The 10-year T-note is again falling toward 5 percent, and has taken low-fee mortgage rates to 6.75 percent.

Newspapers today say that “mortgage rates rose” this week, but this factoid is based on Freddie Mac’s bone-headed method of early-week survey and delayed (Thursday) release. Rates had risen in nervous anticipation of Federal Reserve Chair Ben Bernanke’s Wednesday testimony to Congress, but fell instantly — before he began to speak — on release of his prepared remarks.  

Bernanke’s communication skills are improving: the testimony was as bland and even-handed as could be. However, the heart of his testimony, and the strong reaction in the bond and stock market, were odd. Bernanke, now repeatedly referring to a “moderating” economy, offered a forecast of GDP growth to decline from “3.5-3.25 percent in 2006 to 3.25-3 percent in 2007,” and core inflation to decline from “2.5-2.25 percent in 2006 to 2.25-2 percent in 2007.”

Oddity number one: a centerline decline in GDP growth of .25 percent from 2006 to 2007 is too small to measure, the insignificant over-the-weekend change in the waistline of a binge eater on a diet.

Number two: how would a .25 percent GDP moderation reverse the obvious inflation problem at hand? Bernanke seems supremely confident that if oil stabilizes here, inflation will gradually abate without economic sacrifice, and stock and bond markets gleefully agreed.

Number three: Bernanke indicated no particular angst that core inflation has crawled out of its 2 percent box. When one senator asked him his reaction to inflation above the 2 percent target, he snapped, “We have no target.”

I think you get a post-testimony bond-buying surge like this only if the market believes that the economy is going to moderate a hell of a lot more than Bernanke’s .25 percent, and that if the Fed goes to 5.5 percent on Aug. 8 it will result in deeper moderation — ideally, a recession.

Now, there’s nothing really odd about that line of thought. It is, after all, the standard, end-of-Fed-cycle, bond-market dream of Christmas. And, in the short run, the bond market is always more worried about the Fed than inflation. If the Fed sounds as tough is done, it’s safe to buy bonds.

The deepest peculiarity here is the absence of caution in the market, especially the bond market. The worst moment for bonds in a hundred years was the 1970s, during which the Fed tolerated the gradually rising inflation pushed by energy costs, refusing to inflict the economic pain necessary to keep inflation in the box. Inflation ultimately spun out of control altogether.

Today we pay attention to “core” rates of inflation, excluding energy and food costs, because of the presumed up- and down-side volatility of those prices. However, overall CPI rose 4.3 percent in the last year, and I don’t see any reason for optimism about offsetting, down-side volatility near ahead (or far ahead…China’s imports of oil surged 15.3 percent in the first quarter). In the last year, the average return on a 10-year T-note was about 4.8 percent; an investor’s after-inflation, real return was perhaps a half-percent.

Why would the marketplace accept such a miserable return? The classic answer is found above in the expectation that the economy is not in a moderating process, but about to hit a wall. If so, OK for the mortgage biz, and another chance approacheth for adjustable-rate borrowers to refinance their mistakes.

The answer to the trading-desk counter-question — what are you going to do if you’re wrong? — is unhappy. This market is exceedingly vulnerable to growth or inflation surprises, or an unraveling of the unnatural, foreign-based buying of long debt at non-economic yields.

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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