Yields Rising: Fed Expectations Changing

A: Follow up, from my post last week on Fed nearing the end of rate cut cycle. It's one crazy world we live in, and the coming months and quarters will certainly be very interesting indeed when looking at how the Fed handles runaway commodity pipeline inflation threats at the same time they navigate through the credit crisis. I told you guys last November that mortgage rates were "...no longer tied to bond yields" as the markets re-priced risk and the bond market started to price in a slowdown and bring down yields; which didn't bring down mortgage rates! But now, the bond market seems to be pricing in a near term end to fed rate cuts! My question is, if lending rates rose while the fed eased because of the re-pricing of risk in the mortgage markets, what happens when bond yields rise on expectations of a more hawkish fed?

According to Bloomberg:

Yields on Treasury two-year notes rose to the highest level relative to the Federal Reserve's target rate in almost two years as traders pare expectations for additional reductions in borrowing costs by the central bank.

"Stocks are down, and no one wants to buy the front end if the Fed is done," said Ian Lyngen, an interest-rate strategist in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 20 primary government security dealers required to bid at Treasury auctions. "The market is clearly thinking more about a 2 percent fed funds than a 1 percent fed funds rate", said Jason Brady, a managing director in Santa Fe, New Mexico, at Thornburg Investment Management, which oversees $4 billion in fixed-income.

Traders see an 18 percent chance the Fed will keep its overnight rate unchanged on April 30, up from no chance a week ago, futures on the Chicago Board of Trade show.

This is a very important dynamic to watch for in the coming quarters: will the fed shift their focus from growth to inflation? We know that fed policy is lagging and takes time to work through the economic system; so, we have 300 basis points of cuts yet to fully show their effects! The fed clearly is noticing the stimulatory effects of these cuts on commodity prices and its debasing effects on the US dollar; it may be time for a change!

Because of the credit crisis, fed rate cuts did NOT have any effect on jumbo mortgage rates over the past 7-8 months or so. The chart on the right, courtesy of bankrate.com, shows the relationship between Fed Funds Rate (red) vs 30YR Jumbo Mortgages (blue) & 30YR FHA Mortgages (green) over the past year. Notice the separation between the jumbo rates in blue and the conforming rates in green since the start of the credit crisis: this shows you the re-pricing of risk in the mortgage markets for non-GSE backed loans and the rise in jumbo rates even as the fed eased.

Right now, the fed is nearing the end of their rate cuts but jumbo rates are still high! The point of acknowledging this is the very fact that the bond market is now pricing in a 'nearing of an end' to rate cuts due to commodity inflation pressures, bringing yields higher!

KEEP AN EYE ON HOW HIGHER BOND YIELDS MAY AFFECT LENDING RATES IN THE NEAR TERM!

I'm thinking they will. What if 10YR yields rise from 3.8% to 5% in 6-8 months time? In the world of 'repricing of risk', it was possible for bond yields & fed funds rate to come down WITHOUT lending rates following; it was because of the dysfunctional secondary mortgage markets at the time and the higher risk associated with larger non-guaranteed loans. But, if bond yields & fed funds rates start to rise in response to a more hawkish fed, it will be highly unlikely that lending rates will not follow suit higher as well!

Hence, the importance of discussing this. We never got the drop in lending rates after all the fed's actions, but will likely see the rise when rate cuts are taken back!

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