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Mr. Greenspan's Peculiar Cycle
We are now a full year into the Federal Reserve's newest tightening cycle, Mr. Greenspan's third since taking office in 1987.
The Fed began this cycle on June 30 last year by raising its interest rate -- the overnight Fed funds rate -- from 4.75% to 5.00%; five additional hikes later, the Fed funds rate stands at 6.50%. New economic data in the last six weeks describe a slowing economy, and this tightening cycle may be near its end.
The peculiarity in this cycle: mortgage rates have risen little in the last year, and the least in relationship to Fed funds during any of Mr. Greenspan's three tightening cycles -- or any chairman's tightening cycle, for that matter.
Fed fundsMortgages
Begin EndBeginEnd
1988-896.50% 9.81 10.50 11.75
1994-953.00% 6.007.259.75
1999-004.75% 6.507.508.125
This cycle may not be at its end, and there was a spike to 8.75% during May (mortgage rates are shown on "zero plus zero" terms). However, even at the May high, the mortgage-market resilience has been astounding.
The likely causes of this unusual performance include some happy changes in our economy, the benefits of Mr. Greenspan's long-term policies; and an entirely new factor, the federal budget surplus.
A deepening and well-founded belief in low inflation is the happiest change. In the 1988-89 tightening cycle, inflation fears were still fresh and deep, and today it is hard to believe that 10.50% mortgages were the low going in -- four full percentage points above Fed funds, versus roughly 1.50% today. A mild recession followed the 1988-89 cycle, and the interval since is the longest recession-free span in the nation's history.
That recession broke most of the expectations of high inflation left over from the 1970's and early '80's... but not all.
As the Fed tightened in 1994, the old, reflexive fear returned, and long term rates rocketed three percentage points in ten months, again nearly four percent above Fed funds, only to fall back quickly in 1995 as the Fed's pre-empting campaign worked. The campaign also very nearly caused a recession, and the Fed was forced to begin to ease only five months after its last tightening move.
The change in inflationary expectations from high to low is not entirely due to fear of Mr. Greenspan and his hit and near-hit recessions. Two extraordinary events have contributed as much as he: first, the "new economy" has brought a once-a-century surge in productivity. Second, the world is at peace among great powers to the largest extent in a very long time (Pax Romanum comes to mind), and correspondingly free of budgetary pressure, instability, and mayhem.
I hear tell that some of the benefits of low inflation have turned up in the stock market, but you know how easily rumors spread among those people.
Then, there's the wild card: the federal budget surplus.
On current projection, cumulative surpluses will be sufficient by the year 2012 to pay off the entire $3,500,000,000,000 national debt held by the public. Sometime around 2020 we'll begin to borrow again, to pay for the retirement of the Boomers.
Until 2012, the U.S. Treasury will be the most bullish and fat-walleted buyer of bonds in the history of the world. Having a buyer like this loose in the market has a splendid effect on the value of remaining bonds: values rise, and yields fall.
As the world's highest quality securities -- U.S. Treasurys -- disappear, market demand for quality will especially favor the remaining bonds issued by U.S. government agencies.
Among them: Fannies, Freddies, and Ginnies.
I may be wrong, but I feel sure that some of the peculiar performance of mortgages -- beneficial, Lord knows -- has been due the Treasury's indirect buying pressure.
So, one modest piece of advice: keep an eye on those budget forecasts.
If it turns out that most of the budget surplus to date has come from a one-time run-up in stock prices, stimulating the economy and generating tax revenue; and from here on the economy returns to 2% growth instead of the 3% forecast... Well, then the Treasury would have to back off its buying binge, and mortgage rates might no longer behave in such a pleasantly peculiar way.
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