Last week Currensee Chief Market Analyst Shaun Downey wrote a blog post titled A Maze of Counterintuitive Forces: Volatile Sideways Ahead? There were a couple of things in there that I disagreed with, so I decided to take the opportunity to present my own view point. You can decide which one you prefer, or if you think both of us have no idea what we're talking about. J
Mortgage Rates to High
Shaun made the comment that mortgage rates remain stubbornly high and that even though they have fallen, it apparently isn't enough to induce an increase in mortgage applications. Seeing as the rates have recently been making all-time lows, I have a hard time agreeing that they are stubbornly high.
Speaking to the mortgage applications, consider two things. First, the tax credits pulled forward a lot of home buying activity, and the numbers have been reflecting a drop off since the credit expired. That was something inevitable and very little related to mortgage rates. Second, the potential home buying public is experiencing a quartet of symptoms helping to keep their activity down. They are:
- Fear prices may yet go lower again (or at least not rise for a while),
- Impaired personal/family balances sheets and credit ratings,
- Being gun shy about borrowing for anything at this point, and
- The belief that banks just aren't lending. Again, none of this has anything to do with mortgage rates.
Fed Capping Long Rates
Assuming you agree that rates are too high, Shaun's solution to the problem he sees is having the Fed cap long term rates, maybe at something like 1.5% for 30-year money. If, as Shaun has suggested, mortgage rates are too high then lowering long rates would help. Standard fixed rate mortgages are closely linked to the rate on the 10-year Treasury Note. If that can be pushed down, then mortgage rates would likely follow (falling 10yr rates is exactly how mortgages have been making record lows of late). There are several problems with this plan, though.
At the top of the list is the fact that the Fed cannot simply cap long rates. There is no long-term equivalent to the discount rate they can just set at 1.5%. Long rates are determined by the market.
If the Fed really wanted to drive 30-year rates down to 1.5% it would have to embark on a massive quantitative easing (QE) program of buying Treasuries. Keep in mind the $1.2 trillion the Fed spent buying mortgage securities, plus the hundreds of billions it put in to Treasuries last year. You could maybe say that knocked 80bps off 10yr rates at the most positive. After the Fed stopped buying, the 10yr rate went right back up and eventually made a new high before it rolled over into the current downtrend, which has nothing to do with the Fed buying.
If the Fed were to go back into the market to buy Treasuries and drive long rates down to 1.5% it would send alarm bells ringing across the financial universe. The dollar would get hammered (currency traders hate QE), which wouldn't help any other global economy, perhaps aside from China (because of the close dollar peg for the yuan). That, in turn, would likely drag on global stock markets, especially for exporters to the US.
A sharp move lower in the long end of the yield curve will also flatten it. A strongly up-sloped yield curve tends to be an economic positive. A flat, or negatively sloped curve is generally the opposite.
And then there are the bond vigilantes. These are the folks who sound the alarms and sell fixed income securities when they perceive a risk of inflation. If the Fed starts a major new QE effort you know the vigilantes will be screaming and yelling about the inflationary implications of monetizing the debt. In order to neutralize the QE the Fed would have to perform massive short-term draining similar to what the ECB has been doing to sterilize its bond purchases. That would tend to put upward pressure on short rates, getting us back to the flattening yield curve.
If the Fed didn't do that then you get a big spike in the monetary base, which will worry the inflation hawks. The money multiplier isn't working real well right now, but the fear will be that eventually there will be a massive explosion in M2/M3 type of aggregates as the borrowing/lending contraction loosens up, which would lead to a spike in inflation (already the fear, actually). That could end up leading to big players shorting T-Bonds and T-Notes, which would make it harder for the Fed to drive rates down – kind of like how some big players in the forex market play against central bank intervention.
And to top all of this off, anything the Fed does will tend to create market distortions. It's happened in the mortgage market now, to the extent that the Fed has had to rearrange its holdings to allow for more supply of certain securities in the market so they can trade and be held in portfolios. If the Fed holds most of the T-Bonds and T-Notes in existence, as it would likely have to do, it will put a squeeze on those who need to hold them in their portfolios (bond funds) and others who need them for other purposes.
This is just my view on things. Feel free to tell me I'm crazy. Differences in opinion are what make the markets so interesting.
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