Thursday, February 10, 2005

What Is Up With The Bond Market?

by Tom Bozzo

When last we considered such matters, right after the last FOMC action, the 10-year Treasury note yielded 4.14 percent. Since then, the big U.S. macro news has been a disappointing, but hardly disastrous, jobs report, and a FY 2006 federal budget proposal that — with smoke, mirrors, wishful thinking, and outright deception removed — looks to give us closer to a half-trillion dollar unified budget deficit for '06 and worse going forward.

And there's been some Fed tea-leaf reading to the effect that the pace of rate increases may slow, or maybe not. It depends on what the removal of the modifier "measured" means (as in "measured increases").

Yesterday's trading (mainly on the Fed watching) brought the 10-year yield down to 3.98 percent, less than 1 percent over CPI-U inflation. What are they thinking?

(I still would not chase yield even if it were dangling a La Brioche eclair just beyond my reach. My "advice" [not to be construed as actual financial advice]: if you took out a mortgage at any of the recent local interest rate peaks, as we did in the late spring when we moved, refinancing may not be a bad move.)

My candidate explanation involves, well...

Call me a conspiracy theorist, but I think the Bushit administration favors developers and builders over seniors and people who would normally save some of their disposable income. Think about the twenty-two year old who is looking at the housing market skyrocket out of control. Apartment owners rejoice. Will this be an artificial boom? I think so. Look who would benefit from an artificial boom, developers, builders, and real estate agents. Who looses? Why the people of course, the people who paid somewhat high in their homestead investment. Any ideas to add or correct on this?
From my perspective, Junior's economic policies more fundamentally favor capital over labor -- and I'd include in "labor" the group middle and upper middle class people who might have, say, large retirement account balances but not a significant amount of nonretirement savings. In that regard, you're not paranoid -- they're really out to get us.

With housing, you can't ignore the role of the Fed. Houses act like bonds in that their value goes up when interest rates go down. So, in lowering rates so much to try to keep the economy afloat after the tech bust, the Fed created conditions where you'd expect house prices to rise to some extent (quite a bit, in fact) -- so not all of the boom is artificial.

And, if you're borrowing to buy a house, there's a tradeoff between prices and interest rates -- there are combinations of rate drops and price increases that leave out-of-pocket affordability constant.

Of course, affordability has been a problem for the out of control housing markets. Various increasingly risky mortgage products have helped keep the boom alive, though the very high rates of use of variable rate, low down payment, and interest-only loans -- particularly in skyrocketing markets -- are signs of instability.

The weird phenomenon of long-term interest rates falling even as the Fed has been pushing up the short-term rates (which, the post is intended to suggest, I see as a mass hallucination on the part of the market) also makes the current situation highly unstable. The markets could wake up and spike interest rates fast, under the right conditions, and the boom will unravel messily.

When that happens, you're right -- you wouldn't want to be the last sucker to have paid bubble-era prices. And while they have benefited considerably from the boom, there are too many developers and real estate agents to weather a bust when it hits.

But there is a saying that the market can stay irrational longer than you can stay solvent. So we're basically along for the ride.

Sorry for being so long-winded!
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