“Inversion” is the word blaring from all financial outlets in these holiday weeks. Ignore this word!

“Inversion” is the word blaring from all financial outlets in these holiday weeks. Ignore this word! It may matter later, or not at all, but at the moment it is a numerical curiosity.

What does matter: an overlarge two-part bond-market bet. Part One: that the Fed’s concluding rate hike will be one last .25 percent on Feb. 1, to 4.5 percent. Part Two: before the end of 2006, a slowing economy will force the Fed to cut its rate.

The accumulating weight of chips has pushed the 10-year T-note yield down from its 4.65 percent high in November to 4.36 percent last week, in turn pulling 30-year fixed-rate mortgages down close to 6 percent for the first time since September.

This “inversion” business refers to shorter-term bonds paying a higher yield than longer-term ones, which was true from time to time last week, but in miniscule negative spreads: .02 percent and such. Inversions are predictive of recessions, but the predictive probability rises as the negative spread deepens; insignificant negative spread, as now, means insignificant recession risk.

Deep inversions prior to recessions are usually the mark of a Fed forced by inflation risk into overdoing its rate hikes. This Fed has merely removed excessive ease; if it has overdone its tightening, it’s not by much.

The Part Two bet on an economic slowdown reflects the overwhelming conviction that a slowing housing market will slow the economy, and that a bubble-burst would be a special bonus to owners of bonds. A slowdown in housing is inevitable because of rate hikes, the sudden disutility of ARMs, and the compounding of prices beyond purchasing power. However, it’s way too early to guess at the damage that will be done at the housing/economy border, and the housing bubble thus far exists only in the minds of envious stockbrokers.

The rising prices of homes has been a cause of economic growth, but also an effect of a healthy economy and the immense increase in household financial wealth since 1990. I suspect more effect than cause, and a more resilient economy than bond-market bettors currently think. The house-as-ATM argument is overdone.

For the moment, the advice here is to avoid the housing/inversion jabber, and watch real stuff like the job market. Fixed mortgages near 6 percent should be snapped up; most of a 2006 slowdown is already built into long-term rates.

At each New Year I recite Peter Drucker’s warning: “Nobody can predict the future; the idea is to have a firm grasp of the present.”

Last year I broke discipline on three items. Got lucky and won the trifecta: there was no need to worry about the dollar (not when the Fed is on the warpath); we have learned the level of a neutral Fed Funds rate (though I thought sooner, and lower); and 2005 was the last year the United States could sustain a big ground force in Iraq.

A sensible man would retire the trophy and shut up. But, no guts, no air medals.

In ’06 the dollar will be under pressure, especially if a Fed retreat develops, but the trade deficit woe-is-us is way over-woed.

Interest rates will be more volatile in 2006. The Fed has been on autopilot for 18 months, and now a rookie pilot has to land the damned airplane.

Iraq has been a quiet corrosive for three years, and had negligible impact on markets. We might make it through one more year that way, but I suspect that by the end of ’06 failure will be evident (neither a functional Iraqi state nor army), and markets will get skittish at the prospect of regional instability.

Two other Druckerisms: decisions should be made at the lowest level, and on the scene; and those expected to be responsible must have adequate authority. Nobody but the Iraqis was ever going to sort this out, and in the contrarian thought for 2006, they may — messy, bloody, partition, or whatever — do just fine on their own.

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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