Long-term rates dipped briefly this week on shaky economic data, the 10-year Treasury to 3.59 percent and mortgages to 5.375 percent, but ran right back up in the shadow of another $104 billion in new Treasury borrowing next week.
Optimists tried to find a housing bottom in modest rises in starts and new permits, but the reports were garbled by apartment overweight, and the reality is the same: New-home construction is steady 77 percent below the 2005 total. Inflation may come, but not now, CPI up 0.1 percent in May, no way to rise with industrial capacity utilization at a new-record low 68.3 percent (health = 80 percent-plus), and production off another 1.1 percent.
Leading indicators put in a second-straight solid increase, up 1.2 percent for May, but the internal components are suspect. One is the rise in long-term rates; in normal times a healthy precursor, but today has undercut purchase-mortgage applications and collapsed refis. All surveys show modest increases in confidence, but all is relative: A shift from panic to anxiety is better, but is not "confidence."
At this stage, neither authorities, traders nor civilians can confirm an economic bottom forming, let alone the extent and slope of recovery ahead. Fiscal and monetary stimulus deployed … now we wait. We’ll know soon, this summer.
The strange and circular tale of the Bond Vigilantes defines this moment, and includes backhanded good news — at least for inflation.
The term was coined in 1984 by economist Ed Yardeni to describe then brand-new self-protective behavior by bond investors. For city folk, and those too young to know cowboy movies, vigilantes form a civil-defense "posse," either rounded up by the sheriff, or a self-organized mob as dangerous to civilization as the bad guys they would catch and drag to a necktie party.
Prior to 1981, the bond market was a very small and sleepy place. Federal deficits became chronic after 1963, but were dinky even during Vietnam. Most Treasurys were the rolled-over remnant from World War II. Even giant businesses were financed by banks, not bonds. Muni bonds were a tiny market, mostly for infrastructure funding as local governments stayed in fiscal balance. Mortgage securitization had hardly begun, with home loans held in S&Ls. Bonds were physical pieces of paper, awkward and slow to trade. …CONTINUED
Thus as inflation ramped steadily from the ’60s through ’70s, holders of lower-rate bonds suffered great losses. Increased deficits were no more responsible for inflation then than now: Inflation came from a tardy and timid Fed, two oil shocks, and from a weird regulatory hangover from the Depression. Bank deposits had an interest-rate ceiling until 1979, 5.25 percent versus inflation finally twice that level, and the low deposit costs held down mortgage rates, which in turn inflated real estate.
This experience created deep conviction: Debtors including government can inflate their way out of trouble, and commodities and real estate are investors’ safe harbor.
The great divide in 1981 has been misunderstood ever since, concealed by the following 20 years of falling inflation and increasing fiscal discipline. In 1981 the federal deficit exploded: A terrible recession cut revenue, and we cut taxes while ramping defense spending. As the Treasury for the first time in peacetime filled the budget hole with massive sales of paper, everyone at a bond desk saw rates rise.
Bond owners suddenly great in number and mass sold holdings in self-defense and refused to buy, raising rates and bringing caution to government. Today, those fearful of inflation, or an effort to debase national debt, completely miss the pre-emptive effect of the Bond Vigilantes. Any nation trying such a thing will quickly face ruinous long-term interest rates. I think the Vigilantes’ excessive fear today is already aborting bottom, and assuring low inflation, but it will take time for them to see.
If that first necktie party goes home, there is another one waiting, rope over branch right now. Inflation or no inflation, if you intend to sell too many Treasurys, the posse’s willingness to buy will diminish in proportion, the demand for rate reward rising to ruin.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at firstname.lastname@example.org.
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