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April 8, 1994
Mortgage rates have fallen almost a half percent from Monday's hysterical top, but you haven't heard the last of "nine" this year.
This week's economic data were at least as disturbing as last Friday's employment report. Auto and truck sales in March surged to levels 20% or more ahead of last year, and retail sales showed the same, explosive pattern.
The improvement in long term interest rates has not come from any new-found weakness in the economy, nor from any reassurance about inflation.
Central to a temporarily better bond market in the last four days has been the unraveling of huge, unwisely leveraged trading positions. It is possible to buy Treasurys with only a 3% down payment; if bond prices suddenly fall 5%, margin calls generate a downward spiral.
Now that the leverage bubble has burst, the market is back to economic fundamentals. Though interest rates won't rise as fast as in they did in the last two weeks, there is nothing in the rule book that says rates won't eventually end up in some high place. "Gradually" is not as exciting, but it's just as painful.
How high is high? How gradual is gradual? Should everybody building a house scurry out to buy a long term rate commitment?
Last first: buying a really long commitment (six months out, or more) is seldom a good idea because you can't know for sure when the house will be finished. If the house is late by one day, you're out the commitment money and the rate. Inside four months, the builder has a better idea of completion, and commitments are cheaper and more flexible.
How high and how soon.
At the moment, the forecast is disturbing. The economy is much stronger than anybody thought possible two months ago, and has corresponding inflation potential.
The standard, overconfident line has been "Š so much excess capacity, and no demand for labor Š inflation is impossible." Maybe so. But the markets no longer believe the party line. Long term investors have voted with their money, and their vote is a profound shout of "No confidence!"
Investor confidence shows up in spreads between short term and long term interest rates. The "no confidence" signal is this one: while the Fed has raised Fed funds from 3.00% to 3.50%, the market has raised the yield on 30-year bonds to 7.44% (at the worst of Monday) from 6.20%. Since January, the market has "tightened" not quite three times as much as the Fed.
As the Fed continues to nibble away, one quarter-point rise in Fed funds every 45 days, the yield spread to bonds had better begin to narrow. If it doesn't, we are at risk for double digit mortgages before the end of the year.
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