Mortgage Rates Ramble, Little Changed

July 18, 2008 -- Volatility being what it is these days, mortgage rates bounce around a lot. Upward pressure for rates one day gives way to downward pressure the next, only to succumb to upward pressure again.

Mortgage rates actually remained little changed by the time the week came to a close. HSH's Fixed Rate Mortgage Indicator (FRMI), the overall average interest rate for 30-year FRMs of all stripes -- including conforming, jumbo and expanded conforming offerings -- declined by two basis points (.02%) to close the weekly survey at 6.85%. ARMs continue to suffer from the whims of the market to an even greater degree than do fixed rate mortgages, and the overall average for five-one Hybrid ARMs rose by four basis points, finishing at 6.45% by week's end.

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That said, it looks like upward pressure will be back with us next week, if movements in benchmark Treasury yields are any indication. Of course, the relationship between Treasuries and mortgages remains distorted to a very great degree, and it's hard to know to what extent rising Treasury rates will affect the prices for mortgage money.

The see-saw between concerns about growth and fears about inflation tilted toward the inflation side again this week, after Fed Chair Ben Bernanke addressed Congress in the semi-annual report on monetary policy. While detailing the challenges facing the economy, Mr. Bernanke noted that inflation was above desired levels and that upside risks for higher prices have "intensified" lately. A Fed seeing higher inflation usually can be expected to react with an upward move to the Fed Funds and Discount Rates at some point in the not-too-distant future. In fact, the Federal Reserve Open Market Committee explicitly noted at its last meeting that "with increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate."

The timing of any such move is still in flux, however. Cheap money may be serving to exacerbate inflation risks, but the economy and financial markets remain quite fragile; any rate hike might make the operating environment somewhat more difficult (or at least more expensive). However, it's abundantly clear that the Fed is done trimming interest rates, and market participants are now positioning their investments for the next rate increase -- whenever it may come.

The longer the Fed holds off, however, the more potential effect on already-high price pressures. The Producer Price Index flared 1.8% higher in June, an increase almost fully attributed to energy and food costs. Without them, the 'core' rate of PPI inflation was only 0.2%. Over the past year, headline PPI has risen by 9.1%, and core PPI by 3.1%, both high enough to continue to set off warnings. However, for the first time in a while, price pressures at the earliest stages of production actually eased a little bit, suggesting that prices reflected in the PPI may settle in the next few months.

Of course, the Consumer Price Index suffers (perhaps more so) from rising food and energy costs. For July, the CPI rose a stout 1.1%, above forecasts; even eliminating those most volatile components left an increase of 0.3% for the month. The 4.9% year-over-year increase in the CPI was the biggest in some 17 years, and even core CPI at 2.4% cannot be considered as tame as desired.

If inflation is rising, bond yields must follow, lest their returns erode over time. Inflation can be tempered by a slump in demand caused by an economic recession, but no one prefers the pain that brings. Steps have been taken to try to keep us out of one (so far, so good) but those economic supports keep inflation cooking at the same time.

One of those supports had been the "economic stimulus" checks, shipped off to taxpayers in hopes of spurring growth. Despite that intent, retail sales moved just 0.1% higher in June. Slumping automobile sales held the number back, but it was just barely improved when auto sales, and the influence of more-expensive gasoline, were removed. The 0.2% increase was meager at best, and it may just be that most of the rebates went into the tank or savings account. Perhaps we'll see some of those savings spent when the back-to-school season kicks in in a few weeks.

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The final measure of overall inventory levels for May found a total 0.3% build in stockpiles across manufacturers, wholesalers and retailers. Sales increased 0.8% for that month, so the ratio of goods on hand relative to sales remained pretty steady at lean levels. Given the uncertainty in the economy, no one wants to get caught with a huge pile of unsold goods should demand falter, and keeping inventories lean means smaller orders to factories.

Speaking of factories, the latest measure of Industrial Production unexpectedly moved 0.5% higher during June. However, much of the gain was related to utility (+2.1%) and mining (+1.1%) output. Manufacturing managed just a 0.2% increase, and the percentage of factory floors in active use remained at 77.6% for manufacturers (77.9% overall). Looking at more local numbers for July, though, it's hard to expect any substantial improvement in manufacturing activity anytime soon. The Philadelphia Fed's regional indicator of factory health posted a reading of -16.3, its eighth consecutive negative reading (though marginally improved from June). The New York Fed's look at manufacturing in that state saw their index decline by 4.9, still down but also somewhat improved from June's -8.7 level.

The market for housing remains bleak. The National Association of Home Builders index of member sentiment set an all-time low of 16 in July, as sales, traffic levels, and expectations all slumped. The head of the NAHB called for additional government support for housing markets and pressed for the passage of the housing bill in Congress, which includes large tax breaks for first-time buyers.

The dour attitude did seem a little at odds with Thursday's headlines trumpeting sizable increases in Housing Starts and Building Permits during June, but a peek behind the headlines revealed that all the increase was due to a distortion from New York, where a July 1 expiration of incentives to get projects underway prodded builders to get them underway. All the boost was in multi-family buildings; single-family starts slipped to 647,000 from 683,000 during the month. The 1.066 million start rate belies the actual amount of softness in the market, but permits for future activity edged upward, too. The pattern here, like that for existing home sales, has been one of backing and filling around a plateau of five million sales (annualized) for existing homes (about eight months, now), and about an annualized one million for starts (about seven). We may or not be at absolute bottom for housing, especially for new home sales, but by our reckoning, we do seem to be bouncing along the bottom in many ways.

Consumer moods remained steady last week, according to the ABC News/Washington Post poll of Consumer Comfort. The -41 reading for the week ending July 13 was a mirror of the week prior, and came on the heels of two weeks at -43. Although this is a very low level, the index was considerably lower a number of weeks ago and has staged a grudging improvement over the past seven weeks.

New claims for unemployment benefits ticked higher by 18,000 to 366,000 new applications filed during the week of July 12. After a holiday- and seasonal-adjustment issue during the July 4 week, we'll probably climb back closer to recent ranges over the next couple of weeks; we've recently seen numbers just below 400,000 per week. Labor markets remain weak.

As noted above, Treasury yields moved considerably higher during the week, so we expect a boost in mortgage rates for next week, at least at the moment. Although nominal interest rates are at reasonable levels for conforming-loan borrowers, some folks might find mid-6% rates for fixed rate mortgages too expensive. They might consider a 5/1 ARM; the average rate of 5.95% this week offers a savings of nearly a half-percentage point. The same range is true for jumbo-size loans, too, but with both interest rates over 7%, it would be hard to call the selection of one "relief" for a jumbo borrower.

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