A Warning in the Bond Market

The rise in the stock indices on Wednesday may signal it's time for relief to some investors, but there is a serious warning being sounded in the bond market.

Late last year, I published a couple of posts (here and here) noting that some pundits were calling for the 10-year Treasury note to come down to 2.5% or below in order to revive the housing market and stave off a deflationary spiral. While I agree that interest rates that low would help staunch the bleeding in the housing market (and by extension, the credit markets), I expressed my skepticism at the possibility of this event — after all, who would buy 10 year notes at 2.5% with (imaginary) headline inflation over 4%?

Since Friday, the 10 year yield has risen from 3.47% to 3.7%, which is a huge move. Long-term mortgages closely track this rate, so expect mortgage rates to head back up.

This complicates the Fed’s ability to create a floor in housing, which it desperately needs to do. Consumers buy housing based on how much they can afford on a monthly payment — little distinction is made between which portion goes to equity vs. financing, i.e. the mortgage rate. If the Joneses can afford a $1500/month mortgage payment, that’s what they will spend regardless of house prices or mortgage rates. The Fed has 3 basic options:

1. Lower the mortgage rates so less of that $1500 is sucked up by interest, allowing the Joneses to buy “more house.” Theoretically, this would help put a floor under house prices.
2. Allow house prices to come down. Rising mortgage rates are a double-whammy where buyers are hit since the lower house price that is partially offset by more of that $1500 is eaten up by interest and sellers are hit with lower home equity. The current situation most fits this case and the Fed (and everyone else) is desperately trying to mitigate this scenario with its knock-on effects on wealth consumption effect, housing-based derivatives, related industries, etc.
3. Give the Joneses more money so they can afford a bigger monthly payment and pay more for houses, which should stabilize housing. As far as I can see, this can happen only through wage inflation. The Fed is actively working against this option as it believes this would spark an inflationary spiral (yes, I know inflation is already spiraling but let’s just play the Fed’s shell game for the purposes of this post). Despite the official mucking of inflation numbers, this scenario is bad news for everyone.

A fourth scenario — raising productivity and generating more wealth which percolates through the whole economy (as opposed to nominal inflation), including the housing market — is discarded here since I believe such a scenario requires a recalibrating of the American economy, which should eventually happen as the current crisis plays out.

Can the Fed engineer an environment with dropping interest rates and rising equity prices? To a degree, it already has, but whether it will be enough remains to be seen. But I have serious doubts we will see 2.5% 10 year Treasurys without government intervention.

Many commentators have asked how much of the pain from Wall Street will hit Main Street, but I think they have it backwards. The current mess happened because many Americans couldn’t afford to pay their mortgages. The pain started on Main Street, introduced itself to Wall Street in February of last year and entrenched itself last August. As such, rising yields in Treasurys is worrisome sign.

Disclosure: None.

Comments

[silverspring:]

Yes, it is a worrisome sign, however this could be natually solved after you see many bad earnings report in near future, commodity negative effect... All these forces will bring equity market down, volatility up which will bring the yield down. Any comments?

2008 Apr 17 12:18 PM

[karchad:]

Treasury rates under 4% are hardly troubling! So, there's been a sharp increase for the last week or two. That hardly constititues a trend, except for the most short-sighted of investors. Only when the rate gets to 6% would I get worried.

2008 Apr 17 02:03 PM

[Jason Rines...:]

The writers point number three is right, give the Joneses more money and his following paragraph is wrong in thinking we can't create wealth. The Fed cannot fix this alone nor Wall St. This all of us know. How about Treasury subsidizing wealth creation and jobs in alternative energy? This will happen when Main St. is demanding heads on pikes and then you will see Washington politicians either moving or being replaced. What has prevented the U.S. from being energy independent and a major exporter to boot? Greed. When Washington politicians (on both sides of the aisle) get phenominal inside information on oil, they invest in oil. Perhaps pass laws that forbid energy investment for politicians/family & friends during there tenure in office?

2008 Apr 17 03:15 PM

[Chorniki:]

Laughable how all commentators give the banking industry and the real estate industry a pass on the present mess. Realtors had lists of "buyers" who would sign the docs for purchase cooked up by the banks
as AAA. Purchase completed, the realtor would share his profit with the buyer. The house would then be rented for a few months and a new "buyer" would then purchase the flipper, at a higher price, of course. Some properties were "flipped" three and four times in a span of less than two years. Illegal immigrants owned two and three houses bought in this fashion with the connivance of the usual suspects. Today they continue to collect the rents on these houses
even though they have stopped making the mortgage payments for some months now. Dilatory mortgage foreclosure procedures at the banks(the "AAA" paper was passed on to WS investment banking firms to slice and dice to their heart's content) is aiding and abetting these scams. The next shoe to fall will be when all these properties are thrown on the market for the value investors to place in their portfolios. We are not even half way there yet in my opinion, witness
MER's most recent write down.

2008 Apr 17 06:02 PM

[Fred W:]

Chorniki,
You seem to be one of only a few people who really understands the scams that drove home prices up so rapidly. Brokers/lenders, appraisers, and realtors were in cahoots to "make the deal happen". Any "bailout" for homeowners should be extracted from these perpetrators...however... how to do so is not an easy matter.

2008 Apr 18 10:29 AM

[User 28329:]

I think people are completely unrealistic about interest rates. They are going to have to move them up to fight inflation as there are more food riots and in todays world where the FED is actually effected by political pressures more than they ever had. The FEDS job is more about inflation than it is about economic growth.

2008 Apr 18 11:34 AM

[Robert Trudeau:]

I respectfully disagree with nearly everything you have stated. Investors WILL accept 2.5% on a 10 year if they believe that there will be no inflation, or possibly deflation, over that time frame. A real return of 2.5% on bonds is attractive, and about in-line with histroical returns. The Fed does not control interest rates, the global market does, that is why their are treasury auctions. If the Fed had its way, long-term rates ie. mortgage rates would be much lower than they are today. The Fed doesn't fund mortgages, investors do. What the Fed can do is dump money into the economy at low interest rates and it has done so, with M3 growing by about 18%. The temporary spike in interest rates on the 10 yr is due to the fact that the market now believes the worst is behind us and that the economy will continue growing. Don't believe in efficient markets.

2008 Apr 19 03:55 PM

[Robert Trudeau:]

The problem was created when Wall Street created mortgage products that allowed Main Street to by houses at absurdly high prices. I don't know of anyone on Main Street who went to Wall Street and asked them to pool negative amortization mortgages into CDO's. Moving forward, most folks will not buy houses based solely on the monthly payment, they'll buy based on what they think the value of the house will be 5-10 years down the road when they want to sell. People aren't dumb, they just hadn't seen falling real estate prices like we have today, and most weren't around during the Great Depression. They have been educated.

2008 Apr 19 04:06 PM

[Cutter:]

Some of us were around during the great depression. Believe me, you don't want to experience anything close. As a new reader to these financial commentaries (blogs) makes me wonder where we might find the records of the commentators success in the markets. I would pay some good money to get guaranteed advice. The best I can do is about ten per cent return.

Jul 06 01:38 PM