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March 10, 2006
The high for mortgage rates in ’03, ’04, and ’05 was 6.50%; we’re almost there, and likely to rise above. The word “seven” may be in vogue by summer.
February employment data confirmed a solid economic expansion underway, and a new pattern of wage growth on top of energy-price pressure is pushing the Fed from a neutral rate target toward a restrictive one. Late in all Fed tightening cycles the bond market comes to the depressing conclusion that the Fed will keep going forever. It won’t, of course, but a market convinced that the Fed would almost be done at 4.75% on March 28 now faces a sure-thing 5.00% in May, a probable 5.25% in June, and an ultimate stopping point higher than that.
Those rates are not priced into today’s mortgages.
One year ago Alan Greenspan (remember him?) gave us “conundrum” to describe the peculiar behavior of long-term rates, which for the first time remained stable during the beginning and middle phases of a cycle of Fed rate hikes.
“Conundrum” sent the financial world into a triple scramble: first to find a dictionary; second to sell a ton of bonds, figuring this was no riddle at all but a needle, the Chairman telling owners of long bonds that they were nuts to fight the Fed. The third scramble, after the selling spasm subsided and long rates re-stabilized, has continued: nuts or not, why are long rates stable?
Now they are not stable, and the speed of the rise is quickly validating or embarrassing the various “why” theories.
The old timers (including present company) thought that the narrowing spread between short and long rates was a traditional slowdown signal, confirmed by January’s “inversion” (short rates rising above long). Alternately, Perfesser Bernanke said -- before he sat down in his new chair -- that a global excess of savings was chasing bonds so hard that yields were suppressed. Others argued that exporters to us, flush with dollar winnings, had over-bought long Treasurys. Still others say that Mr. Greenspan’s habit of extinguishing financial crises by fire-hosing cash has left the world awash in liquidity that has bubbled the price of every asset on the planet.
We don’t have a sure winner, but we do have a loser: the old timers have been wrong. In January, just before the Fed went to 4.50%, the 10-year T-note departed the 4.30s and 4.40s for 4.50%. In the last six trading days, two weeks before the Fed is certain to go to 4.75%, the 10-year has gone to 4.75%, and the inversion has evaporated. One move like that was a curiosity, two is a trend: the heavily foreign buyers of Treasurys will tolerate a yield the same as the Fed’s, but not below.
By strong implication, as we approach each of the Fed’s next meetings, the 10-year T-note and mortgages are likely to ratchet upward a quarter-percent at a time. That would mean 6.75% mortgages in April, 7.00% in June, and then higher… until something breaks. During this trudge upward, soon to enter its third year, the Fed acting now in concert with central banks in Europe and Japan, what might the Fed be thinking about the odds of breaking something?
Perfesser Bernanke is tongue-tied (where are you, man?), but two regional Fed Prezes had uncomfortable things to say this week. Tim Geithner (New York), noted abnormally low and still-stimulative long-term rates, and said the Fed “would have to offset the effects” -- obviously, by being tougher. William Poole (St. Louis) said that a slowing housing market was “not a significant concern” for consumer spending [!].
The Fed’s effort to prevent energy prices from igniting core inflation is laudable. However, the Fed always has trouble with the time lag from rate-hike to economic effect; its last experience with a housing-led recession was 25 years ago; it has never before tried to offset the effects of abnormally low long term rates; and it has a rookie Chairman. That’s a setup for an accident.
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