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There’s been a slew of good news lately, including improved consumer sentiment, lower than expected job losses, increasing wages, and a contracting TED spread. The stock market has been up for 12 of the past 14 weeks, and the Dow recently broke even for 2009. Public officials including President Obama and Fed Chairman Bernanke have declared the worst to be over.

Unfortunately we are not yet in the clear. The yield on the 10-Year Treasury Note increased 60 basis points during the one-month period from May 12 to June 12. Oil prices rose 23% over the same period. Keynesian economists argue that interest rates and oil prices are higher due to the expectations of economic recovery. While the recovery may partially explain the increase in these prices, it doesn’t explain all of it. The Treasury continues to auction billions of dollars, and auction demand has been less than great. The rate on the 10-year recently skyrocketed to 4.00%.

Many economists are also predicting significant long-term inflation. They point to the Federal Reserve’s policy of buying over $1.5 trillion of mortgage backed securities and US Treasuries, thus increasing the money supply. They also fear monetization of the ever increasing national debt due to the exploding federal budget and the $787 billion stimulus package.

These fears are causing significant problems, especially in the housing market. Without a recovery in the housing market, things aren’t likely to improve anytime soon. Housing prices are the key to economic recovery. Higher home prices will relieve the number of homeowners currently underwater on their mortgages, thus reducing the risk of them simply walking away. Higher home prices also improve consumer sentiment, since more equity in their homes provides consumers with a sense of security. This would result in both an increase in home equity loans and in personal spending.

But since mortgage rates are closely correlated with the 10-Year T-Note, the sudden jump in rates is threatening the economic recovery. The 30-year fixed-rate mortgage rate increased 81 bps from 4.78% on April 30 to 5.59% on June 12. Mortgage applications have been falling significantly, and it isn’t difficult to see why. 81bps adds $100 a month to a $200,000 mortgage. $100 per month could be the difference between keeping your home and losing it to foreclosure. If rates continue to climb, foreclosure activity will only get worse.

Higher rates will also force out first time homebuyers, causing downward pressure on home prices. Though enticed with an $8,000 tax credit, higher monthly payments may cause them to rethink their decisions, and higher debt-to-income ratios may make it harder for them to get financing. Combine this with continued housing starts, and you have a housing glut, thus driving down home prices further.

At this point, the Federal Reserve and federal government can’t do much to lower mortgage rates. If the Fed purchases more securities, the inflation screams will only get louder. If the Federal government spends more money, more investors will fear the government’s ability to repay its debt. The President talks about the importance of balancing the budget, so let’s see him put his money where his mouth is.

- Nick Klein

Disclosure: None.

Source: Housing Market Recovery Is the Key to Real Stimulus