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Housing Recovery Depends on a Big Peak to Trough Drop

Economic Notes for Friday, June 12th, 2009

Interest rates stabilized at the conclusion of $65 billion in new Treasury borrowing this week, mostly by sales of long-term bonds.

"Stability" is a relative term: all long-term rates have risen roughly one percent in just six weeks, and a further run-up will undercut any economic recovery. The question is whether current prospects for recovery justify this rate-surge, or is this surge already unsustainable? If the latter, what's the chance for a reversal, especially in mortgages?

In today's epic divergence in economic outlook, you found what you wanted in new data. May retail sales rose .5% -- some say presaging positive GDP, others weak-as-ever, flat after extracting a spike in gasoline prices. New claims for unemployment insurance fell close to 600,000 last week, down from the 668,000 peak in early April but almost triple anything resembling job growth.

The damage to long-term rates was entirely pushed by Treasurys -- for whatever reasons (broken markets, inflation-dollar-commodity-oil fear), more borrowing than the market could absorb. At the current deficit pace, the Treasury must repeat this week's damage-doing borrowing, $65 billion every 12 days, most of it piling up in short-term debt that must be rolled. And rolled, and rolled, and rolled...

The Fed's effort to control mortgage rates has succeeded beautifully, in the sense of restoring a proper spread between mortgages and Treasurys. Historically, a retail mortgage rate should be about 1.70% above the 10-year T-note; all through 2008 the spread ran 2.50% to 3.00%+. Today's spread is about 1.80%.

There are $10 trillion in US 1st mortgages outstanding, $5.5 trillion of those Ginnie-Fannie-Freddie "Agency" MBS, which the Fed began to buy on January 5. The market for the other $4.5 trillion is dead as a hammer, and there has been no net growth in total 1st mortgages since summer 2007. Of that Agency $5.5 trillion, Fannie and Freddie own $1.5 trillion -- portfolios embalmed, replacing loans as they are refied, foreclosed, or prepaid by sale, zero-growth. Of the remaining $4 trillion, by the end of this year the Fed will have bought $1.2 trillion. Thus spread has been restored in a market with essentially no private buyers (for that matter, few buyers for any IOUs).

Those so convinced of recovery might consider: to maintain any functioning mortgage market, the Fed has had to buy 12% of all outstanding loans, a portfolio that took Fannie and Freddie 75 years to accumulate. Only the Treasury yield-surge could push mortgages to a marginally affordable 5.75% -- certainly not borrowing demand.

Angry voice in back of room: "Hell man, that's only a half-percent above the fifty-year low in 2003!" True. However, housing recovery depends on a big peak-to-trough drop, and all recession-recoveries have required a housing recovery (and autos... heh-heh). In the recovery from the 1973-74 recession, mortgages fell from 10% peak back to 8.5% (the decline greatly magnified by rising inflation); 1979-82, from 18% to 10%; 1991-93, from 9.50% to 6.75%; and from 2000-03, 8.50% to 5.25%.

This time, from 6.50% 2004-08 to 5.75% ain't gonna cut it, especially with the most severe tightening of credit standards ever seen.

Mortgage rates will not come down unless Treasury yields do, and they are beyond Fed control. It is possible that the economy has entered a normal, cyclical recovery that will create loan demand at these and higher rates, but that is the least likely scenario. As is the inflation-dollar-commodity-oil camp, itself dependent on substantial recovery.

In scenario two, if this interlude reveals itself as a false recovery in the next 30-90 days, most likely to us, the severity of anxiety will set the boundary of rate decline. Fear would take us back to the fours, merely soggy-bottom perhaps to 5.00%.

Scenario three is the truly confounding one. Greenspan's Conundrum was the 2004 refusal of long rates to rise with a tightening Fed. Now we may be entering Bernanke's Conundrum, long rates rising despite all-time Fed ease, pushed by excessive Treasury borrowing. The only remedy: cut Federal spending. Now, in mid-recession.