A Busy Week Ahead - 30 November to 4 December

Mortgage Bonds are currently testing tough resistance levels. With only $211 billion left to purchase in the Mortgage Backed Security purchase program, it could be a hard to close and trade above those levels. If this week’s economic data is weak, MBS may be able to close above those levels. The Employment Report on Friday will be key as to which way Bonds will trade. A lower number could push Mortgage Bond prices lower thus increasing home loan rates

Short But Jam-Packed Week

Stocks got a boost on a survey released this morning from the National Association for Business Economists (NABE), which lifted its forecast for economic growth over the next year. While it seems they are being overly optimistic in the face of rising unemployment, Stocks continue to seek out reasons to ride higher. Overall, the recent rise in Stocks is easily attributed to the low interest rate environment and constant hints from the Fed that rates will remain low for a long time. Investors are searching for higher returns, and apparently have radically changed their thought process from just a year ago, when it was all about safety, and preservation of capital. But the allure of high returns has investors leveraging with cheap money to push up Stock prices. We’ve all seen this before – markets making large gains on momentum rather than fundamentals – and it usually does not end well.

Our new Fed Friend, St. Louis Federal Reserve Bank President James Bullard said over the weekend that the Fed should keep its Mortgage Backed Security purchase plan active beyond the current end date of March 31, 2010. He stated that keeping the program alive would enable the Fed to do something to react, should the economy take another turn for the worse. With unemployment remaining stubbornly high, and likely to remain so beyond the present end of the MBS purchase program in March 2010 and the Homebuyer Tax Credit in June 2010 – doing something to keep home loan rates from rising sharply would be beneficial to the housing market, and the economy overall. However, there is a long term cost for this, and the effects as well as unintended consequences may be quite significant. It’s getting harder to see what a “real market” looks like, and eventually, we’re going to find out.

Today the market will digest the results of an enormous record $44B 2-year Note auction. This could impact the Bond market, and the record levels of supply keep coming this week, with a huge $42B being auctioned in 5-year Notes tomorrow, followed by $32B in 7-year Notes on Wednesday. So who is buying all this paper…and why? For example, with the yield on the 2-year Note around .75%, where is the attraction? The answer is that “leverage” can make the trade very lucrative. If you can borrow at the Fed Funds Rate like banks can – say at .25% - and invest in 2-year Notes at .75%, there appears to be a .50% arbitrage of “free money”. But Treasuries can be leveraged 10 to 1, or in other words, you need only to put 10% down to buy them. The .50% gain becomes 5% of “free money”. That’s a huge spread in the banking world. But when the Fed Funds Rate starts to move up, it usually does so at a faster rate than the Treasury yields do, making this play less attractive. That would make it both more difficult and more expensive to sell Treasuries, which points to higher rates down the road.

A story to watch very carefully – the Fed’s independence as a Central Bank is under fire. Last Thursday, the House Financial Services Committee voted to undo a 31-year old law that shields Fed interest rate decisions from Congressional auditors. It is yet to be determined how much control or influence Congress will have on the Fed, but if they somehow start to weigh in on monetary decisions...beware. One of the main reasons why the US has never seen runaway inflation is the Fed's ability to act quickly and respond to inflationary threats without political interference. Politicians by nature have a very short term view, and care about polls and immediate public opinion – much like a child who cries for a quick fix of candy, instead of eating vegetables and balanced meals. The candy sure tastes good and quiets the child, but a prolonged diet of candy would have terrible long term impact on the child’s health. Can you imagine what might have happened to inflation if then Fed Chairman Paul Volker had to get Congressional approval to raise the Fed Funds Rate to 20% in the summer of 1981? While the move didn’t taste good temporarily, inflation may not have been choked off as successfully as the Fed was able to do back then – which led to the greatest and longest period of economic prosperity the US has ever had. If decisions had been left up to political influence, the results may have been sweeter in the very short term, but the US would have been far worse off in the long run. There is historical evidence that the loss of independence for a Central Bank leads to rampant and devastating inflation. The great economist Milton Friedman stated, “Inflation is a monetary phenomenon, but hyper-inflation is always and everywhere a political phenomenon.”

And looking forward, there is a real threat of inflation. It may be dormant now and not evident to the masses – but it’s there. And how the Fed responds to this threat will be crucial to the economic health of our country. The thought of politicians with reelection concerns, playing in the midst of monetary policy decisions when inflation comes knocking…it’s enough to keep us up at night.

Some good news on housing...Existing Home Sales were reported at 6.10M, far higher than expectations of 5.70M. The inventory of unsold homes dropped to a 7-month supply, the lowest in 2 1/2 years. Yes, the possible expiration of the Homebuyer Tax Credit certainly influenced the amount of buying in October, but it’s still encouraging to see these improved readings, especially the reduction in inventory levels.

Mortgage Bonds Running Out Of Gas

After hitting resistance at price peaks on Monday, Mortgage Bonds are drifting lower.  A look at the chart now shows a Negative Stochastic Crossover as well as lower highs each of the last two days.  This tells us the recent trend higher is running out of gas…and with a lot more room for Bond prices to fall before hitting support, it's time to lock your rate.

  

The Core CPI reading jumped to 1.7%, up sharply from the 1.4% reading just two months ago.  However, this jump must be taken with a grain of salt, as prior month readings of CPI were skewed lower through the creative accounting used during the now-expired Cash for Clunkers program.  The Cash for Clunkers rebate was considered as a reduction in purchase price, which artificially reduced the actual level of CPI.  Today's CPI number is a little hotter and the trend looks higher.

This morning's CPI report has already outraged a few Fed members.  St. Louis Fed President James Bullard pounded the table this morning about his concerns on inflation and loose monetary policy.  He bellowed that an inflation risk has been created due to the expansion of the Fed’s balance sheet – the virtual “printing of money” by the increased debt.

You may be wondering why mortgage rates and Bond prices have remained quite favorable in the face of dwindling Fed purchases of Mortgage Bonds.  This is mostly due to supply and demand.  The Fed is presently purchasing closed and securitized Mortgage Bonds on loans which were originated back in July and August.  A look at past rate sheets shows that rates were significantly higher then.  Thus, origination volume level in those months were lower.  So the Fed’s reduced levels of purchases are meeting the reduced supply coming to market pretty well.  But because pricing and origination volume levels have improved during September and October, more supply will hit the market over the next couple of months.  This will arrive at a time when the Fed purchases will be even lower.  The result should be worse pricing and higher rates. 

Housing Starts during October were 529,000, sharply below the 600,000 expected.  While it’s certainly clear that the new construction market has slowed down significantly – it’s only about 25% of where it was a few years ago – is this all bad?  Maybe not.  Perhaps we need to slow down new supply, so the current housing excess can be sopped up.  There may be some longer term benefits to the housing market with a slowdown in new construction. 

Mortgage Bonds Hitting Firm Resistance

Mortgage Bonds are trading near unchanged levels this morning as they hover near a firm resistance level. Bonds have not been able to move above this level since early October, when Bonds traded above this ceiling for only a few short days. Prior to that, it was May of this year when Bonds rose above this ceiling.

Consumer Sentiment came in lower than expected but this is not much of a surprise. The media has been beating the drum in seeming attempts to rouse some euphoria…and while Wall Street might be buying it temporarily, Main Street isn’t.

The Fed bought more Mortgage Backed Securities yesterday, helping Bond prices recover from news of a weak Treasury Auction. Overall, Fed purchases will continue to decline as the program winds up. Remember, as the Fed winds down their buying support, this will be a contributing factor in Bond prices moving lower and home loan rates rising over the coming months.

Next week will be loaded up with high impact economic reports, including Retail Sales numbers and a look at inflation with the Producer Price Index and Consumer Price Index. Check back to stay in touch with these releases and learn how they affect mortgage rates.

Mortgage Bonds Holding Steady

Mortgage Bonds are starting the day near unchanged levels after Initial Jobless Claims came in slightly better than expected. Continuing Claims also fell--but, as I've said before, that's likely due to benefits expiring rather than people finding jobs.
In other news, foreclosure filings slowed for a third straight month, signaling that a recovery could be in the making.
Through all the economic news of late, rates still represent an amazing near all-time low opportunity. I recommend floating for now. But be prepared to lock, if today's Treasury auction shakes things up later this afternoon