Mortgages: Opposites Attract

September 21, 2007 -- With unusual flair, the Federal Reserve slashed short-term interest rates by a more-than-expected 50 basis points (.50%). The average 30-year fixed-rate mortgage (FRM) responded by rising five basis points (.03% ?), closing the nation's leading survey of mortgage prices at an average 6.80%. Five-one Hybrid ARMs also rose, climbing by four basis points to finish the week at an average 6.61%.

In a kind of reversal of fortune, conforming 30 FRM averages moved up this week, while jumbo 30 FRM averages edged down, narrowing the gap between them to "only" 85 basis points. Given the extraordinarily wide markup over a comparable 10-year Treasury, there is plenty of room for fixed mortgage rates to decline even if Treasury rates don't. For the moment, however, those wide spreads are serving to help restore profitability in mortgage lending, so they may be slow to diminish.

Why would rates rise after a Fed cut? It's fairly easy to understand if you look at a few simple economic tendencies. Stronger economic growth has a history of throwing off more inflationary heat, while weaker growth (with its diminished demand for goods and services) tends to temper price pressures over time.

Outside from the recent "panic buy" of risk-free assets such as US Treasuries (which drove yields way down), inflation has been slowly cooling for a while, helping to keep a lid on increases in market-based interest rates. This, in turn, produced the relatively stable environment for most interest rates so far this year.

Especially over the last few weeks, and particularly since the last employment report, concerns that credit market issues have begun to trim economic growth have become more pervasive. If growth was slowing, inflation pressure was certain to follow, and a lower "inflation premium" could be built into interest rates, helping rates to decline.

On Tuesday, the Fed took a bold step to reverse the process of (expected) economic decline, making money in the market cheaper for certain borrowers, notably banks. If the Fed's actions have the desired effect, economic growth would increase -- which would bring with it the potential of higher price pressures down the road... which could be exacerbated by record-high crude oil prices and the rising cost of other commodities. Stronger growth could bring higher inflation; as a result, market prices for interest rates tend to rise to offset the corrosive effect that higher inflation has on the investor's ultimate return.

In the release which accompanied the close of the meeting, the Fed noted that "the tightening of credit conditions has the potential... to restrain economic growth more generally. Today's action is intended to forestall the adverse effects on the broader economy..."

Bond and mortgage markets need always be careful in what they wish for, and getting what you wanted isn't always what you expected it to be. Cries for cheaper money have been answered, but should the economy not falter in anticipated fashion, inflation pressures may become more pervasive, and fully or even partially-fixed rate mortgages would rise as a result.

The Fed also lowered the cost of borrowing directly from the Fed itself via the "Discount Window," where banks can pledge assets as collateral and receive loans of cash against them. In the past couple of weeks, those infusions of liquidity have helped ease the logjam in credit markets to a degree, just as it appears that injections of cash into UK-based markets have helped lower the rates for LIBOR to a good degree. Important for all kinds of adjustable rate loans, the yield on one-month LIBOR rose from the low- to the upper-five percent range in a matter of weeks, but has since settled back, which is better news for American ARM holders than they might have otherwise expected.

On the housing front, there was little but more of the same news available this week. The latest survey from the National Association of Homebuilders found increasingly bleak outlooks, at their index of member sentiment slipped down to a reading of 20, the lowest September value in the history of the survey. Troubled credit markets in August simply added to the misery seen among homebuilders, so a downbeat attitude was to be expected, especially when viewed in light of the decline in housing starts during August, as the number of units where initial construction happened declined by 2.6% to an annualized 1.331 million pace. Building permits, a harbinger of future activity, declined by a sharp 5.9%, sliding to a 1.307m rate.

Inflation numbers released this week looked pretty good, but were largely dragged down by falling energy costs in August, a situation unlikely to be repeated with oil hitting record prices of late. The Producer Price Index for August declined 1.4% overall, but actually increased by 0.2% with energy and other volatile costs removed from the equation. For the PPI, "headline" inflation is running about 2.1% on a year-over-year basis, while "core" PPI stands at 2.2% over the past 12 months.

The same is largely true for the Consumer Price Index. Headline CPI eased by 0.1% during the month, while "core" CPI ticked 0.2% higher. Over the past year, CPI is now running at 1.9% at the top level, while "core" CPI eased to 2.1% year-over-year. With inflation largely been on a gentle downward (if erratic) path for much of this year, the Fed probably felt slightly more comfortable in easing rates on Tuesday.

Other economic signals weren't dire at all. Local surveys of manufacturing health in the New York and Philadelphia Federal Reserve districts both encountered growth, with the Philadelphia area growing more strongly in September after a flat August. Activity in the New York area declined a little to a less-strong level, but remains in expanding territory.

Although the Index of Leading Economic Indicators slumped by 0.6% in August, this was merely a reversal of the 0.7% increase seen in July, leaving the indicator virtually unchanged over the past two months. While the LEI is supposed to forecast growth up to six months down the road, it probably better reflects the period in which it's produced, and August was a trying month all around.

The latest measure of Consumer Comfort nudged higher. The weekly ABC News/Washington Post poll sported a reading of -15 during the week of Sept. 16. It was the highest reading since the credit market disruption of mid-August; rising stock prices and still-cheap gasoline since then have served to improve moods, but that may prove fleeting. Also, layoffs seem to be improving, and the number of initial applications filed for unemployment benefits fell to 311,000 during the week ending September 15, the lowest number of claims since the first week of August. Our speculation that the disappointing employment report last month may have been a kind of temporary credit-market-induced hiring stasis may prove to be the case, but we'll have to wait about two weeks to see.

There's a rather busy economic calendar next week. Three measures of consumer attitudes are due out, as are several local and national reports covering manufacturing issues, spending for construction projects, sales of new and existing homes, and the last look at GDP growth for the second quarter. If widening economic troubles related to the August credit dislocation are happening, we may start to see some of that reflected here, but it would need to show outside of home sales to have any additional merit.

Although trouble yet persists -- HSBC closed its Decision One subprime lending unit on Friday -- but with the Fed "on the case" and with a half-point cut already in the bucket, we think that the overall average for mortgage rates may tick a little higher again next week, as credit markets begin to normalize from panic levels.

Our new fall visitor survey, "Fixing The Mortgage Market Mess: What should be done... and by whom?" seeks your input as to how the aftermath of the credit market mess should be addressed. There are a lot of proposals on the table and the potential for a lot of change to come to housing and mortgage markets, and we think you should get a chance to chime in. Take the survey here.

For more in-depth commentary, see our latest two-month forecast. And for today's top stories, see our daily news column.