has dramatically affected Energy costs. Crude oil was +1.30 or +2.07% to $64.23/brl.

This could spark inflation fears. We are concerned with the influence that could have on rates.

MID-TERM OUTLOOK [28 March 2007]

There may be a problem for rates for the next quarter. IF homeowners start to see a rebound in housing – it appears that there is some small turn around – their confidence will increase. As confidence increases, so will spending. Economic growth is moderate now with problematic inflation. Strong growth could renew strong inflation.

In February we wrote:

We have one great inflation fear in the mid-term; corn prices. With all the talk of alternate fuel and ethanol, corn futures have nearly doubled. That will impact not just corn flakes, but pop/soda, beef, and pig, just about anything we eat.

Steve Boxmeyer [612] 799 – 6858
steve@LendWithIntegrity.com