January 24, 2005


Housing's Pillars Hold Firm: Mortgage rates are likely to stay low despite tighter money policy as inflation's weakness is expected to keep long-bond yields sliding (Christopher Farrell, 1/22/05, Business Week)

The odds are that mortgage rates will stay where they are or even trend irregularly lower this year. And this continued low level suggests the housing market's coming slowdown will be modest rather than cataclysmic in 2005.

Why should long-term mortgage rates come down? The expected rate of inflation plays a large role in setting long-term market rates. The more investors anticipate inflation, the higher the interest rate they demand to compensate them for the risk that a debauched currency will ravage the value of their fixed-income investment -- and vice versa.

But inflation isn't about to stir. The Federal Reserve Board is waging an open campaign to stem any resurgence in inflation by raising its benchmark interest rate. And consumers rebel whenever retailers try to raise prices.

Take the recent holiday season. Wal-Mart (which accounts for about 10% of the nation's retail sales) tried to avoid offering shoppers special promotions. And what did buyers do? They went elsewhere to find deals. Wal-Mart (WMT ) got the message and quickly reversed course, whipping out the markdown pen. Delta Airlines' new low-fare strategy is wreaking havoc on its competitors. The Japanese auto makers are taking market share from the Big Three with generous incentives

With so little evidence of inflation, investors have reduced the yield on the benchmark 10-year Treasury bond from around 4.6% in June to about 4.2%. With inflation heading lower this year -- and the Fed continuing to raise its benchmark interest rate -- there's additional room for further decline in bond yields and mortgage rates. "When the Fed says it wants low inflation and that it's willing to further tighten monetary conditions, the record suggests it should be taken at its word," bond mavens Van R. Hoisington and Lacy H. Hunt of Hoisington Investment Management Company wrote in their fourth-quarter 2004 outlook.

Tightening during a deflation can't help but be deflationary.

Posted by Orrin Judd at January 24, 2005 12:16 PM

Flattening the yield curve between short and long rates will cause other problems, like killing the "carry trade", or borrowing short term to invest long term. Watch for some major wipeouts among over-leveraged hedge funds. It will also do a number on the profits of the financial sector as a whole. The Fed will continue to raise rates until something breaks. Something always breaks when they raise rates.

The article doesn't mention the major reason that long rates will stay low - China and Japan. As long as they continue to buy Treasuries to manage their currency pegs, rates will stay low. When they stop, rates will rise. We don't control our financial destiny, they do.

Posted by: Robert Duquette at January 24, 2005 4:33 PM

Your mileage may differ, but I clipped this ad from last week's Maui News:

'Very old kamaaina plantation home on a charming country style corner lot. Single wall plank construction needing all the upgrades you can imagine, but it's super cute in an old fashioned way. $375,000.'

This is in a community of field hands, with no church or store or school within 10 miles.

Tell me again about deflation.

Posted by: Harry Eagar at January 27, 2005 4:27 PM

Housing costs more because there are more of us--everything else less.

Posted by: oj at January 27, 2005 6:16 PM