Mortgage Rates - Has the Fear Subsided?

If one has been in this market long enough trading and hedging interest rate risks is that any manipulated market will not be manipulated long, and when it ends - it ends quickly and to some very badly. Market manipulation can be of many forms: false data, false information, inaccurate conclusions. Manipulation does not necessarily mean some kind of under-handed or criminal activity; it means the markets were led to focus attention in one direction by events that may be very temporary and lead expectations that exceed reality.

The Fed has been manipulating interest rate markets ever since it began quantitative easing; it did so to save and keep the economy from falling further into recession. Rates declined rapidly as the Fed bought about all of the Treasury borrowing over the last two years, thus reducing supply. When supply of anything declines the prices increases, in the case of interest rates higher prices are translated to lower interest rates. The Fed's actions did not accomplish one of its main charges of lowering unemployment much, but it did lower rates and set some fire under the key housing sector.

It may not be the proper way to define the Fed's action as manipulation as it connotes something evil but in essence that is what has happened in the rate markets in the last few years. The other issue that sent rates to historic lows was the chaos in Europe and the EU that almost led to the breakup of the Union and most of Europe's banks. The rush to safety of the US Treasury markets drove rates down, but for a year now Europe's troubles, although not over, are under control so that issue lessened but we still had the Fed. Now that the Fed is somewhere close to ending its market crutch interest rates are increasing, uncertainty reins and consumers are stunned.  It was inevitable that when the end came in view and the crutch was about to be taken away markets are left to return to under-lying economic fundamentals.  The past week is clear evidence that markets are exceptionally un-settled, trying to adjust to life without the Fed.  What levels should interest be now that the Fed is being removed from the equation?  How well will the economy do now that the rates have increased?

The 10 Year Note and the 30 Year MBS’s are up 1.0% from early May, a high percentage increase but given the average of rates over the last 50 years is still exceptionally low.  In the wider perspective not much of an increase with the 30 year mortgages at 4.5% area.  Inflation, usually the one thing that has driven rates higher when it has increased, is not a problem today, inflation rates are very low.  It has been speed of the run-up that has shocked markets and sent investors and traders along with mortgage lenders into emotional reactions.  No one was prepared for the magnitude of the move in the short time span.  We remain confident that rates will continue to increase over time as the economy heats up; the inflation fears will also warm up a little; however we do not believe interest rates will move as rapidly as the last few days.  More than likely the bond markets will consolidate at present levels possibly decline a little but the trend over the next few years is for rates to gradually increase.  It depends on how the global economy performs; there are still many that believe the US economy is not as strong as maybe the Fed believes today. 

Today Fed officials were out trying to soften the reaction from Bernanke’s comments last week.  Shocked by how the markets reacted – look for more chatter from the Fed people attempting to cool off market fears.