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May 19, 2000
The Fed's half-point raise in the Fed funds rate to 6.50% has done no additional harm to mortgage rates. The damage, a rise to 8.75% on low-fee loans, was done two weeks ago in anticipation of the Fed's move.
That is the good news.
The bad news: the market has not yet begun to anticipate the Fed's next move, likely to be at least an additional .25% hike at its June meeting.
There are three grounds for unrelieved pessimism in the near-term: the Fed's press release, ongoing economic strength, and inflation prospects.
The Fed did not bother to flip to a between-meeting "neutral bias", instead saying: "Increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply....
"Risks are weighted mainly toward... heightened inflation pressures in the foreseeable future." The foreseeable future presumably includes next month.
The sum of news on housing starts, industrial production, and the trade deficit indicates the economy is still steaming along at a 5%+ growth rate.
CPI is under reasonable control, but danger mounts: the National Federation of Independent Business reported three times as many of its members raising prices as reducing them for the second month in a row.
For the longer run, measuring the probability of an unexpectedly deep slowdown in the economy is every bit as important as guessing at the Fed's next tightening moves.
Every recession since World War II was preceded by a period of well-intended efforts by the Fed to slow the economy which slowed the economy more than the Fed intended.
Both the chief executive and the chief Fedologist at PIMCO, one of the world's largest and most successful bond fund managers, have had instructive things to say about the consequences of the Fed's toughening stance.
"Stay long high-quality bonds until something breaks."
-- William H. Gross
"To me, this scenario has hard-landing risks written all over it."
-- Paul A. McCulley
A hard landing is the traditional phrase used in the markets to describe a Fed-induced accident. Perhaps the economy will gradually slow down; if not, something will break. Housing, perhaps... or the stock market... or maybe consumers in the aggregate... or maybe something unexpected, like Japan, or the euro.
If something breaks big, producing a deep slowdown, it would produce an equally deep drop in mortgage rates -- very good news, except for the newly unemployed.
The odds of a big break later this year are growing quickly.
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