Fed's "Tough Guy" Act & Lending Rates

A: Well, it's officially summer but there is nothing hot about the markets these days. The second half recovery that economists and analysts have been predicting, certainly seems a distant memory at this point. What I see, is what so many of us have been talking about since this credit crisis began, except now its finally here. I mean, the bond insurers' saga took weeks of front lines in January, and now its actually here inflicting it's pain. The credit crunch has way more respect, now that it is causing collateral damage and dragging stocks down with it. Hmmm, to think, who would have thought that a blow to the credit engine (a.k.a. the US growth driver) would cause such worries? I mean, so what if people's houses are worth 10-20% less. And if their portfolio's are worth 15% less. And if their debt is quickly rising and costing more to maintain. And if they can no longer use their home as a nearby ATM. And if their job is at risk. The fed can always inflate us out of this mess right? Well, yea, but first we will need to deal with the 'tough guy' act and for us Manhattan real estate junkies that means discussing how lending rates may behave.

I have said before how the I believed the 2nd half recovery, if any, will be short-lived, and how I just don't see the fed starting a rate hiking campaign as soon as others (and the bond market) predict. Rate cuts and hikes are hardest to predict at the very beginning & end of the cycle; as a trader, you got used to being addicted to fed moves and their effect on markets. Rarely will the fed just throw out a cut on its own, unless it is nervously required; such as after some sort of event occurring. With housing still pressured, a weak jobs market, a broken wall street revenue model, a struggling credit market, an upcoming election, uncertain tax policy, and teetering growth, the fight against inflation will have to wait a bit more. Which brings us to the upcoming 'tough guy' act the fed will pull off in order to smoothly transition investor psychology for the coming rate hike campaign.

The fed will smooth us into a rate hiking campaign by talking before acting (in essence, doing a stealth ease by letting the markets act first), because trust me, when rates start to rise it will probably be a continuous and prolonged campaign. To fight the collapsing credit markets, housing markets, and potential effects on the US economy, the fed cut rates 7 times from Sept to April. Included in these 7 rate eases, were a few event cuts (75bps twice) to fight off the SocGen debacle and the failure of Bear Stearns as an independent company. It was serious action for a serious situation; well, not the SocGen cut as that in hindsight was simply to calm the equity markets as Int'l markets cliff dived first.

Thinking back to the Greenspan era, easy Al took us down to 1% on the funds rate in his efforts to combat the dot com collapse and short recession of 2001. He kept rates all the way down at 1% for a year; giving rise to the argument that Greenspan allowed too much lagging monetary policy, or umph, to seap into the economic system fueling the housing/credit bubble. The resulting rate hike campaign to cool things down was slow & methodical. All in all, we had 17 one quarter point rate hikes between June 2005 and June 2006; finally pausing at 5.25%. Graph below (via St. Louis Fed page):

Rate hikes are most effective in slowing down an economy that is overheating with growth, where capacity limits are reached and input prices are inflationary (wages, rents, supplies, etc.). But right now, we do not have rising wages or rents. What we have is runaway commodity inflation that is kicking us while we are on the ground struggling to get up!

Economic growth is not the cause if this inflation; at least not here in the US! Rather, we are experiencing commodity inflation as housing/credit deflates. The fed won't hike right now because the next rate hike campaign will likely be another long and calculated one. I wouldn't be surprised if the first rate hike will be 1/2 point. After that, the majority of rate hikes will likely be 1/4 point moves; a bunch of them. The problem this time around is we have no housing market boom, job growth or easy money (credit) system to go along with the real reason the fed is raising interest rates; to cool inflation! At least not at this point.

Instead of hiking, the fed will put on their tough guy act and talk about how inflation is becoming the bigger threat. It's already happening, and the markets are listening. We in essence had a stealth ease when Ben talked about the rising threat of inflation; treasury yields rose, credit got more expensive, and the effect on corporate profits was clear. Citigroup CFO, Mr. Crittendon, announced recently that "...credit costs are rising, provisions for bad consumer loans are rising, and more write-downs on subprime assets are likely". The effect on lending rates was even more clear, as rates jumped noticeably over the past 3-4 weeks; my post on May 29th discussed Bond Yields Hitting Mortgage Rates, leading me to say:

When I see what the bond market is doing (which by the way is causing some havoc in the mortgage markets with higher rates in the past week or so), I get the same feeling I got a few weeks ago: bond market is pricing in future inflation risks, not growth prospects.

How tough will the fed get before pulling the trigger? It all depends on how smooth a transition they manage to pull off before pelting us with rate hikes! For now, I think we will have some rate relief as the bond market realizes the fed won't raise rates until more economic/election uncertainties erode away. But that relief is likely to be short-lived as surging headline inflation data (the seasonal component will be removed starting in July), re-invigorates the bond market's perception of the rate hikes that will ultimately come. The first round of the tough guy act is in the books, and we have seen the effect on lending rates in the past few weeks. Expect continued volatility for mortgage rates for the next few months, with the risk clearly to the upside.

Thoughts?

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