Monday, September 14, 2009

Data due out this week should reinforce the belief that the Fed will not be "under-the-gun" to raise short-term interest rates anytime soon because inflation currently poses no threat to the budding economic recovery.


Economists are looking for a tame 0.1% rise for core producer prices (a value that excludes the volatile food and energy components) on Tuesday followed by an equally benign reading for core consumer prices on Wednesday. If that assessment proves accurate the data will tend to be supportive of steady to perhaps fractionally lower mortgage interest rates. In my judgment, it is worth taking just a minute more to drill down into the "so what" factor attached to the inflation reports a bit further.


Right now, short-term funding costs are at rock-bottom levels - the overnight federal funds rate is floating somewhere near 0.15% and the three-month Libor (London interbank offered rate) is near 0.3%. As I write, the 10-year Treasury note yields 3.3% and the Fannie Mae 30-year 4.5% mortgage-backed security is offering investors a return of something in the neighborhood of 4.15%.


Don't give up and quit reading just yet . here's the important stuff.


You don't have to be a rocket scientist to do the math here - big banks and other major financial institutions can pocket a net 3.0+ to 4.0+% return simply by borrowing short and investing in top quality, longer-dated securities like government debt obligations and mortgage-backed securities. As long as short-term interest rates remain low - the "carry trade" (as this financing structure is commonly known in the credit markets) - will continue to support the prospects of lower mortgage interest rates -- if for no other reason than it is hard for big financial institutions to say no to easy money.


The bad news here is that this same "carry-trade" financing phenomenon sets the government debt and mortgage-backed securities markets up for a painful adjustment when (noticed I didn't say if) Fed policy and the inflation outlook changes. For the time being there seems to be little chance of that happening, given the expectation that the Federal Reserve is projected to keep short-term interest rates extraordinarily low for fear of derailing the emerging economic recovery. Even so, you can take it to the bank that selling pressure in the mortgage market will increase when once the core levels of both the producer and consumer price indexes begin to trend higher. As usual I'll keep you updated on the inflation story as we go forward - but at least now you know why the inflation numbers will take on added significance in the coming months.


For the balance of the day look for mortgage interest rates to take the majority of their directional cues from trading action in the stock markets. Higher stock prices will tend to drag mortgage interest rates higher while falling stock prices will likely be supportive of steady to slightly lower mortgage interest rates.