Mel's Blog

FOMC members, who meet June 23 and 24 to map monetary strategy, have already indicated the need to keep interest rates low for a "long time" to help revive growth. Rising Treasury bond yields, though, show that Wall Street is concerned that their policy may lead to an inflationary bubble. Ten-year notes reached an eight-month high of 3.95 percent on June 10th. The market is concerned about excess supply and does not yet understand the Fed’s exit strategy. On the other hand, the risk is that higher rates will hold back the budding economic recovery by lifting borrowing costs for existing homeowners and prospective buyers. Economists surveyed by Bloomberg forecast growth of only 0.5 percent in the third quarter, followed by the prior four consecutive quarters of shrinking GDP (gross domestic product). The World Bank estimated in its annual development-finance review that GDP in developing countries will grow just 1.2 percent this year, well off the 8.1 percent pace set in 2007 and the 5.9 percent gain in 2008. The challenge ahead for Bernanke and his colleagues is to balance any optimism with caution and communicate to the markets the clear view on rates and the exit strategy on more than one trillion dollars already pumped into the economy. They are standing at a critical crossroads.

So why the over-optimism for a quick second half recovery and the inflation fear may turn out to be somewhat pre-mature? Consumers are in the middle of a wrenching -- and historic -- adjustment. They are unloading debt taken on over the past decade as a result of cheap financing, lax lending standards and a surge in wealth from home values and stock prices that made it just a little too easy to carry the load. In April they socked away 5.7 percent of their earnings, the most in 14 years. Efforts to unload debt and rebuild savings are sure to limit the pace of economic recovery. But households have already made progress in realigning their finances and de-leveraging has been under way for more than a year already. So this ongoing adjustment is unlikely to cause a sharp upturn in the economy in the second half and may check a quick rise in consumer prices.

Last week marked one of the most volatile weeks in bonds and mortgages that we have seen for some time. Mortgage rates backed down after their upward three-week spiral. A tempering of enthusiasm about how quickly the economy will resume a pattern of growth, and no new auctions of Treasury Bonds contributed to the decline. The average 30-year mortgage rate rose to 5.59 percent earlier this month, the highest since November, before slipping to 5.38 percent during the week ended June 18. The Freddie Mac low for the year occurred twice in April at 4.78 percent. Many borrowers must be wondering whether they will be able to get back to April lows. How quickly the scenario changes when one remembers that not long back there was a lot of chatter about 4.5 percent mortgages. Now, investors demand for better returns as well as the threat by other Central banks that they would be reducing their purchases of U.S. debt have further contributed to the rise in rates. In addition, as we have seen less bad data of late, the demand for higher yields has grown as money is moving out of safer investments and into more risky investments. We are still far from conceding that we are out of the woods... and we may still see interest rates decline in the coming months if the prediction by several economists of more economic doom and gloom becomes reality.

Inflation fears are abated for the time being with weak economic demand in the U.S and abroad keeping prices in check at both the producer and consumer levels. Deflation fears have also eased with a slightly elevated core number at the producer level. The core number at the consumer level remains near the top of the Fed’s comfort zone of 1 to 2 percent, coming in at 1.8 percent on a year-over-year basis. Any number of things could derail the up-tick in growth, including a new drop in the stock market and mortgage rates rising enough to choke off refinancing and home buying opportunities. To really get things moving forward, a resumption of hiring needs to occur, as the 9.4 percent unemployment rate remains a strong deterrent to any upswing in consumer spending. Although layoffs have abated from their peaks, the 608,000 new applications for benefits filed during the week ending June 13 remains high. We note that the number of "continuing" claims -- people on unemployment rolls for some time -- slipped back this week, the first decline since January. However, it's unclear if these people have suddenly found work or simply have exhausted their benefits and are therefore no longer included in the weekly totals. We'll need to watch to see if any trend develops here.