July 12, 2019

Preface
Relentless pressure from markets over the last couple of months has seen the Fed looking for appropriate cover to lower interest rates, and the central bank has signaled that a cut will be coming, most probably a quarter of a percentage point move and most likely at the end of this month. The markets have essentially been agitating for a cut in rates since the last increase in the funds rate last December, and official Fed statements since the last increase clearly show the Fed has changed its thinking about the proper position for both conventional and unconventional monetary policies it manages.

Although the U.S. economy continues to perform fairly well, activity has clearly slowed from an unexpectedly strong pace to start the year, with a current run rate for GDP estimated at 1.4% for the second quarter (the official "advance" report for GDP isn't due until the end of the month). Meanwhile, inflation here has remained soft, with "core" Personal Consumption Expenditure inflation running at about 1.6%, rather below the Fed's desired level. Even so, it's our opinion that the Fed would probably prefer to wait out the summer to see if the recent growth swoon reverts; there have been some recent signs of a mild uptick in activity, now that (for the moment) there is a truce in the trade-and-tariff wars. Truce or not, the mercurial way these items are being handled by the President has injected a good deal of uncertainty into the business climate, adding rather a bit of caution to an already slow period.

Among other pressures aimed at the Fed to influence policy, the Fed has been repeatedly badgered by the President to lower interest rates. However, in order to maintain a stance of being free from political influence, the Fed may have had to slow walk a move in policy it might otherwise have already made in a different political climate. That said, it has now latched on to "uncertainties around trade tensions and concerns about the strength of the global economy" and their influence on the U.S. economic outlook as a reason to make a change.

It bears pointing out that lower interest rates can do nothing about capricious tariff and trade policies or much about the strength of the global economy. After all, it's only a quarter of a percentage point in an overnight cost-of-money rate. However, such a move may shore up business confidence a little, and that could help provide some stability to markets. To our mind, it also presents an interesting policy question, as such: "If the Fed is cutting rates in part because it is worried about the lack of strength in the global economy, can it be expected to be lifting rates if activity abroad picks up?"

HSH.com 30-yr FRM Forecast Recap Graph

Recap
We expected that the souring economic climate amid low inflation would likely see mortgage rates decline for the May-July forecast period. That said, we could not foresee the abrupt collapse of trade talks with China and the threat of expanding and increasing tariffs to nearly all goods coming from there. We also could not see a threat of the imposition of new tariffs on goods coming from Mexico as a cudgel to influence cross-border migration, or those aimed at the Eurozone or any number of others. These "crosscurrents" (Fed's choice of words) intensified during the period, battering financial markets; in turn, this sent investors scurrying for the relative safety and positive yields available in the U.S., as bond yields in Germany hit record negative lows and those in Japan turned more deeply negative, too. Although we expected lower rates, the wash of cash coming here simply pulled rates down with more intensity than we expected.

During the last nine-week period, we thought that the average offered rate for a conforming 30-year FRM as tracked by Freddie Mac would hold a range between 3.86% at the bottom and 4.23% at the top, and generally holding around the 4% mark. The markets presented borrowers with a 3.73% bottom and a 4.07% top, so while our expected range of movement was close (37 basis points expected versus 34 realized) the range we expected was clearly too high, with the average rate for the period rather below our forecast. For Hybrid 5/1 ARMs, this was also the case, but less so, as we thought we'd see a range of initial offered rates from 3.48% to 3.80%, and the actual high and low markets were 3.39% and 3.68%, respectively. Not the worst forecast ever, but not as close to actual conditions as we'd like.

HSH.com 5/1 ARM Forecast Recap Graph

Forecast Discussion
In some ways, we think the Fed has put itself in a box. In roughly six months' time, it looks as though it will have fully recanted expectations for growth, inflation and future monetary policy. At a time of record high major stock indexes, already-low market-based interest rates and an economic expansion that has just become the longest in U.S. history, a reasonable argument can be made that interest rates don't need to be moved at all. In fact, and absent the injection of great uncertainty by the President's messy trade management, it is likely that the Fed would have simply remained in a "patient" stance and let other central banks take action to perk up their local economies. As well, and even with a good bit of uncertainty about the climate, members of the FOMC had only recently begun to move toward a slight easing bias, with voters nearly evenly split as to whether existing rate levels should remain in place for now even as expectations for lower rates later in the year increased.

While there is little chance of an abrupt upswing in domestic or global growth or inflation in the next nine weeks, at this point even a diminishment of uncertainty would go a long way toward improving the global economic climate. As well, if interest rates in Germany and Japan manage to move upward to something approaching positive levels this too would improve the outlook... but would also tend to firm interest rates here a bit, too. At the same time, any bright spots as it pertains to the U.S. economy should temper market concerns that a recession is looming, and these will tend to change investor expectations about the future path of monetary policy. For example, after a stall in hiring in May, job growth roared back in June, and in turn markets began to discount the prospects for a 50 basis point cut this month... and dial back front-running expectations of perhaps three cuts by the end of the year. The fact is, things aren't that bad, and an insurance cut in the federal funds rate doesn't necessarily signal a new round of sustained easing. In reality, an insurance cut likely means the Fed will move back toward a "patient" stance.

For mortgage borrowers, it would likely be better if the Fed didn't lower interest rates, as the likely outcome will be that longer-term rates and mortgage rates will firm up a bit as a result. Why? If the Fed stands idly by while markets think the economy is failing, the result of fading growth and inflation would see longer-term interest rates continuing to fall. Conversely, with the Fed moving to prop up growth (even in an "insurance" move), improving prospects for increasing future growth and inflation tends to lift long-term rates. Essentially, with the sheriff back on the job instead of rocking on the porch, things are likely to get better, and better tends to bring higher rates.

Forecast
The next nine weeks strike us as a bit of a transitional period. It very likely the period will feature an interest rate cut by the Fed in just a couple of weeks time. However, we may also see the central bank pushing back hard against market expectations of future cuts in rates (President Trump will continue or may even intensify his rhetorical pressure). This forecast period ends just before the September Fed get-together, and we'll certainly know by then if they have succeeded in recalibrating market expectations of future monetary policy.

We also think that the unexpectedly steep downdraft for mortgage rates this year is likely over, at least as far as this forecast period is concerned. Over the next nine weeks, we think that the average offered rate for a conforming 30-year FRM as tracked by Freddie Mac will hold a range between 3.67% and 4.07%, most likely moving up and steadying during the period, while the average initial offered rate for a hybrid 5/1 ARM is expected to find a 3.33% and 3.71% pair of bookends.

This forecast expires on September 13. Summer will be fading into fall, with the school year and football season getting into full swing. In between running about and watching games on TV, why now drop back in to see if this forecast was a touchdown or a fumble?

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