trying to get my thoughts straight...

I was pretty sure that interest rates were going to keep going up. After taking a profit on 2-yr. treasuries, I was looking for an opportunity to go short again. I thought I might get it when Bernanke testified to congress.

However, Big Ben turned into "Gentle Ben" as Abelson from Barron's put it. Ben had plenty of ammo to go after inflation, but he didn't. Instead, what caught my ear was his assertion that "the downturn in the housing market so far appears to be orderly." If Big Ben is worried about housing, he won't raise rates. This year and next, $1.7 Trillion in ARM's will readjust, taking about $22 billion out of consumer spending according to numbers from this article.

Here's a Consumer Federation report from May 2006. I've analyzed its numbers below, and they are worse. Its analysis is telling:

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interest-only mortgages are not new; they were common in the 1920s. At that time, most mortgages were interest-only loans for their entire terms (usually less than 10 years), so borrowers did not amortize the loan at all and had to refinance the loan at the end of the term. Homeowners used their money to invest in the stock market prior to the 1929 market crash rather than paying down their debt. When real estate prices collapsed during the Great Depression, interest only foreclosures spiked and lenders stopped making interest-only loans for the next seven decades.

Borrowers who are basing their mortgage decision on the initial monthly payment level could face significant payment shock as soon as the mortgage adjusts. For a median-priced existing home with a 10% down payment at the current 5.32% interest rate for 5/1 ARMs, the monthly payment would be $1,069.71. If interest rates adjusted to 7.5%, the monthly payment would rise to $1,352.98, or a nearly $300 or 26.5% increase. In the late 1980s, interest rates rose to 10.25%. If interest rates adjusted to that high level, the monthly payment on a median-priced home would rise to $1,733.96 – a 62.1% increase. A March, 2006 survey by the Los Angeles Times/Bloomberg found that one quarter (26%) of homeowners with adjustable rate mortgages were not confident that they could continue to make their mortgage payments if rates adjusted upwards in the future.

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Here are some new numbers to play around with:

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For example, if a borrower took out a 3-year hybrid ARM in January 2003 at the prevailing rate of 4.26% on an average sized existing home with a 10% down payment ($215,000 home with a $193,500 mortgage) the payments would have been $954 a month for the past three years but would rise to $1,074 in January (if rates remain about where they were in November at 5.30%).

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But rates aren't what they were last November. 5/1 ARM's are at 7.24%. That would make payments equal to $1,342. A $400 per month jump on 8.5 million ARM loans will take $41 billion out of consumer pockets. These are the same people who couldn't afford a house in the first place.

Now that I've made the case that Big Ben will not raise rates, I will speculate on what the ramifications will be.

1. An immediate and precipitous decline in the dollar. Rate increases are the only thing propping up the dollar at this time. The Yen is the currency to bet on because the rising Yuan makes Japanese goods cheaper compared to Chinese. Soros says that export economies that import everything can keep a high exchange rate almost indefinitely.

2. If the dollar declines, then what? Commodities should stay high because as long as China's buying. This and higher relative rates with other currencies will fuel inflation. However, a lower dollar will help our exports abroad. The trade deficit should narrow.

3. Current rates of inflation without higher interest rates will result in a negative real rate of interest, driving away foreign investments in the dollar. This could easily become a vicious cycle that requires government intervention.

4.What does this mean for the economy? Stagflation or recession.

5. What does this mean for stocks and bonds? Corporate earnings will suffer, which will depress the stock market. Bonds will seem safer, but lose ground to inflation. When this is realized, they will fall out of favor.

We are in a transition period, which means that markets can and will make huge directional shifts suddenly and unexpectedly. The pulse of the market needs to be taken almost daily to keep on top of it. Also, there is a great danger in becoming married to one line of reasoning without being ready to reverse course immediately if new conditions warrant it.