Monday, June 1, 2009

So which is it - are rates rising because the economic recovery is gaining noticeable traction or do rising rates mean the global investment community is worried about the deterioration in the creditworthiness of the U.S. as a debtor nation?

The Fed is not sure if one of these two dynamics is at play -- or if some other factor is creating all the volatility in the credit markets.

The idea that a major shift in investor sentiment has occurred regarding the budding economic recovery -- is an extremely weak one. It is true many economic measures have turned higher - but these improvements still leave many macro-economic measures only fractionally above all-time record lows recorded within the last six months. The vast majority of macro-economic indexes remain well below values normally associated with expansion.
The argument that the global investment community is loosing their appetite for dollar-denominated assets is weak as well.

Data shows international demand for American financial assets is as high as ever, even as the value of the dollar slides and the U.S. deficit expands. Data compiled by Bloomberg show the Federal Reserve's holdings of Treasuries on behalf of central banks and institutions from China to Norway rose by $68.8 billion, or 3.3% in May, the third most on record. The Treasury Department said bidding from foreigners was above average at last week's $101 billion three-part note auction. To lay last week's major swoon in the debt markets at the feet of massive incoming government supply misses a key point, the $2 trillion dollar supply inbound into the credit markets from Uncle Sam has been public knowledge for months, the likelihood that market participants just woke up to that fact last Wednesday is beyond ludicrous.

There are all kinds of suppositions floating among market participants regarding the cause(s) behind the swoon in the credit markets. There are an even larger number of theories focused on what the Fed should do to stem the crash and to push borrowing rates back to notably lower levels.

Many are suggesting the Fed needs to immediately expand their funding authorization for the direct purchase of Treasury debt obligations from its present level of $300 billion -- to $1 trillion dollars or more.

Others argue the Fed simply needs to make it abundantly clear to market participants that the central bank will hold their mortgage-backed security portfolio to maturity - reducing any threat to other mortgage investors that the government will become an aggressive seller of mortgage-backed securities somewhere down the road. Proponents of this argument believe that if this particular threat is eliminated -- one of the major root causes behind last week's crash in the mortgage market will be greatly reduced.

I have no idea what the "right answer" is - and I think it is a very safe bet to suggest the Fed is doing a lot of collective head scratching right now as well. Central bankers will not want to appear as though they are reacting to every market swing by doing something instantly-- for fear of losing creditability in the global investment community. If the capital for significant expansion of their direct purchase programs is going to be authorized -- and/or if they are going to make a dedicated commitment to hold their mortgage portfolio to maturity- and/or if they are going to do something not yet on investors radar screens - it won't likely happen in a breathless rush.

The next regularly scheduled Federal Open Market Committee meeting is set for June 23 - 24th. At least until then, like it or not, volatility levels in the mortgage market will almost certainly remain inordinately high