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July 25, 2003
Bye-bye, fives. Mortgages still haven't found solid ground, low-fee stuff trading nervously just above 6.00%, as a mid-week rally failed on a surprise, 29,000-person drop in new claims for unemployment insurance. If that job news is confirmed and sustained, the interest rate rise ahead will be an epic mirror of the prior decline.
Tentative employment news aside, markets were dominated by The Great '03 Double Hedging Whammy.
In the first leg of the Double, mortgage hedgers had bought a mountain of long Treasurys to lay off the risk of falling mortgage rates, and when the risk flipped to higher rates on the sudden prospect of rapid economic growth, the hedges had to be reversed. Not tapered: reversed all at once. At the same time, the Street had to prepare to absorb and re-sell $80 billion in new Treasury bonds in the next few weeks, and prospective investor/buyers are no longer motivated by fear of economic weakness. The Street was inadequately hedged, and had to sell like mad to catch up.
My sense is that a lot of big outfits are still trapped on the wrong side, still long bonds or not short enough, hoping desperately for a rally in which to escape. They never get it in a Whammy like this, and the overhang from bad positions will tend to keep bonds weak, hit again and again by new Treasury borrowing.
Some relief may come from a rapid evaporation of new mortgage originations. A debate is developing about how much harm a fast rise in long-term rates would do to an economic recovery, and several people at and near the Fed insisted that the rate rise won't have much impact. Fed governor Poole: "Rates are no higher than they were in late April."
Historically, these voices are correct. A rapidly growing economy can tolerate large rises in long-term rates: in '94, mortgage rates rose from 7.00% almost to 10.00% before choking the housing market. (Further note: they were back to 7.50% six months after the peak, and a near-hit recession).
However, nothing in rising long-term rates helps the economy to get going, and this one is barely going. And Mr. Poole is wrong: mortgages reached 6.00% last September, triggering the giant stimulative wave of refis to 6.00%, then 5.75%, then to 5.25%. As of the last closings in August, refi stimulus will have concluded altogether.
Sales of new and resale homes will feel some hurtful pressure, but no real harm. Yet. The fundamental driver in those markets is not rates, it is demographics: the population of the US is growing by 300,000 citizens and non-citizens each month.
Back to the deficit. In a very short span of time, eighteen months, we are swinging from a bond market financing little or no borrowing by the Treasury (preceded by five years of surplus), to a Treasury which must to sell $120 billion in new bonds every ninety days. This deficit is a tremendous shock to the financial system. Its predecessor was a long-building affair, beginning in the early '60s, peaking in the '80s, and resolving it required four huge tax increases (Regan X 2, Poppy Bush, and Clinton). Only the dot-com/telecom bubble put us in a surplus.
Doctrinaire Righties aside, there is no way to get this deficit under control with economic growth and spending cuts, which means that a still-forming recovery will face both rising rates and a serial tax increase. Whether those headwinds will abort the recovery, and force the Fed to buy Dubya's paper, just like the post-bubble Bank of Japan... we'll see. For now, the Fed is boldly whistling past the graveyard.
(Note 1: Try to read gov. Ben Bernanke's 7/23 speech at federalreserve.gov -- it is a clear statement of where the Fed thinks we are, and Mr. B may succeed Mr. G.)
(Note 2: Personal. Our daughter's heart surgery yesterday went fine. Thanks for all the thoughts and prayers that pulled her and the surgeons through.)
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