Big doings this week. The tentative signs last week of a top in long-term mortgage rates this week turned into a brass band blaring the news.
The 10-year T-note fell as low as 4.45 percent yesterday, down from the scary top just short of 4.7 percent only 10 business days ago. Yes, mortgage rates are supposed to follow the 10-year bond, but this time for technical reasons involving hedging of rate risk, fixed-rate mortgages are stuck just north of 6.25 percent.
And, don’t confuse a top with the prospects for a decline, the latter not being good.
The change at hand is the shift from fear that the Federal Reserve Board would continue to raise the cost of money from its current 4 percent up to 5 percent or more, open-ended into 2006, to the belief that the Fed is very close to being done. The bond market is telling the Fed that neutral is nigh.
The Fed meets next on Dec. 13, and all still expect 4.25 percent at that meeting, and most expect 4.5 percent at Fed nominee Ben Bernanke’s first meeting on Feb. 1. This week’s trading has removed thought of the Fed going beyond 4.5 percent, and has called into question the wisdom of going any further at all; the pattern of rates across all maturities suggests that if the Fed does go to 4.5 percent it will not be able to stay so high for long.
Pay no attention to prognosticators in this situation because few have done well. Instead, pay attention to the market, the cumulative vote by $30 trillion invested in bonds. Pay attention to two changes in the market: the drop in the 10-year bond is a big deal, but two other things are bigger. First, the crucial, Fed-predicting 2-year to 10-year spread; and second, the behavior of the 2-year T-note itself.
The 2s-to-10s spread last week broke inside .2 percent for the first time in this tightening cycle (except for that misbegotten Katrina scare), and this week inside .1 percent — at the narrowest, .07 percent. Fed Chairman Alan Greenspan obscured the importance of a narrow spread with his “conundrum” fog, but traditional analysis is winning out over the Chairman’s this-time-it’s-different: a narrow spread reflects a tough Fed and portends a slower economy. Narrow spreads have always done so, and still do.
The key data this week causing the spread to narrow was cumulative testimony that the housing market is slowing, perhaps abruptly. October housing starts and permits for new construction fell 5.6 percent and 6.7 percent respectively; a survey of home builders sank in November to levels of two years ago; surveys of real estate brokers show a sharp decline in contracts written; and several regions report deterioration in the listings-to-sales ratio. Throw in some benign inflation numbers and a visible topping in energy prices, and the-Fed-is-going-to-the-moon psychology has broken for the first time this year.
The most extraordinary market move has been the outright decline in the 2-year, down .10 percent to 4.36 percent. The 2-year T-note must pay a yield higher than the Fed funds rate because it has two years of risk; the only time the 2-year pays less than the Fed is when rates are on the way down. Specifically, when it’s clear that the Fed has overdone a tightening episode and will have to retreat. The 4.36 percent 2-year is the brass band: it says the Fed will not go to 4.5 percent, and if it does will soon wish that it had not.
So far, so good, but we’re a long way from the economic weakness that would cause a Fed reversal, or mortgages back in the fives. Industrial production, capacity utilization, and the job market are all doing fine.
There is a better than 50-50 chance that Greenspan’s final circus act will be to deliver a reasonably stable economy and rate structure to his successor, inflation risks waning, and housing cooling. He hasn’t been called Maestro for nothing.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at email@example.com.
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