Long-term rates are clinging to their highs (6.25 percent for mortgages, 4.77 percent for the 10-year T-note), but the bond market looks lousy, poised for another rise.

The straight-line, quarter-percent rise in rates began in the second week of December, as data began to arrive too strong to support sweet dreams of a Fed rate cut, especially strength in the job market. Unemployment is a dead-low 4.5 percent, and a sustained decline in new claims for unemployment insurance says that conditions are, if anything, improving.

The Fed’s January “beige book” describes the labor market as “tight,” competition developing for scarce types of training and talent, and in the stage historically leading to wage pressure in excess of productivity. Wage-induced inflation is the worst form, quenchable only by racking up the unemployment rate — which is not difficult to do, except that politicians will then filet and fricassee the perpetrator at the Fed.

So far, the tight labor market is just a threat, but there is no way that the Fed will ease in its presence. Year-over-year core inflation has drifted down from 2.9 percent to 2.6 percent, but that’s a long way from the 2 percent top of the Fed’s target zone. Yes, oil falling to fifty bucks is good news for inflation, but it’s nothing more than a balance to the harm in ’05 and ’06 — volatility in energy prices is the reason that markets watch core inflation instead of overall.

The rest of the beige book is quite different. All through 2006, the Fed’s descriptive and predictive word was “moderate” (both noun and verb); this beige book switched to “modest” to describe most of the economy. I don’t know if modest is weaker than moderate, but it is not stronger, and the report frankly described housing as softer than the worst-is-over types would have it, and the same for vehicle sales and production.

Down one line of argument, the job market is always the last to slow in a slowdown, and the Fed, stuck at 5.25 percent to prevent wage inflation, will ultimately make things worse. Recession still ahead.

Down another road, the housing bubble is no more hazard than Y2K, and the economy has rapidly adjusted to 5.25 percent — after all, about the same Fed funds rate prevailing from 1995 to 1999, one of the hottest, most productive and inflation-free intervals ever.

At this instant the bond market is leaning to road two, but my hunch is that there is no single fork ahead, but successive bouts of indecision. Reasons as follows:

1. Any big rise in mortgage rates from here is going to be self-correcting. Adjustable-mortgage rate re-sets could be doing real harm (they’re all headed for 7.5 percent or more right now), but cheap fixed-rate loans are an easy and attractive escape hatch. There is no question that the drop in fixed rates from 7 percent to 6 percent from July to December softened the housing blow, and a re-trace upward would hit hard.

2. I do not now, nor have I ever believed in a housing bubble — not in the sense of a widespread collapse in prices by 20 percent or more. However, announcements that the corner has been turned are unfounded optimism. The worst is not over when the market reaches a flat-price bottom, the worst begins then: flat prices over time expose more and more mistakes and bad luck, numbers often rising for years. The corner is restored appreciation of prices, and many coastal areas and the Desert Southwest are many years away.

3. PMI publishes its estimate of risk of falling prices, and is a serious and skilled observer (note that mortgage insurance providers have chosen to lose market share rather than join in the piggyback and subprime foolishness). Of 50 MSAs, PMI forecasts a 50 percent-plus probability of falling prices in 18, and a 30 percent-plus probability in another eight. Housing risk ain’t over; it’s hardly begun.

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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