Nobody knows how healthy housing really is

Commentary: Every modern Fed tightening cycle has ended in recession

Today’s sleepy, semiholiday dawn was interrupted by news of a surge in new jobs, up 195,000 in June plus 70,000 in upward revisions of prior months.

Every bond big shot is at the beach, heard the news through hangover fog, and then barked or texted “sell,” and went back to sleep. The 10-year T-note jumped almost a quarter-point to 2.72 percent, putting the most vulnerable mortgage borrowers close to 5 percent.

Tightrope image via Shutterstock.
Tightrope image via Shutterstock.

Gold’s in a new collapse, to $1,215, and stocks are struggling to decide whether good economic news is worth a tightening Fed.

Those of us who are little shots, working stiffs today, read on. Most of the new jobs were low-end: retail, hospitality, business services and health care. Construction added a piddling 13,000, and manufacturing shrank for a fourth month.

“Involuntary part time” rose, the 25-54 age group weakened, and the unemployment rate stayed the same at 7.6 percent, new jobs a push versus new people trying to find work.

The one legitimate bright spot: Hourly wages gained 10 cents in a single month, so strong it looks like an error.

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No other fresh data took off with jobs except car sales, which are pushed by the only easy credit in the economy other than student-sharking. The twin ISM reports for June were shaky: Manufacturing crawled back just above breakeven to 50.9, its employment component especially weak, and the service sector expected to grow in June to 54.4 from 53.7 in May instead tanked to 52.2, the poorest in three years.

Affordability is so strong that even a run above 5 percent mortgages is survivable. But credit is as scarce and tight as ever.

All economies have weevils and fleas. There is always a list of what’s wrong, if only in government policy. Groups of citizens always take turns in difficulty. The Fed’s job is the aggregate, and no central bank has the ability to micro-spray the bugs.

The Fed also has the horrifying obligation to look around invisible corners. An overriding central-banking assumption: Whatever you do — or don’t do — the consequences will not be apparent for six to 18 months. The Fed must rely on whatever forecasting tools it has.

Since the Great Bank Run began in July 2007, the Fed’s forecasting has been awful. (“Then shut them down!” cry the cavemen. Appropriate reply: “Stick to hoarding gold.”)

The forecasting errors have not been the Fed’s fault. Imagine dropping the National Weather Service and a supercomputer on a previously undiscovered planet. We have never been in this economic situation before, and we’re guessing, all of us.

No predictions, but some benchmarks:

1. The Fed sees an accelerating economy. Bill Dudley, New York Fed: “A strong case … growth will pick up notably in 2014.” OK, if you say so. However, the next sentence, “Growth prospects among our major trading partners have begun to improve,” is nuts.

2. The Fed seems to give top importance to “reduced fiscal headwinds,” lessening effects of the sequester and Fiscal Cliff tax increases, and to housing strength.

3. Our fiscal situation is extremely unstable. A new debt-limit fight lies ahead, and the health care sinkhole is widening. The New York Times reports that the average cost of childbirth in 2010 was $37,341. The White House silently deferred key provisions of Obamacare beyond next year’s election. Three years after passage, execution is in chaos. All through the Great Recession the one category of employment to add jobs every month: health care.

4. Nobody knows how healthy housing really is. We are enjoying a release of pent-up demand and an accumulated shortage of supply. Affordability is so strong that even a run above 5 percent mortgages is survivable. But credit is as scarce and tight as ever.

5. A new load of Basel III and total-leverage requirements are about to land on U.S. banks, which can’t generate credit now.

6. Every modern Fed tightening cycle has ended in recession, and long-term debt investors are on the run. The Fed paused in 1980 and 1998, and made every effort to prolong expansions, but outcomes are inevitable. The bond market is out in front of the Fed, but that’s what it’s supposed to do.

We can hope for a few or even several years of expansion, but in this time without precedent the bond market may intercept a process the Fed would like to be gradual.

No matter how artificially low the 10-year T-note was, a runup like this must have some slowing effect on the real economy.

Rates on 10-year Treasury notes, 2013.

Rates on 10-year Treasury notes, 2013.

The federal funds rate (chart below) is the overnight cost of money directly controlled by the Fed. Long-term rates often begin to rise before the Fed begins to raise the funds rate. But that event marks the beginning of tightening — even if the Fed has not formally begun.

Federal funds rate, 1968 to present.

Federal funds rate, 1968 to present.

The Fed then embarks on a middle stage, trying to extend recovery as long as possible while tamping risks of inflation. In the end stage the inflation threat has risen enough that the Fed pushes the funds rate above long-term rates (an “inversion”), and recession ensues.

We have no modern experience with a long-rate-induced recession — that is, long-term rates running away from the Fed.

A primary purpose of quantitative easing has been to push down or control long-term rates. By jawbone alone – doing nothing, insisting the funds rate will stay at zero for a long time — since May 22 the Fed has let go control of long rates.

The odds still are that a near-zero federal funds rate will tend to anchor long-term rates at a level below serious damage to the economy.

However, our cumulative fiscal excess is without precedent, and as the Fed lets go direct control, the bond market can do some extreme things to indicate displeasure with excessive borrowing.

Lou Barnes is a mortgage broker based in Boulder, Colo. He can be reached at lbarnes@pmglending.com.


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