Friday, February 20, 2009

Mortgage investors seem to be dividing into two distinct groups. One group is fretting that disinflation within the economy may soon morph into deflation, a condition which erodes profits and makes debts of all kinds harder to repay. The other group is becoming increasingly concerned that the unprecedented fiscal stimulus and the Fed's policy of buying more assets and pumping money into the financial system will reignite inflation.

I don't think it matters much which group you choose to align yourself with - the 800 pound gorilla in the living room is Uncle Sam - who is currently on track to borrow a record $2.5 trillion dollars in the fiscal year that ends September 30th. That amount of new debt issuance doesn't just exceed the previous record of roughly $650 billion - it obliterates it by multiples.

The old rule of supply and demand states that in a competitive market place once supply exceeds demand (the point of equilibrium for you Econ 101 purist) -- price will fall. Like the law of gravity - the law of supply and demand is unbendable. Granted, there may be short periods of time when the level of supply and demand is being recalibrated during which price may temporarily rise - but ultimately the law must be obeyed. In our world when the supply of treasury obligations exceeds the global demand level prices fall - causing interest rates (including mortgage interest rates) to rise. From this point forward expect rallies to lower mortgage rates to be short-lived -- especially in comparison to the period of time mortgage interest rates will spend trudging to fractionally higher levels.

In my judgment it will take an event - like a major swoon in the stock markets - to create enough "flight-to-quality" buying interest to support a move to the 4.5% 30-year fixed-rate level for conforming mortgages. A bounce from current DJIA lows into the 8000 to 8400 price area followed by a plunge back through the 7300 level will, in my judgment, set up one final down-leg for the stock market into the mid- to low-6000's range. Should this event occur (most likely within the next 30-days) look for a large part of the dramatic amount of capital that will be fleeing stocks to find its way into the conforming mortgage market -- temporarily creating a environment of steady to fractionally lower rates.

Looking ahead to next week the macro-economic data will take a distant back-seat to the record breaking issuance of $94 billion of Treasury obligations in the form of 2-, 5- and 7-year notes. On Tuesday (10:00 a.m. ET), Fed Chairman Bernanke will be on Capitol Hill presenting his semi-annual testimony on monetary policy before the Senate Banking Committee. Investors will listen intently to Mr. Bernanke's comments for any mention of the Fed's possible intervention as a direct buyer in the Treasury markets. If the Chairman continues to remain mum on that issue - Treasury yields will likely rise - dragging mortgage interest rates higher as well.

There are a number of very volatile cross-currents washing through the credit markets right now. Stay Tuned...