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October 18, 2002
A thousand-point Dow rally and too many refinance applications blew up the credit markets this week.
In the largest such detonation in a year, mortgage rates rose as much as a half-percent, settling 6.25%-6.375% with the lowest fees; and, from low trade to high, the ten-year T-note yield ripped from 3.57% to 4.22%.
Of the two forces, stocks and refis, the stronger short-term pressure came from refinancing effects, but the long-term future for mortgage rates will depend on stocks and the underlying economy.
The impact of record-volume refinances on the credit markets is as bizarre as overwhelming. When a rate decline begins, the holders of mortgages (almost all are securitized, today) and of related loan-servicing contracts must protect their positions by buying some other long-term instrument, notably ten-year T-notes. This buying tends to accelerate any general decline in rates.
Meanwhile, the rate decline triggers a surge in mortgage applications, and rates are locked with giant wholesale/securitizing intermediaries. These wholesalers begin to sell locked loans in futures markets -- committing locked (but unclosed!) loans for future delivery. The wholesalers dare not sell all locked loans for fear that rates will fall more, and many consumers will break their locks and cancel applications.
A terrible imbalance takes form: buy-side hedging by existing-loan holders exceeds sell-side hedging by wholesalers, and the rate decline enters an artificial and unstable extension.
Then, some economic good news, a rally in the stock market, a mosquito landing on a trader's nose... any sales pressure in the bond market instantly rolls out of control, tipping over one imbalanced position after another. The holders realize that they have excessively hedged, and must dump all the ten-year T-notes they bought, and worse, the wholesalers must fire-sale every loan they have in process -- every single loan will now close because the locks are all below the new market.
You cannot imagine the chaos and pain at wholesalers at this moment, as they try desperately to unload their locked pipelines. Buyers sit, hum-de-humming happily, waiting for panic to drive prices even lower (and rates higher). We can see the pattern in wholesale price sheets today, as many have priced out of the market.
A common solution to owning too many loans: don't make any new ones at all.
How long might it take for rates to come back down? The mortgage market took five months to recover from an identical blow-up last November, hindered by a six-month stock rally. This time, the holder-wholesaler hedging whipsaw won't last so long, as bond market fundamentals are better, and traders learned a lot last fall.
Stocks? Yeow. One authoritative source told me yesterday that the P/E on the S&P 500 had reached a healthy, optimistic, 15; while another insisted it was still a mid-bubble 27. The optimism at this week's earnings reports has a flimsy foundation, at best: stock pushers seem overjoyed by flat results.
As a chart matter, this stock rally looks like another bear-market affair which will fizzle in a month or three or four. If the Dow goes above 9,000, then we're in a very different place, and mortgage rates could rise to or through 7.00%, until the housing market stalls out.
The key economic fundamental: business capacity utilization is stuck at or under 75% at a time when consumers are pulling as hard as they can, maybe harder than they can sustain. The business capacity not in use is brand new, and bought with borrowed money. Businesses have to pay on their debts without earnings from the investment, and idle capacity in waiting everywhere means no one can raise prices.
The stubborn hunch here: we'll see the mortgage lows again before year-end.
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