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Your Interest Rate Update

August 25, 2009

What does our economic recovery mean for interest rates?

I wish I knew, exactly. But, all I can really do is make an educated guess. As you can imagine, it's very dependent on what type of recovery we see.

You're probably hearing the same alphabet soup of recovery letters I am - will it be a V shaped recovery, which is how most recoveries over the last 80 years have been? Maybe it'll be a slower slog, shaped like a U (or even a bathtub, with an elongated trough, before slowly curling into the upside of the U)? Could we see a W? That's basically two back to back Vs. What impact would that have on interest rates? And then there's the L - like Japan's "lost decade." How would that play out for our borrowing costs?

As you know, there are two basic factors that drive mortgage rates. First is supply and demand, and second is inflation, or fears of it.

Despite what we hear in the main stream media, mortgage rates are not based on the 10-year Treasury yield. Investors doling out the money to borrowers set mortgage rates they demand for their return on investment. They adjust for the risk/reward they're taking and the opportunity cost of not placing that money elsewhere. There is no direct linkage to Treasury yields. There's a small correlation between the yield on the 10-year Treasury yield and mortgage rates, because both offer similar "safe" long-term investments, with similar rates of return, but it's not a direct link.

For example, right now the 10-yr Treasury yield is around 3.45%, and 30yr fixed mortgages are at 4.875%. Treasuries have very little risk of default, because they're backed by the full faith and credit of the United States, but... investors may choose to accept a little more risk - since guidelines are not so loose anymore - and park their funds in Mortgage Backed Securities, returning about 1.5% more than Treasuries. Or, they can bet on corporate profits driving up share prices and yielding greater returns from the equity markets. Or, there are other bonds, real estate, and a myriad other investment vehicles. Lots of places to make money, and mortgage backed securities are their own animal, priced based on supply/demand, and... Inflationary pressures - or lack thereof.

So, a V-shaped recovery - which I think is the least likely scenario for our recovery - would tend to bring about rising interest rates faster than any of the other possible outcomes.

If we see a V-shaped recovery it would mean that corporations' top and bottom lines are growing, fueling economic growth where personal consumption has lagged. They're selling more stuff, charging more for it, and boosting profit margins. In such an environment, stock market returns would likely be strong relative to the perceived risk. So, investors would pull money out of savings, and safer investment vehicles (bonds, mortgage backed securities, etc.) to deploy that money in stocks for greater returns. This would decrease demand for those bonds and MBS, at the same time that the supply of Treasuries is burgeoning - to finance our increasing deficits. With supply up, and demand down, rates would rise to entice investors to keep money in bonds/treasuries/mortgage backed securities rather than deploying it elsewhere. However, as I've said before, I think the excess capacity in our economic engine, combined with rising unemployment, increased savings, and decreased consumption will likely prevent us from seeing too much of a V shaped recovery, despite the stock market's current rally.

A U shaped recovery would have our economy lazily kicking around the lower end of the recovery spectrum for a period of time - possibly an extended period - if our recovery ends up more like a bathtub, than a U.

In this environment, corporate earnings would likely languish for some time. They've done an amazing job of cutting costs, increasing productivity and protecting margins so far, despite significant drops in sales across most industries. But, cost-cutting can only go so deep. We may be close to that point. Once you've cut to the bone, you have to start healing the flesh to grow again. Where will that growth stem from?

In this U shaped environment, corporate earnings may languish across most industries for a while. There will certainly be winners and losers, and occasional rallies, as well as niches where pricing power remains in tact, or new growth is solid, but for the broader economy, this could be a tough environment.

We may find that the recession ends, but...it won't feel like it to the 1 in 10 people who don't have a job, and another 1 in 10 who are working less than they want/need. In this environment, investors may welcome a steady, relatively safe return for their savings, driving demand for bonds, treasuries and mortgage backed securities, thus keeping rates relatively low.

A W shaped recovery would probably be pretty volatile with wide swings in all markets across asset classes. We're sort of seeing the stock market on this trajectory now, without any real turnaround in the underlying economic fundamentals - at least not yet. This would be an environment where keeping your eyes on the road would be critical. Having a sense of the underlying trends in equities and fixed investment vehicles would be invaluable to making the right decisions about how and when to deploy your money.

Lastly, there's the L-shaped recovery. It's really not a recovery at all. It could be akin to Japan's "lost decade" where, according to The Guardian "From its 1989 peak of 38,916, the Nikkei stock average fell 63% during the 1990s; land prices slumped - a far cry from the days when the grounds of the imperial palace in Tokyo were rumoured to be worth more than all the real estate in California." But, I don't think this scenario is very likely to unfold for the US.

The Bank of Japan was slow to react to their crisis. They waited 17 months to cut their overnight lending rate, and only in the mid-90's, five to six years after their asset bubble burst, did they get down to .5%. Our Fed, on the other hand, went from 5.25% to .25% in about 18 months, from the mid-2006 to their December 2008 meeting, when they hit the range of 0%-.25%, where we still sit today.

Additionally, Bernanke and company pulled out all the economic tools and levers. They pumped massive amounts of liquidity back into our system. Yes, their balance sheet exploded, but it definitely helped a really bad economic event from turning into an economic disaster. More importantly, to very little fanfare, the Fed's balance sheet has actually shrunk this year, and is no larger now than it was just after the Lehman Brothers collapse.

And, just today, for this Bernanke has been rewarded - as I think he should be. I'm sure he'll face some heat as he is questioned by Congress to confirm his reappointment, but... Uncle Ben is the man.

And, it will be interesting to see exactly how Bernanke guides us through this cycle. He'll also have two new Board members, since Obama will likely make appointments for seats that have been vacant since 2006.

Hopefully, they'll be able to engineer us back to a solid foundation for economic growth. I'm confident they will. And I'm sure it'll prove interesting, too since they're walking a tight rope of inflation and deflation as they cross over to renewed economic growth.

Once there, they'll have to impress upon our administration and Congress that as we return to stable economic growth, it must become a priority to reduce our budget deficit. You can already hear this in Bernanke's talking points. The trajectory we're on now with our federal spending is unsustainable over the long haul.

Clearly, as Japan has evidenced, our debt to GDP ratio can climb significantly for an extended period, without driving inflation, but...at some point they - and we if we follow their path - will have to pay the piper. So far, our piper - China and our other creditors - are playing a nice tune. But, at some point, they may start to worry if we don't clearly voice our plan to repay them.

As always, I don't know how this will all play out, but I'll do my best to keep you posted, so you can make the most of your opportunities.

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	4.875%	1	5.075%	$300,000.00	$ 1,588
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	6.750%	1	6.876%	$550,000.00	$ 3,567
15 yr fixed mortgage	5.750%	1	6.005%	$550,000.00	$ 4,567
3/1 ARM	4.000%	1	4.180%	$550,000.00	$ 2,626
5/1 ARM	5.250%	1	5.470%	$550,000.00	$ 3,037
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.