In the Bond Market, A Warning

The rise in the stock indices today may signal time for relief to some investors but there is a serious warning being sounded in the bond market.

Late last year, I published a couple of posts (here and here) noting that some pundits were calling for the 10-year Treasury note to come down to 2.5% or below in order to revive the housing market and stave off a deflationary spiral. While I agree that interest rates that low would help staunch the bleeding in the housing market (and by extension, the credit markets), I expressed my skepticism at the possibility of this event — after all, who would buy 10 year notes at 2.5% with (imaginary) headline inflation over 4%?

Since Friday, the 10 year yield has risen from 3.47% to 3.7% which is a huge move. Long-term mortgages closely track this rate and so expect mortgage rates to head back up.

This complicates the Fed’s ability to create a floor in housing, which they desperately need to do. Consumers buy housing based on how much they can afford on a monthly payment — little distinction is made between which portion goes to equity vs. financing, i.e. the mortgage rate. If the Joneses can afford a $1500/month mortgage payment, that’s what they will spend regardless of house prices or mortgage rates. The Fed has 3 basic options:

  1. Lower the mortgage rates so less of that $1500 is sucked up by interest, allowing the Joneses to buy “more house.” Theoretically, this would help put a floor under housing prices.
  2. Allow house prices to come down. Rising mortgage rates are a double-whammy where buyers are hit since the lower house price is partially offset by more of that $1500 is eaten up by interest and sellers are hit with lower home equity. The current situation most fits this case and the Fed (and everyone else) is desperately trying to mitigate this scenario with its knock-on effects on wealth consumption effect, housing-based derivatives, related industries, etc.
  3. Give the Joneses more money so they can afford a bigger monthly payment and pay more for houses, which should stabilize housing. As far as I can see, this can happen only through wage inflation. The Fed is actively working against this option as they believe this would spark an inflationary spiral (yes, I know inflation is already spiraling but let’s just play the Fed’s shell game for the purposes of this post). Despite the official mucking of inflation numbers, this scenario is bad news for everyone.

A fourth scenario — raising productivity and generating more wealth which percolates through the whole economy (as opposed to nominal inflation), including the housing market — is discarded here since I believe such a scenario requires a recalibrating of the American economy, which should eventually happen as the current crisis plays out.
Can the Fed engineer an environment with dropping interest rates and rising equity prices? To a degree, they already have but whether it will be enough remains to be seen. But I have serious doubts we will see 2.5% 10 year Treasurys without government intervention.

Many commentators have asked how much of the pain from Wall Street will hit Main Street but I think they have it backwards. The current mess happened because many Americans couldn’t afford to pay their mortgages. The pain started on Main Street, introduced itself to Wall Street in February of last year and entrenched itself last August. As such, rising yields in Treasurys is worrisome sign.

More on this topic (What's this?)
The Worst Is Not Over
406 Days Until This Market Crashes…
Read more on Bond Investing, U.S. Housing Market at Wikinvest

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