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February 24, 2006
Mortgage rates are still within a closing-cost argument of 6.25%, held stationary by 10-year T-notes locked in trading between 4.50% and 4.60%.
The bond market is in a total standoff: fears of an overheating economy and energy-pushed inflation are matched by belief that a rapidly cooling housing market will slow the economy. In the slowdown equation, it doesn’t matter how high the Fed pushes short-term rates; the farther it does, the quicker and more the economy will slow, and the more money that owners of bonds will make in the slowdown.
Perfesser Bernanke says GDP growth this year and next will be in the 3.5% range. If so, with unemployment low and falling, energy price pressure still high, a 5% Fed funds rate (up from 4.50% today) would be the soul of prudence. PIMCO, the giant of bond-market mutual funds, fee-fie-foe-fums that GDP will slow to 2% before the end of 2006. If the economy is in the early stages of that slowdown, then 5% Fed funds would be an even-money recession bet.
Far as I can tell, nothing is slowing in the economy except the hot coastal housing markets, and the Arizona/Nevada overflow. The job market seems to have phase-shifted to its best level since 2000: new claims for unemployment insurance are running about 275,000 weekly, little more than half the worst of 2001-2002, and consistent with further declines in the unemployment rate.
The bond market shook off a .7% January CPI spike because the core rate (non-food, non-energy) stayed at .2%. However, inflation numbers like these since mid-2005 justify a Fed error on the tight side. The Fed sounds confident about inflation, but can’t be.
So, what’s the chance that housing will slow enough to bring true the PIMCO prediction, and knock interest rates back down?
A few early signs are right on slowdown track: new-construction condos are the traditional favorite of speculators, and it’s now every greater-fool for himself on both coasts. Inventory-to-sales ratios are deteriorating in most of the used-to-be-hot markets. Slowdown signs end there. Purchase mortgage volume is steady, and production builders focused on entry-level housing are still doing fine. It’s too soon, anyway, for the defaults and foreclosures of a self-feeding, housing-led downturn.
The Fed and many others still say that mortgage rates are too low to do damage to housing. Maybe. Today’s rates in the low sixes are low by forty-year historical standards, but are high by five-year standards. A big part of the housing heat was fed by fixed mortgages bottoming at 5.25%, and more important, by the exhilarating process of stair-step descent from 8.50% in 2000, now long-concluded.
Even more important than the fixed-rate decline was the bottom-falling-out ARM market: five-year money at 4.00% or less, and fully-indexed COFI ARMs were 3.50% all through ’02, ’03, and ‘04. The purchase utility of these loans disappeared completely by last fall, pushed up by the Fed’s hikes in the overnight cost of money.
Now the second-stage bite is setting its teeth. All existing one-year T-bill ARMs will index this month to 7.50%. If the Fed goes to 5% by May, one-year T-bill ARMs will go to 8% the next month, as will “prime.” Loans tied to the two dominant lagging indices, COFI and MTA, are this month indexing “only” to 6% or so, but even if the Fed stopped right now, these loans will all head for 8% by the end of 2006.
There is no escape hatch for these borrowers except a refinance to fixed-rates higher than their old ARM. Psychological shock is unfolding in slow motion: since the rollout of ARMs in 1980 there has never been a sustained rise in ARM rates. PIMCO’s slowdown case is built on the simultaneous impact of flattening home prices, no new equity to extract, rising house payments, and still-high energy costs.
It’s a good case.
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