U.S. Mortgage Rates Slip: Is the Fed's Course Affirmed?

Freddie Mac (FRE) reports that mortgage rates fell in the US in the past week. The average 30-year fixed rate mortgage fell 10 bp to 5.32%. Fed officials may find some comfort in this development, but it is unlikely to silence its critics.

In some ways the Fed is damned if they do and damned if they don't. Some pundits have been critical of the Fed for buying any long-term assets. Others believe the Fed needs to buy more.

The Fed has done two things recently that this second group of critics find particularly frustrating. They have taken steps that slow their purchases of Treasuries and did not expand its long-term asset purchases at the June FOMC meeting in response to the sharp backing up of interest rates.

It has a little more than $100 bln to go of its $300 bln commitment. At the new pace, the Fed does not have to make a decision about its future intentions at the Aug FOMC meeting. It can, at least theoretically, wait until the Sept 23 FOMC meeting.

The fact that the Fed did not respond to the backing up of interest rates demonstrates, at least in part, what they have been saying. They are not targeting a particular rate. Fed officials have recognized some role in the backing up of interest rates as a function of the large supply, but tend to emphasize the easing of the economic and financial crisis.

Some Fed officials have opined that the asset purchases have been successful insofar as it did help fuel a mini-refinancing boom that arguably helped reduce some stress. Even if the Fed is not targeting a particular interest rate, it obviously wants to avoid a situation in which the backing up of interest rates will choke off the recovery and the healing of the housing market. This poses a dilemma for the dollar.

For people trying to understand the dollar through the debt market, there is no winning for the dollar. If investors are buying bonds and driving yields lower, we are told the dollar is not attractive. If investors are selling bonds, we are told, this is obviously not good for the dollar either.

Many investment houses appear to be recommending selling of Treasuries for German bunds on ideas that the US is likely to recover before the Continent. We have argued that the relationship between the dollar and interest rates is not linear but cyclical. We too expect interest rate differentials to continue to move in the US favor and expect that this will give the dollar better traction. It will, or course, require that the current relationship by which the dollar rallies on bad news has to break down more convincingly.

Comments

[Russ Wetherill:]

The housing market, being a market, is self-correcting. What goes up must come down. The Fed interest rate strategy seems to be directed at controlling the manner in which the housing market returns to equilibrium. It has to be. Bubbles do not re inflate. They either pop or they slowly deflate, but don't soon return to prior levels. (remember NASDAQ 5000?)

Now, there are sharp, short corrections, and there are slow, drawn-out corrections. The Fed has clearly chosen the latter. By lowering interest rates to historic lows the Fed hoped to encourage refinancing activity, which it did. But the laws of unintended consequences were also in play. Low interest rates also encourages economic expansion which drives up inflation fears. Economic expansion encourages treasury bond holders to sell their treasuries to invest in better interest earning areas thus driving down the price of treasuries and driving up treasury yields. This then causes the 30yr mortgage rates to adjust upwards choking off the refinancing and home purchasing sectors.

At the same time, treasury investors are concerned about inflationary effects of the Feds purchasing of their own treasuries. (Quantitative Easing). And these treasuries investors demand lower prices and higher yields thus driving the mortgage rates up further. Now the mortgage market will react to the higher 30yr FRM rates. This lower level of home purchasing and refinancing drives down home prices increasing defaults and foreclosures. The economy now retracts instead of expands and stock prices fall. Falling stock prices drive equity investors back into safe havens of treasuries, driving down the treasury yields and lowering mortgage rates. And the cycle continues.

The wild card is the premium between the 10yr treasury yield and the 30yr FRM rate. If investors think that there is more risk of future mortgage defaults they may demand 250 to 300 basis point premiums. This will keep the mortgage rates in the 5.5 to 6.0 percent range since the 10yr treasury note will probably remain above the 3.0 level because of inflationary deficit spending.

Investors may view the risk as low since the two government GSEs are now backstopped by the federal government. The really funny, or tragic, thing is that investors are essentially buying all of this bad mortgage debt by buying dollar-denominated 10yr treasuries that only pay 3-4%. When the two GSEs have to take back a small portion of the $5.5T in mortgages and the treasury market dries up, the government will have to debase the dollar to be able to meet its debt payments. The Fed is walking a very fine line, and the two GSEs are very slow to foreclose on delinquent mortgagees.

I expect that we will see several of these bear market rallies followed by further economic retraction as the mortgage market unwinds all of its debt. The Great Depression had 6 or 7 bear market rallies, and the debt/GDP ratio dropped for 20 years before it began to increase again.

Provided the government doesn't do anything really stupid like when it raised taxes 1932, then we should be through this in maybe 10 yrs. Raising taxes includes hidden taxes like enacting a misguided anti-CO2 policy, national health care, or deficit spending which only raises future tax burdens to service a future debt. None of which are supportable with the current financial state.

Jul 02 05:51 PM