FOCUS
As expected, mortgage prepayments increased 11% in May (June reporting period), due to a seasonal rise in home sales and three extra business days. June prepayments are estimated to come in flat as a strong housing seasonal turnover could offset the impact of higher mortgage rates. Looking ahead to July, the Street expects prepayments to drop 10% to 15% because of lower seasonal turnover and a drop in day count.
As we head into the summer months the slowdown in the housing activity relative to last year continues. Perhaps this is best evidenced by the weakening in mortgage applications. For example, mortgage applications for home purchases, as measured by the Mortgage Bankers Association Index, look to be down about 15% for the second quarter versus a year ago in response to a jump in mortgage rates. Refinancing activity is down a more dramatic 35%. Thomson Financial’s economist Jeff Hall points out that the purchase index has risen only once in the last six weeks and is down a net 7.8% since the week of May 12 and the refinancing index has declined in 15 of the last 22 weeks. Interest rates on the 30-year mortgage rose for the 3 rd straight week to 6.78% up from 6.71% two weeks ago, reaching the highest level in more than four years. Clearly, the downward trend in these indexes shows that the weakening in the housing market has yet to end and may continue throughout the rest of the year as mortgage rates and historically low housing affordability continue to weigh on demand.On June 28, the Federal Open Market Committee raised the Federal Funds rate target by 25 basis points to 5.25%, marking the 17 th consecutive meeting at which the funds rate was raised. The hike itself was fully expected by the market. The language in the accompanying statement, however, was somewhat of a surprise, as the market interpreted it to be less hawkish.
The more dovish components of the statement left the impression that the Fed was leaving all of its options on the table, including a pause at future meetings. Specifically, the statement said “economic growth is moderating from its quite strong pace earlier this year”, and identified the three forces driving the slowdown: the cooling of the housing market and the lagged effects of increases in interest rates and energy prices. Moreover, while the May 10 statement said that tight resource utilization and high energy and commodity prices had the potential to “add to” inflation pressures, today’s statement said those items had the potential to “sustain” inflation. Finally, while the May 10 statement explicitly said “further policy firming may yet be needed to address inflation risks but…the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information,” the June 28 th statement eliminated the first part of the sentence.
Our takeaway from the statement is that the Fed has no bias towards tightening or pausing. The data coming out over the next month will be critical to the determination of the future course of monetary policy. In particular, we will be watching inflation, employment and housing. The PCE measure of core inflation came out on Friday June 30 and, at a 2.1% year-over-year increase, it was more benign than core CPI, primarily because it does not have as heavy a weighting for housing costs. The employment picture is murky and leaning towards weakness. A persistent inversion of the yield curve such as we have now (the Fed Funds rate is the highest point on the curve as we write this) could be a predicter of an economic slowdown that the Fed will have to notice.
Adding to this information is the continuing deterioration of the fundamentals in the housing market. The National Association of Homebuilders index of homebuilders’ confidence dropped to 42 this month, an 11-year low. A number below 50 means pessimists outnumber optimists. The Housing Affordability Index of the National Association of Realtors (NAR) dropped to 104.5 in May, the lowest since July 1989. As economist Asha Bangalore of Northern Trust points out, “The reduction in affordability of homes works against maintaining momentum in the housing market. A sharp slowing of the housing market will have significant ripple effects that will derail economic growth and raise the chances of a hard landing.” The months of supply of every type of home for sale is soaring: New homes are at 5.5 months, well above the 2005 average of 4.4 months; existing homes are at 6.4 months, a nine-year high; condominium supplies stand at 7.9 months, the highest level ever recorded by the NAR. David Rosenberg, North American Economist for Merrill Lynch, believes this does not bode well for the US economy. “There have been ten housing sector downturns in the past five decades and seven ultimately landed the economy in a full-blown recession within 24 months. The other three gave us the fabled soft landing where GDP growth slowed by an average of two percentage points.” Like any other market, when supply starts outstripping demand, prices correct. A similar turnout in the housing market could have profound ramifications for the ability to the average homeowner to extract equity from their home for the purpose of consumption.
This morning the nonfarm payroll numbers came out weaker than expected as the US economy added just 121 thousand jobs during the month of June (the market expected 175 thousand). The unemployment rate held steady at 4.6%, and average hourly earnings were up 0.5%, a little higher than expected. The Fed Funds futures market reduced the probability of another 25 bp move to 5.5% at the August 8 meeting to 63%, down from 80% yesterday.
We don’t normally make predictions about the direction of interest rates because we know we can’t predict the future and because it establishes investor expectations over something that we do not control. We would rather explain how we prepare and manage for different outcomes. Nevertheless, we believe that today’s employment data argues for the Fed pausing in August. Ultimately this decision will come down to the Federal Reserve’s focus on inflation over growth. Between now and the next meeting we will have another set of inflation data, Chairman Bernanke’s semi-annual testimony before Congress on the state of monetary policy, new housing data and another employment report. Should any of these data points prove to be unequivocally strong or if Chairman Bernanke is hawkish in his testimony, we think the Fed will raise one more time and then pause. Should the strength of the data be weak to moderate, we believe the Fed will pause at the next meeting.The Markets
Interest rates around the world are largely higher year-over-year. For example, the yield on the 10-year benchmark JGB up over 64%. Similarly, gold is up 40.9% year-over-year. Mortgage rates continue to tick up, and the Refi Index declined.
30-Jun-06 |
31-May-06 |
30-Jun-05 |
MOM % change |
YOY % change |
|
Federal Funds Rate |
5.25% |
5.00% |
3.25% |
5.0% |
61.5% |
2-year US Treasury |
5.154% |
5.037% |
3.637% |
2.3% |
41.7% |
10-year US Treasury |
5.138% |
5.121% |
3.915% |
0.3% |
31.2% |
10-year JGB |
1.930% |
1.840% |
1.174% |
4.9% |
64.4% |
10-year euro |
4.071% |
3.982% |
3.127% |
2.2% |
30.2% |
10-year UK Gilt |
4.710% |
4.591% |
4.173% |
2.6% |
12.9% |
10-year Canadian govts |
4.584% |
4.445% |
3.751% |
3.1% |
22.2% |
30 yr conventional mortgage |
6.75% |
6.57% |
5.41% |
2.7% |
24.8% |
Dollar Index |
85.16 |
84.72 |
89.09 |
0.5% |
-4.4% |
Japanese Yen |
114.47 |
112.37 |
110.93 |
1.9% |
3.2% |
S&P 500 |
1270.20 |
1270.09 |
1191.33 |
0.0% |
6.6% |
Nasdaq Composite |
2172.09 |
2178.88 |
2056.96 |
-0.3% |
5.6% |
Gold $/oz (nearby contract) |
$616.00 |
$642.50 |
$437.10 |
-4.1% |
40.9% |
Oil $/bbl (nearby contract) |
$73.93 |
$71.29 |
$56.50 |
3.7% |
30.8% |
MBA Refi Index (month-end value) |
1356.0 |
1409.0 |
2529.2 |
-3.8% |
-46.4% |
Source: Bloomberg; Japanese Yen quote is the London feed
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