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August 22, 2003
Mortgage volatility declined this week, as rates held a stable, 6.25%-6.375% range despite more signs of an improving economy.
There were no definitive reports, but trends are developing: the index of leading economic indicators is a poor predictor, but four straight rising months are significant. Weekly claims for unemployment insurance have every-so-slowly slid below 400,000, and consumer confidence is holding its gains.
The housing market is still in good shape, though reports on its performance are always a month out of date: July's new home starts rose 1.5% to a record 1,872,000. This strength led some commentators to roll out one of the all-time dumb ideas of economic prognostication: "Rising mortgage rates have caused buyers to rush to buy before rates go higher."
In twenty-six years of this work, I've never once seen a buyer hurry because rates have gone up. Central to home purchase is the hope that its value will appreciate; buyers know full well that rising rates are incompatible with appreciation. The newest data from the Mortgage Bankers Association show the collapse of refinancing activity (down 72% since May), but for the first time in this cycle also show a crack in purchase applications, down 6.5% last week, and 14.6% in a month.
In a normal post-recession economic acceleration (aka "recovery", which this is not, because the recession wasn't normal, either), the housing market does tend to race ahead as interest rates rise. However, in those normal cycles the economy is very strong, so strong that only the cumulative effect of a series of Fed rate rises will slow housing.
This time... no one should confuse the current economic pick-up with a strong economy. The unemployment rate is over 6%, and at that is badly under-measured, as many potential workers have stopped looking for work, and more have accepted under-employment. Even after July's improvement, capacity utilization is below 75%. Healthy numbers, at which the Fed could begin to worry about overheating, would be unemployment back down in the fours, and at least 80% of capacity in use.
Given this "output gap," the Fed has no reason to raise its rate -- as four Fed governors said in speeches yesterday. If so, why the explosion in long-term rates?
Because for the first time in a quarter-century, the Fed is not the friend of the owners of a global ocean of bonds and mortgages.
The story begins in 1982, at the peak of a twenty-year cycle of rising inflation. In the ensuing counter-inflation campaign, the Fed had one key ally: bondholders. Since '82, at any sign of renewed inflation, or even too-hot economic growth, bondholders would sell, thereby raising long-term interest rates and helping the Fed to ratchet inflation down from 12%-plus to the 1% or so prevailing today.
This behavior by bondholders got them a nickname in the markets: "The Bond Vigilantes." If the Sheriff at the Fed had forgotten to do his job, or politicians had hog-tied him, the Bond Vigilantes would rustle up a posse and shoot the economy plumb full of holes.
Now, Sheriff Greenspan has succeeded too well. Inflation is, if not too low, threatening to go too low, and the Fed's mission is to "reflate" the economy, to bring pricing power back to businesses, to get inflation back to 2% or so. For the first time in the working life of anyone in the markets, the Fed is trying to raise the rate of inflation.
The Vigilantes ain't happy about that. Not one little bit. Until the posse can develop faith that the Fed knows what it is doing, that it can pull off the neat trick of reflating back to 2% and not 3% or 4%, Sheriff Greenspan is at risk to find his reflation intercepted by a renegade posse.
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