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November 8, 2002
The Fed's half-point surprise on Wednesday had a delayed reaction; it did not begin to settle into the financial markets until yesterday, and is still not complete.
Mortgage rates have reached a new low (which Freddie Mac's survey will not discover until next week), easily 5.875% with the lowest fees. However, that's not even a whole eighth-of-a-percent below the old low. Any market drift lower -- to 5.75%, say -- would trigger a high-velocity mass of new refinance applications, which in turn would blow the market back above 6.00%, a pattern repeated over and over in the last two years.
Since 2000, mortgage rates have tended to stair-step down about a quarter-percent at a time, each time launching a half- to a full trillion dollars' worth of refinances, the market each time taking two to six months to digest the volume before the next decline.
The prospects for additional steps down, deeper into the fives, into 2003? Three forces, interwoven, will decide. In the long run, economic weakness; in the short run, the stock market; and in the who-knows run, war. The Fed is out of the game, in the sense of future action. The Republican victory means we should all sit up straighter in our chairs, and wear neckties more often, but has no rate impact: no matter who had won, we were going to borrow a hell of a lot of money and spend it.
I think there's only one way to interpret the Fed's action: a final shock-treatment, trying to defibrillate the economy. Traditionally, the Fed revives the economy by cutting its overnight rate below the inflation rate; today, it cannot. It's new, 1.25% cost of overnight money is about the same as the inflation rate, which is falling, and the Fed dare not go lower. If the Fed tried to go lower, the yield on money market funds would go negative (management fees...), risking withdrawal of a trillion dollars or more, and a new credit crisis. The Fed has enough trouble.
Still, near-zero returns are on the way to bank lobbies and mail boxes everywhere. What impact will that have? To a lot of people, a zero rate of return looks pretty good compared to taking the advice of the jackasses braying cheerfully on the stock-talk shows.
In the last forty-eight hours, near-zero returns on cash have driven money to longer-term debt: to threes, fives, tens, thirties, and mortgages, suppressing those yields. Yields are low, but they feel safe. Some money at last flowed to battered corporate bonds, a desperately needed restoration of credit to business.
The Fed's last-ditch try signaled investors in long-term paper that it has no bear trap waiting, as the Fed would like nothing in the world more than rising prices. Out there into next year, or '04, or '05, the Fed will begin to worry about limiting the desired effect: getting inflation from zilch to 2% would be great, but overshooting to 4% would begin the age-old cycle again. No worries about that, now; buying bonds is as free of Fed-risk as it ever gets.
"Geo-political risk" is a classroom phrase. Never, ever euphemize about war. War is the risk at hand, yet in its prospect lies the best chance for good news, soon.
All of its risks are built into the markets, now, and none of its benefits. Hussein will try to wiggle his way through a tripwire web; we'll have more jaw-jaw at the UN before war-war (apologies to WSC); and if Hussein chooses the bunker conclusion, it'll take another three months or so before the shooting starts.
But, we're very likely to win the damn thing, and quickly. Messy, lethal, possibly destabilizing, but oil prices would fall by a third at least, and ambient tension would relax to something we haven't felt in fifteen months. The economy could use that.
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