Financial Markets Reverse on the Fed’s Mortgage Message

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As described in the Weekly Forecast, stocks and the dollar made a sharp and sudden reversal yesterday afternoon, as Wall Street rethought their initial bullish reaction to the FOMC announcement. After climbing 88.12 points to a fresh 2009 high, the Dow reversed, closing down 81.32 points to 9.748.55. And after hitting a new 2009 low, the dollar reversed.

What was “profound” is that the Fed has unequivocally telegraphed that long term interest rates are on a gradual trend up and short term interest rates are being protected at near zero for at least the next several months. This indicates a gradual unwinding of the Fed’s balance sheet and the transition of the finance industry from direct Federal Reserve support through the purchase of their securities.

In addition to what I wrote about Saturn challenging Pluto forcing the Fed to contract its purchase of mortgage securities, Saturn/Pluto represents the need for the Fed to slowly (Saturn) unwind the lending (Pluto) programs the Fed created to expand the type of collateral and duration of its discount window lending. This morning the Fed released a schedule that gradually scales back the Term Auction Facility (TAF) and the Term Securities Lending Facility (TSLF). The Fed will reduce the maturity dates “by early next year to a single cycle of 28-day funds offered every 28 days.” The Fed will also “assess whether to maintain a TAF on a permanent basis.”

Today the stock market reversed its early gains at 10:00 AM after the Fed released the new TAF and TSLF schedules, the same time data on August existing home sales was released that showed a decline instead of an anticipated increase in sales. The fact that slightly over one third of existing home sales continue to be for “distressed homes” and that 70% of homes sold were priced below $200,000, says that even with the Fed supporting low mortgage rates combined with the government’s homebuyer tax credit,* most homes for sale in most sections of the country are still not properly priced.

According to mortgage data tracker HSH Associates quoted in the WSJ Ahead of the Tape column, without the Fed’s support the national average conventional fixed rate mortgage would be about 5.9% vs. around 5.04% now. Once the Fed concludes its purchases by the end of the first quarter of 2010, I think it is more realistic to expect that mortgage rates will gradually rise to the 6.5% to 7% range.

Slack in economic terms represents a lower than normal level of resource utilization. Resources include everything from labor, factories, unoccupied homes and apartments, to unsold motor vehicles. The important thing to note about resources is they’re not fungible; excess capacity in one area of the economy cannot be matched with overused capacity in another. Some forms of capacity can simply grow stale and never be used again.

Excess capacity in the auto industry provides no relief to the need for next generation semiconductor manufacturing, just as excess capacity in luxury housing and luxury hotel rooms cannot easily be transformed into utilitarian housing and utilitarian hotel rooms. Any discussion of “slack” controlling inflation has limited utility itself.

You can still have inflation with excess capacity when operating costs are rising, a situation experienced in the stagflation of the 1970s to early 1980s. A prime example is a house or condo that could be purchased for under $200,000 that has homeowner fees, utility costs, and taxes as high as $1,000 per month.

The Fed “expects that inflation will remain subdued for some time.” With expansive Jupiter conjoining Uranus in 2010, sharp and unexpected price spikes could bring a sudden whiff of ‘70s style stagflation as some areas of the economy operate with excess capacity and other areas are more stressed.

*Banks and the real estate industrial complex have been lobbying hard for Congress to extend this program authorized under the stimulus bill beyond November 30. Republican Senator John Isakson has reintroduced his Senate bill to not only extend the tax credit until the end of 2010, but increase the credit to $15,000 and eliminate the “first time” buyer clause. For all of the opposition’s rhetoric about “government-run healthcare” and complaints that healthcare reform will increase the federal deficit, it’s interesting that deficits fly out the window when it comes to real estate. And somehow government sponsored housing subsidies do not infringe on their so-called free market capitalism.

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