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July 8, 2005
Mortgage rates rose again this week, approaching 5.75% and vulnerable on the up-side as economic data are improving across the board.
Today’s payroll report for June was solid: a 140,000-job net gain in June, a positive revision for May, and no inflation pressure from wages. The purchasing managers’ service-sector index surprised in June, above expectations and reversing a slide; and June retail results were also a happy surprise.
National measures of office space have posted a two-quarter improvement, the first sustained decline in vacancy and rise in rents in four years. A big deal: the best jobs are in offices, and new leasing reflects confidence among businesses.
The next big moment for bonds and mortgages is July 20, when Mr. Greenspan speaks to Congress. I think a majority in the bond market still expects the Fed to stop raising its rate short of 4.00%, perhaps after going to 3.50% on August 9.
Stopping short is a nice thing to hope for, but as intelligent design goes, it is short of evidence. One can argue that a Fed funds rate 2.00% or more above inflation tends to strangle the economy; measured by the PCE deflator at roughly 1.60%, a Fed funds rate north of 3.50% would do just that. However, Mr. Greenspan has for eighteen years dismissed rules of that kind.
I suspect that on the 20th he will engrave his belief that there are still “imbalances” in the markets and economy, and that low long-term yields (the “conundrum”) are stimulating the economy in an unusual way, especially housing. No one, not even the Chairman, has a good explanation for this phenomenon: an investment in a 2-year T-note today pays 3.58%, a 3-year pays an additional .04%, and a 5-year an additional .09%. From the 2-year all the way to today’s 4.08% 10-year, the reward for eight years’ additional risk is only a half-percent.
Sixty years of financial history says that a yield curve so tight is a forecast of economic slowdown ahead. Soon. The Chairman says not.
Okay, if the Fed is going to push the return from an overnight investment above the return on a 10-year investment, why would anyone buy the 10-year? In the classical market response, you buy the 10-year to lock in its yield because cash can’t pay so much for long. The conundrum thus eats its tail: cash can’t pay so much for long because the economy will fold under pressure; but the Chairman says the economy is not folding.
The Chairman is behaving as though indifferent to the answer to the riddle. If the yield curve is flat, or inverts, so be it: he must push up on short rates to make certain that inflation and speculation stay under control. If the economy subsequently faints, or if long-term yields explode upward, then his successor will deal with those conditions then. The best way for Mr. Greenspan to plump the cushion for that successor: be tough now.
I used to think the stock market would break first under this pressure, but now it looks as though housing will win the prize. Existing adjustable-rate mortgages are entering the pain zone right now: a trillion dollars’ worth of home equity lines of credit are this month adjusting into the 6.0%-7.5% range, nearly doubled from last year, and another trillion dollars’ worth of existing adjustables by next month will begin to go to 6%-6.5%, headed higher. Then there’s another trillion-worth of older hybrid adjustables... some of those borrowers know (only some...) that within a year or two or three their rates will jump two or more percent in a single stroke.
Current buyers are discovering that there is no particular advantage to buying with an ARM. Those silly damn “option ARMs” with the 1.99% first month now go to 5.70% in the second month, and three- and five-year hybrids start above 5.00%. Only the long interest-onlies, sevens and tens, still expand buyer purchasing power.
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