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Your Interest Rate Update

August 3, 2009

Have you ever taken a road trip, knowing your destination, but not knowing exactly how to get there?

I've used that analogy before. It's very fitting for what Fed Chairman Ben Bernanke and his car-load of Federal Reserve Board members are doing as they guide our economy back through recovery to stability.

With a broad brush, there are two major economic debates right now. They are whether we're facing an inflationary mountain, or a deflationary quagmire. And, the road we forge back to economic stability will play a huge role in your financial future. It will dictate the interest rates you pay, and the return on capital you get. It will shape the types of opportunities you can seize and drive the challenges you will face.

The Federal Reserve's job is to navigate their way forward, fulfilling two basic mandates: to maintain price stability, and full employment. That's the destination. How they get there, particularly in times of economic crises, can be the uncharted road trip.

Imagine Bernanke et al in the Federal Reserve System driving our "economic mini-van" with the US Family aboard. The "kids" in the back seat (we consumers, business owners, the politicians in Congress, etc.) keep wondering "are we there yet?" Meanwhile, the back-seat drivers (other economists, primarily, but some Congress members too) alternately scream "we're doomed, we'll never make it" and "wait, hit the brakes, we're there!"

Some recent sign posts we've all seen include:

The S&P 500 index closing above 1000 today, for the first time since November of 2008, when the wheels appeared to be coming off our economy.
Steady declines in the numbers of layed off workers since job losses seem to have peaked around January 2009
Increasing unemployment - now upwards of 9.5% nationally. And, if you count the "underemployed" those working part time who'd prefer full time work, that's more like 16%+. Both are projected to go higher, too.
Sliding consumer sentiment and spending, which peaked at driving 70% of our Gross Domestic Product
The highest personal savings rate we've seen in about 20 years
Q2 corporate earnings reports predominantly beating expectations
Skyrocketing national debt

But, each sign post has a different meaning, depending on the eye of the beholder.

Deflationists worry our economy may languish in an environment of falling prices for years, possibly decades, much like Japan has done since the bursting of their credit and asset bubbles in the 1990's. Japan's overnight lending rate - comparable to our Federal Funds Rate - has hovered around 0.5% for the better part of a decade. Their Nikkei Index - similar to our Dow or S&P indices - has declined from the 16,000 range in the summer of 1999 to just over 10,000 today. You'd find a similar deflationary story looking at Japan's real estate, and most other Japanese asset classes over the same time frame. All that despite loose monetary policy.

Inflationists fear hyper inflation, of the type that grips Zimbabwe today, rendering their currency less valuable than the paper on which it's printed. Or like the inflation that helped bring down Germany's Weimar Republic in the early part of last century, when people were carting wheelbarrows of cash to buy a loaf of bread. The inflationists point to the massive infusion of cash the Fed has pumped into our system. They point to the ongoing government stimulus packages - we've already had two, and a third is being discussed - that continue driving our nation further into debt. And, they claim, that at some point our debt will be unbearable, and that China - who currently gives us our allowance - may change the terms under which they want to be repaid. Lastly, these folks worry, that the only way to climb out of the mountain of debt we've built for ourselves would be to devalue the dollar, forcing inflation to effectively reduce our financed deficits.

My take? I don't see either catastrophic inflation, or a prolonged deflationary morass gripping our economy. In Uncle Ben I trust. And no, I don't think he's our crazy Uncle...

But, I do wonder where our economic growth will spring from, and how on earth - just 4 months after our stock market was pricing in Armageddon - it's pushing itself further and further off those lows - when really, we haven't seen any positive economic sign posts of the usual sort, but rather just "less bad" news.

I peg the recent run-up in stocks as a bear market rally - driven by corporate cost-cutting (propping up earnings) psychology/optimism and group think, more than anything. It reminds me of the rebound we saw in stocks after the 2001 tech bubble burst. By 2002 I thought the stock market losses had largely been realized. I invested a bunch of money. Shortly thereafter, the market dumped again to the 2003 lows. I lost. And, the economy as a whole was MUCH stronger then, than we are now, when you compare employment/unemployment, production, average earnings, etc. The tech bubble bursting was "relatively" contained. The credit, housing and asset bubbles were much more pervasive and far reaching. Their bursting has touched every sector of our economy (and the world's) as everyone - but our government - is deleveraging. It seems that as this year continues, we may see another pull back in stocks as revenues continue to languish, and they can no longer cut costs to protect their margins.

As for the lost decade the deflationists fear? Our Fed was much more creative, speedy, and forceful than the Bank of Japan was during the bursting of their asset bubble. Bernanke and Co. aggressively cut the overnight Federal Funds rate. They created an alphabet soup of programs to pump liquidity (credit and cash) back into our economy. They implemented an extensive asset purchase program, buying both US Treasuries and Asset Backed Securities. And, from a fiscal standpoint, both this year and last Congress approved temporary tax cuts which put a little extra money in people's pockets. From my perspective, although economic sign posts aren't yet getting better, just less bad, they are no longer showing shorter milestones to Armageddon. I think the worst is most likely behind us.

Inflation, on the other hand, should be manageable because most of the Fed's programs expire as their demand wanes. In fact, their balance sheet is shrinking even now. Some of the programs are also generating decent returns, which can be used to pay down our debt. In terms of the increased cash supply, which right now is basically sitting in reserve and not being deployed in the economy, the Fed can increase the interest paid on those reserves. According to Janet Yellen, San Francisco Federal Reserve Bank President, "An increase in the interest rate on reserves will induce banks to lend money to us rather than to other banks, thereby pushing up rates in the interbank market and, by extension, other interest rates throughout the economy. This is an important tool because, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even if we maintain a large balance sheet for a time."

Additionally, how can we have inflation when the labor force is contracting, hourly earnings are declining, and nobody - well, all but a select few - have any pricing power to raise prices on either the wholesale or retail level? Yes, if China's middle class burgeoned overnight (consumer spending only drives about 40% of their Gross Domestic Product) and began an era of consumption like we just went through, that could drive inflation. But, we're probably a decade or two away from that happening. Their culture is still vastly driven by frugality, rather than consumption. So, I don't see an epic bout of inflation, either.

But, there is at least one other concern on our horizon. It's trumped right now by the immediate challenge of repairing our "economic mini-van" but.... Our national deficit is a looming problem. The interest expense of financing our deficit could become crushing if we don't curb it. Add to that, the bloated entitlement programs we've promised (social security, medicare, etc.), not to mention new programs on the table, and.... some economists project that our tax revenues would need to climb to 68% of earnings (and if tax revenues are 68%, then tax rates would have to be even higher) to cover our debt service and entitlement programs. THAT's scary.

Fortunately, we can kick that can down the road. At least until we're certain that our "economic mini-van" is cruising ahead, back on its road trip, avoiding speed bumps and pot holes, along the way.

I'm counting on American creativity, ingenuity and resilience to pull us through this cycle and on to the next one. We do have a bitchin' set of tools...In our nation's history we've overcome challenges time and again.

In terms of impact on near-term mortgage rates, I think we'll continue on our slow trend up for 30yr fixed mortgages. If we see a significant economic relapse, look for those rates to dip again, as money makes it's "flight to safety." But, on the other hand, I won't be surprised to see rates touch 6% in the next 12 months or so, either. Meanwhile short and mid-term ARMs are likely to stay low, in the 4.5% range - steepening the yield curve, but not to excessive levels. We're close to the 1.5% or so spread between short-term and long-term mortgage rates now. And, I don't see those rates going too far below 4%, their recent floor, either. But, as always, time will tell.

In the mean time, if you, your family, or friends have any questions about financing residential or commercial real estate, please call or email me. Here are today's rates. Cheers! E

Conforming	Rates	Points	APR	Loan Amt	Payment
30 yr fixed mortgage	5.125%	1	5.365%	$300,000.00	$ 1,633
15 yr fixed mortgage	4.375%	1	4.575%	$300,000.00	$ 2,276
3/1 ARM	4.125%	1	4.315%	$300,000.00	$ 1,454
5/1 ARM	4.125%	1	4.335%	$300,000.00	$ 1,454
5/1 ARM Int Only	4.250%	1	4.510%	$300,000.00	$ 1,063
Jumbo (ask me about the new limit, per your zip code)
30 yr fixed mortgage	7.000%	1	7.126%	$550,000.00	$ 3,659
15 yr fixed mortgage	5.750%	1	6.005%	$550,000.00	$ 4,567
3/1 ARM	4.375%	1	4.555%	$550,000.00	$ 2,746
5/1 ARM	5.375%	1	5.595%	$550,000.00	$ 3,080
5/1 ARM Int Only	5.625%	1	5.875%	$550,000.00	$ 2,578
Rates subject to change without notice.
These rates and statistics are for informational purposes only to give you a sense of market movement and my opinion as to why. Although these rates exist today, based on certain qualifying characteristics, your scenario may allow for lower or higher interest rates. Licensed by the CA Dept of Real Estate, #01760965. Equal Opportunity Housing Lender. If you'd like to be removed from this list, please reply with REMOVE in the subject line. You can also use this link, mailto:egrathwol@priority1stmortgage.com and add REMOVE to the subject line. To add someone who would appreciate this information, send me their email with SUBSCRIBE as subject.