Housing and finance experts say lower interest rates and a healthy economy could help housing markets rebound in 2007.

But there’s no guarantee that a surge in oil prices or another unexpected jolt to the economy won’t send the country into a recession, with long-term interest rates soaring even as the Federal Reserve cuts short-term rates to encourage borrowing.

The slowdown in housing helped keep inflation in check in 2006, allowing the Fed to take a break from a string of 17 straight increases in the short-term federal funds interest rate since 2004. Many analysts now expect the Fed to cut the benchmark short-term interest rate in 2007 to avoid curtailing economic growth.

Financial analysts at UBS and Oxford Analytica are forecasting a 125-basis-point reduction in the federal funds rate by the end of 2007, to 4 percent. Although lower interest rates could serve as an incentive to potential home buyers, long-term rates don’t always follow the Fed’s lead.

Mortgage rates are tied to the yields on long-term Treasury bonds, which usually carry higher returns than short-term investments. Yield curves — the spread between short- and long-term investments — flattened in 2006 and then became inverted in August, reflecting the expectations of bond investors that the Fed’s Open Market Committee would soon begin lowering short-term rates.

The inverted yield curve helped push down mortgage rates even as the Fed was holding the line on short-term interest rates. But with the Fed continuing to express worries about inflation, there’s no guarantee that short-term rates will come down.

“Three meetings ago, bond futures traders were already pricing in a rate cut in January,” said Amy Crews Cutts, deputy chief economist for government-sponsored mortgage lender Freddie Mac. “But the Fed pretty much said, ‘Bah humbug! You’re not getting a Christmas present. We’re not going to cut rates anytime soon. If you’re lucky, we’ll leave them alone,’ ” rather than raise rates to keep inflation in check.

If the Fed does leave the federal funds rate unchanged, long-term rates could be headed back up in 2007. That’s the view of economists at the Mortgage Bankers Association, who in their Dec. 11 economic and mortgage finance forecasts predicted the federal funds rate will remain unchanged through 2008, but that Treasury yields and mortgage rates will climb.

MBA economists predict the average interest rate on a 30-year fixed mortgage will rise from 6.2 percent in the first quarter of 2007 to 6.5 percent by the third quarter, and hit 6.6 percent in early 2008 — an increase of 40 basis points in a little more than a year. That would add $23,000 in interest payments over the life of a $250,000 mortgage loan, and raise the monthly payment from $1,530 to $1,597.

The MBA expects mortgage originations to decline 11 percent from 2006 levels to $2.21 trillion this year, and fall by another 7.4 percent to $2.05 billion in 2008. The MBA also expects the unemployment rate to climb slightly, from 4.8 percent at the end of 2006 to 5 percent by the third quarter of 2007.

The worst-case scenario for the housing industry in 2007 would be a recession and layoffs, coupled with a rise in long-term interest rates. While a recession would likely prompt the Fed to jump-start the economy by cutting short-term rates, long-term interest rates might go the other way if foreign investors in U.S. debt — including China, Russia and oil-producing countries in the Middle East — decided to cut back on their purchases of Treasury bonds.

The dollar has lost much of its value because the U.S. imports far more goods than it exports. Government deficit spending, fueled in part by the war in Iraq and Afghanistan, is on the rise. China and Russia, citing weakness in the U.S. dollar, have warned they intend to shift their investments to the euro, which has gained value relative to the dollar. Democrats in Congress are making noise about the issue.

“If the United States does not begin to take steps to reduce its unsustainable dependence on foreign borrowing in an orderly way, there could be a run on the dollar and that could precipitate an international financial crisis and a sharp increase in interest rates,” Democrats warned in a report, “Relying on the Kindness of Strangers: Foreign Purchases of U.S. Treasury Debt.”

The report — released in November, on the eve of the midterm elections — warned that foreign ownership of Treasury securities has more than doubled since 2001, from $1 trillion to $2.2 trillion, with China’s holdings of U.S. debt increasing more than fivefold, from $61.5 billion to $339 billion.

According to Kenneth Rosen, of the University of California-Berkeley’s Fisher Center for Real Estate and Urban Economics, “even a hiccup” in foreign investment will mean “long rates go up.”

The trade imbalance, deficit spending and consumer borrowing during the housing boom of the last four years add up to “a debt binge unseen in modern times,” Rosen said. The current slowdown in home building will be a drag on the overall economy for at least the next nine months, Rosen said — but not enough for the Fed to justify slashing interest rates.

“Money is as loose as it’s ever been in modern American history — way too loose,” Rosen said. “I can’t imagine them cutting interest rates unless we have an actual recession.”

Rosen predicts a 35 percent to 40 percent chance of a recession in 2007, and thinks mortgage rates will go up 50 to 100 basis points.

Some economists say worries that the United States no longer controls its economic destiny — or at least long-term interest rates — are overblown. With the dollar weakening, growth in the trade imbalance may slow or reverse, as imported goods cost American consumers more and more, and U.S. exports become better bargains for overseas consumers.

The National Association of Manufacturers estimates that U.S. exports grew by 8.7 percent in 2006, while imports expanded at a more modest 5 percent rate. That trend is expected to continue into 2007 and 2008, bringing the trade deficit down from a high of 5.9 percent of gross domestic product (GDP) in 2006 to 5.4 percent by 2008, the group said.

Even if China wants to stop buying U.S. debt, that’s easier said than done, because it’s already invested so heavily in Treasuries and most of its exports are purchased with dollars.

“Maybe they do want to hold euros, but they’ve got to ditch the dollars first,” said Freddie Mac’s Crews Cutts. “There really aren’t any good options for ditching the dollars, so they are buying U.S. debt. The interest rates worldwide are such that ours are still attractive.”

If Chinese officials were serious about cutting back on investments in U.S. Treasuries, she says, “They would have done it already. If they don’t like U.S. policy in Iraq, that’s not new. We’ve given them plenty of reasons to dislike our budget deficits, our war policy — there is nothing new about today that would imply they should do it now.”

Crews Cutts and her fellow Freddie Mac economists expect housing markets to stabilize during the first half of 2007. With the current glut of global investment capital, “If I’m looking at a place to invest, U.S. mortgage-backed securities and Treasury debt … all look good compared to what else I can get in world market,” she said.

U.C. Berkeley’s Rosen is more pessimistic, believing that foreign investors can’t keep financing U.S. debt forever. “We do have a surplus of capital globally,” he said. “But China and Japan are just shoveling money into the system to keep having growth and to create jobs … in the end it will lead to a worldwide correction.”

Rosen says a “Goldilocks” economic equilibrium is still possible for 2007, but that a global correction is inevitable.

“We can’t keep on growing like this — we all know this,” Rosen warns. It won’t be a decision by China to stop buying U.S. debt, but an unexpected “external shock,” such as a sudden rise in oil prices or a terrorist attack, that sets the correction in motion, he said.

But David Heuther, chief economist for the National Association of Manufacturers, predicts the U.S. economy will grow at a rate of 2.9 percent in 2007 and 2.8 percent in 2008, up from 2.1 percent in 2006.

That’s a rate of growth many economists can live with — not fast enough to fuel worries of runaway inflation, but healthy considering the downturn in housing. With inflation contained, Heuther predicts the Federal Reserve can comfortably trim 50 basis points from the federal funds rate by mid-year, lowering it to 4.75 percent.

The California Association of Mortgage Brokers, which polled 400 of its members in October and November, found 65 percent believe interest rates will stay the same or rise less than 1 percent in 2007.

CAMB president Jack Williams also predicts that interest rates will be “extremely favorable to borrowers” in 2007. Fixed-rate loans are already making a comeback, but many of the state’s home buyers will be forced into alternative loan products because of high housing costs, he predicts.

Interest rates aren’t the only factor affecting consumer’s decisions to buy homes. Prices — and concerns about where they are headed — could keep some potential home buyers on the sidelines in 2007.

The University of Michigan’s Index of Consumer Sentiment stood at 92.1 in November, up sharply from the 81.6 score recorded at the same time last year. But concerns about falling home prices were the biggest factor in consumers’ evaluations of home-buying conditions.

“Consumers are uncertain about how much further home prices will fall and therefore their reluctance to purchase a home has remained high,” said Richard Curtin, director of the University of Michigan’s Survey of Consumers, in releasing the survey’s results. “Consumers wanted to avoid buying a home and then realized that the price continued to fall after their purchase. Avoiding buyer’s remorse is second only to the sense of loss incurred from selling a home for less than you had anticipated just a few months ago.”

Curtin said consumers will continue to be the engine of economic growth, with spending on personal consumption expected to grow at an inflation-adjusted rate of 3 percent in 2007 despite declines in residential investment. That will help the economy post a 2.5 percent growth rate in GDP next year, Curtin predicts, “a slower but still positive pace of growth.”

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Send tips or a Letter to the Editor to matt@inman.com or call (510) 658-9252, ext. 150.

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