Rates fell this week, not a lot, but back to the post-spring lows: low-fee mortgages shading under 5.75 percent, taken there by the 10-year T-note trading persistently in the 4-teens.

Last week’s news of modest job creation in August has been overtaken by the reality of negligible inflation (wholesale “producer” prices fell .1 percent last month), and Federal Reserve Chairman Alan Greenspan’s formal acknowledgement of that fact in testimony to Congress on Wednesday: “…Inflation and inflation expectations have eased in recent months.”

However, Greenspan also said, “The most recent data suggest that, on the whole, the expansion has regained some traction.” Traders gave that comment a collective “Huh?” along with sideways glances and “What data? Our expansion, or one in some other country?” The Fed’s own “beige book” was thin reading. The chairman’s optimism looks more like cover for continuing hikes in the Fed funds rate toward neutral than any prospect of economic growth on the order of last spring’s.

Janet Yellen, president of the San Francisco Fed, on Thursday described the 1.5 percent Fed funds rate as an “emergency level” that the Fed would raise unless very weak economic data appeared; further, that expectations for a 2 percent rate by year-end were “not off the mark.” Plain speaking by lower-ranking Fed types should be taken seriously – they do so only if certain. Greenspan is determined to raise the overnight cost of money for three reasons: too-cheap money encourages leverage shenanigans in the markets; second, if the Fed does develop an inflation problem, better to begin to lean into the economy from a 3 percent base than to lurch from a too-low one; and third, to get its rate high enough that it could ease if it had to.

OK, so the Fed goes to 1.75 percent at its meeting in 11 days, and then again at either or both its November and December meetings. A 2 percent-2.25 percent Fed funds rate won’t do any great harm to mortgage rates, but there is a threshold right there in the low twos. Five-year T-notes have been trading below 3.5 percent, and could not stay there with a 2.25 percent funds rate; nor could the mortgage-driving 10-year stay far below 4.5 percent. Once the Fed reaches 2.25 percent, markets for long-term rates will have to hedge the risk of 3 percent, and the last time the Fed was at 3 percent for a sustained period (1993), mortgages were 7 percent.

[Footnote: The bond market has been staring at the probability of a higher funds rate for two years, and all players know they will get killed if they don’t unload bonds in advance of the Fed going north of 2 percent-2.25 percent. Ten-year T-notes at today’s 4.18 percent is a huge bet on an economic stall at any higher funds rate, and a thunderous warning to the Fed that they are playing with fire.]

One of the few predictable consequences of the Fed’s measured march to neutral is the conclusion of the adjustable-rate-mortgage fairy tale. The first ARMs were introduced in 1980, and since then the indices to which they are tied have risen significantly in only four years, none back-to-back. ARMs are very useful tools, properly deployed, but consumers have been misled by a painless quarter-century, and deeply misled by the last three years of rates in an emergency trench.

If the Fed goes only to 2.25 percent, one-year T-bill ARMs will adjust from low-fours to mid-fives. COFI- and MTA-indexed loans will take a while because of their lagging nature, but they are headed for mid-fives by the end of next year, and higher the next. If the Fed’s neutral lies at 3 percent, all ARMs adjusting each year or more often will rise to the mid-sixes within 18 months.

That’s if the Fed is going only to neutral. All free-lunch sales propaganda aside, never ever forget that all ARMs are chained to the Fed, and were invented to protect financial investors against an aggressive Fed.

Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at lbarnes@boulderwest.com.


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