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April 22, 2005
Mortgage rates fell again this week, now the lowest since February. The 10-year T-note has held a 4.20-4.30% range, taking even the lowest-fee 30-year mortgages to 5.75%, but I can hardly over-emphasize the instability in the markets.
The prevailing theory causing stocks to sink and bonds to do well is unproven, unprecedented, improbable -- and might be correct anyway.
One lesser theory died quickly this week, the notion that the huge, two-week bond rally taking rates down almost a half-percent was a mechanical mirror of a straight-down stock market. Last week was stocks-straight-down, Wall Streeters offering clients the traditional euphemism, "unexpected volatility", bonds improving at each stock slide. This week stocks entered true volatility, down 100-Dow points Wednesday, up 200 on Thursday, sinking again today, but bonds held steady.
The real bond trade has not been tied just to stocks, but to energy prices, inflation, and expectations of the Fed and the economy. For anyone who lived through the 1970s, or studied them -- let alone worked in financial markets then -- the theory behind this vigorous return to very low long-term rates is wishful.
In the 1970s, two rapid run-ups in energy prices quickly produced general price inflation. The Fed reacted as it should have to the first, tightening hard and inducing the short, tough 1973-74 recession (and the first double-digit mortgage yield in modern times, 10% -- with two points on top). Inflation fell back to 4% by 1976, but in today's belief, the Fed failed to follow through, to squeeze out residual inflation, and that timidity allowed a pile of inflationary kindling to lie about, all too easily fueling the conflagration following the second oil spike.
This is the largest oil shock since. The constant-dollar price of oil is only about half the 1979-80 level; economies everywhere are more adaptable, especially in fuel substitution; and energy use per unit of GDP growth in most economies is only about one-third of the 1970s ratio. Nevertheless, $55/bbl is a shock, and it is percolating into the general price structure. The .4% jump in core March CPI is out of control, and the Fed's "beige book" this week describes the situation: "Reports from many Districts suggested that upward price pressures have strengthened... firms were able to pass at least a portion of cost increases along to their customers."
News like this in the 70s -- or for that matter, in the '80s or '90s -- would have blown long-term rates out of sight. Incredibly, not now. This week's lousy news on inflation produced as many bond buyers as sellers. Since last summer, bond-buying in the face of a tightening Fed has been dismissed as the work of currency-manipulating foreign central banks, hedge funds, and fools. Mr. Greenspan's "conundrum" speech is still widely assumed to have been an effort to jawbone long-term rates to a higher level -- which worked explosively for a month, but no longer.
Watching day-to-day trading in bonds, news followed by price change, leads to only one equation: the bond market expects the Fed to lean hard against inflation, and succeed -- in knowledge that success will involve a "growth recession" at minimum, GDP growth under 2%, unemployment rising, and maybe a real recession.
There doesn't seem to be any thought given to how hard it may be for the Fed to succeed. The consensus has the economy already entering a slowdown, but the continuing low level of unemployment claims, the marked increase in tax revenue, and especially the way-above-trend increase in tax-withholding dollars says there is a lot more strength in the economy than we see in the low payroll numbers from big companies, and the consequences from their aggressive mismanagement.
I think this current drop in rates is a locking opportunity. We don't yet know -- can't know -- how tough the Fed will have to be to avoid its mistakes in the 1970s, and the current not-very-tough expectation is too convenient.
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