Economy dashes hopes of a Fed rate cut

Mortgage market commentary
By: Lou Barnes: Inman News
Long-term rates are about where they were last week - the 10-year T-note 4.82 percent, mortgages 6.375 percent - but if anything they look increasingly vulnerable to a continued rise.

Wall Street is loaded with ancient wisdoms, mostly useful for rear-view bragging, or inscription on tombstones. One of the few good ones applies to this week's bond trading: "A market that won't improve on good news is soon going to hell."

We got the best we could have hoped for, brand-new January data slipping off-trend: the purchasing managers' index fell into contraction at 49.3 percent, and payroll gains at 111,000 jobs were two-thirds the forecast, also slim on wage gains. Long Treasurys broke below 4.8 percent on each item, and then snapped right back above.

Fourth-quarter Gross Domestic Product (GDP) arrived at a 3.5 percent gain, at least double the forecasts prevailing on Dec. 1, finishing off any prospect of a Fed rate cut. However, the Fed's situation looks good: the inflation figures buried in the GDP report are all gradually going the Fed's way. It concluded its meeting this week with a bias to raise the overnight cost of money, concerned as it should be with an overtight job market, but a continuing rise in long-term rates will tap on the brakes for the Fed.

Markets don't often get their forecast so wrong. The bet was obviously on housing as the agent of slowdown and Fed ease, and the odd part of the 2006 outcome is that housing did have a slowing effect: were it not for the housing recession, GDP would be growing in the 4.5-5 percent range. Despite that drag, and the dismantling of American-owned auto manufacturing, the economy appears to be in fine shape.

A few peculiarities remain. In the 1994-1999 interval, the Fed's cost of money was about as now, in those years 4.75-5.5 percent. The labor market was not as tight, and tech-led productivity gains were somewhat higher, both offsetting the inflation threat from somewhat faster GDP growth than now. However, long-term rates averaged at least a percentage-point higher than now.

By now, everyone should understand that the "yield curve inversion" (bond yields below Fed cost) dating to 2005 is the first ever to be an economic stimulus instead of signal of distress. The cause of subnormal long-term rates, in rough order of priority: a shortage of high-quality bonds (Yes! Federal deficit down to $172 billion, mortgage issuance off by half) versus demand from recycled Asian and OPEC trade surpluses, investors desperate for yield, and equal desperation for long-dated assets among insurance and pension providers.

The question: Is this excess of demand for long IOUs stable? I don't know why not. Risk premia are too low, and there will be a lot more Treasurys for sale in the next decade than this, but any rise in long rates can be offset by Fed easing and restoration of a "normal" yield curve.

Only fly in the excess-capital flow: spooky signs of asset bubbles. But, the "B" word is so ... so ... done that. Tech blew, ages ago, but housing just hissed, no bang.

It is possible that housing's biggest effects are merely delayed, especially the contraction in consumption as equity extraction falls to nil. To date, the housing drag on GDP is mostly in declining capital expenditure, the job losses minor (relative to total labor force), limited to ex-employment within the industry itself.

It's also possible that the whole housing thing is behind us, but I don't believe that. The worst will not be over until all of the borrower/scheme weakness is exposed, and mortgage credit standards inevitably tightened - but that has not yet even begun. Housing will likely be a continuing drag.

Meantime, it is hard to complain too much while long rates rise: they are going up for the best of all reasons. The economy is doing very well.