The Federal Reserve is done, says the bond market, now convinced that the Fed’s next move will be to cut interest rates. Not soon — winter, maybe — but cut, and maybe a lot.

The clincher was this morning’s news that the unemployment rate rose from 4.6 percent to 4.8 percent in July, the highest since February, and a slim 113,000-job gain in July payrolls portends further increases in unemployment.

Mortgage rates are falling again this morning, 6.5 percent on the low-fee deals, taken by the straight-line decline in the 10-year T-note to 4.88 percent.

That good news said, be careful out there. Mortgage bankers: dampen ye hopes for a new refinance frenzy; Realtors: do not expect your hit-the-wall markets to re-leap; adjustable borrowers: do not expect the Fed to bail you out of your free-lunch error.

The bond market is way ahead of itself. It is supposed to be ahead: long-term investors think long term, always anticipating the next cycle. So, the ideal time to buy bonds is at the moment the economy shifts from overheating to slowing, and we are now through that moment and its buying surge.

First caution: Is the economy slowing enough to justify more bond-buying, in a bet on recession? Not hardly. The twin reports from the purchasing managers’ association showed the economy on a steady, healthy growth path. Same for industrial production, personal income and spending, and retail sales. Only housing is on a recession track.

Second caution: the object of the Fed’s exercise is inflation. The economics profession thinks it knows that inflation begins to abate about six months after the economy noses over, and the Fed tries like hell to anticipate that lag, stopping its tightening at the nose-over, and not continuing until inflation abates. That theory rests on the inflation experience in three of the last four cycles: 1973-74, 1979-82, and 1990-91, all oil-market affairs (2000-01 was stock/technology overheating). In each of those three episodes, oil prices collapsed shortly after a U.S. economic nose-over, that by itself enough to defeat inflation.

This time, I don’t have faith that even a global economic slowdown will collapse oil prices. 84-million-barrel-per-day demand has been untouched by the recent, effortless move from $65/bbl to $75/bbl. I am less worried about the oil-supply consequences of President Custer’s adventures in the Middle East (producers have to sell as badly as we have to buy) as news items like this: production in Mexico’s key field, running 2 million barrels per day, has this year faltered, in line with a forecast for 75 percent decline by 2008.

“Wolf” has been cried on the supply side so loud for so long that it will be hard to detect moments of genuine shortage. We are not going to run out of energy, it’s just going to get more expensive, and it may do so faster than the economy can adapt, resulting in a tougher inflation nut than the last three times around.

Caution number three: Let’s suppose all goes well on the inflation front. If so, the Fed is supposed to wait as long as it can before cutting its overnight cost of money from 5.25 percent — it waits to get the full benefit from two years of tightening, not wanting to repeat the process soon — but cutting before a real recession sets in. Today’s 2-year T-note at 4.89 percent indicates the Fed will cut at least 1 percent with in a year. If it does so, we may have something we haven’t had in two years: a spread between short-term rates and long ones. 

The end game in this cycle could easily be a rapid ease by the Fed, and bond yields stalling right about here. Long-term investors think long term. If the Fed starts to ease this winter, that means no recession. If no recession, why would I want to own 4.88 percent 10-year notes or 6.5 percent mortgages, both lower paying than was a good idea at any time during the oil-cost ramp-up, 1968 to 2000?

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

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