U.S. stocks reversed a morning slide to close higher, marking the second-straight day of gains.  Interest rates continued to increase on the longer-end of the curve; the re-opening of the November 9 10-yr auction didn’t go quite so swimmingly as it drew a yield of 3.34% -- average forecast was 3.30%.  (My sense is that this move in rates is more a reversal from extremely over-bought conditions than a durable move higher, for now.  Regardless, those who have carelessly jumped into the bond market have received the duration-risk backhand.) 

Financials led the broad market higher, as the belief that the economy will meaningfully improve had traders/investors thinking loan quality will improve.  Higher yields on the long end of the Treasury curve, resulting in a more positively sloped curve, also may have helped the bank stocks (borrow low and lend higher).  I don’t know, this is a different environment and I’m not sure you can come to this conclusion.  Higher rates do help the interest income side of banking, but they’ll also damage their mortgage assets, which we touch on below.  Tech and consumer staples were the other out-performing groups.

Basic material and utility shares were the hardest hit.  After performing very nicely last quarter, the utility sector is pretty much out of favor right now.  The group offers a 4%-plus yield and under-owned situation creates a nice opportunity in my view – until rates ultimately rise in a durable fashion and thus investors no longer feel they must hunt for yield within the equity market. 

The CRB Index gained a little ground yesterday despite declines in the prices of gold and crude.  Oil prices fell a bit after the weekly energy report showed refinery operating rates overwhelmed demand – gasoline stockpiles jumped 3.81 million barrels, when they were expected to decline by 300,000.  But rising prices for natural gas, nickel, corn, sugar and copper (eight-day streak of new all-time highs for copper) propelled the index higher.   

Market Activity for December 8, 2010

Mortgage Apps and Housing’s Interest-Rate Challenge

The Mortgage Bankers Association reported that their applications index slipped 0.9% last week after the prior week’s 16.5% slide.  Refinancing activity declined 1.4%, following the prior week’s 21.6% plunge.  Apps to purchase a home rose for a third-straight week, inching up 1.8% after the previous week’s 1.1% increase – the week before that saw the largest jump in two years as apps to purchase surged 14.4%.

The average contract interest rate on the 30-year mortgage rose another 10 basis points to 4.66% last week, up from the record low of 4.21% hit in mid October.  Obviously, this cost of borrowing remains extremely low – while many people today see anything above 5% as somewhat high, those who know the history understand that anything under 8% is historically an attractive rate. 

However, the current environment cannot withstand a mortgage rate in the 5%-plus range, not without further downside for housing. 

I keep a pretty good track of home prices in my vicinity and walk through homes from time to time.  Sorry to say, sellers are still living somewhat of a fantasy. Prices need to decline another 5-10% on average in my view, and probably about this level across the country.  Sure, at 4.25% for a 30-year fixed mortgage and still 3% down for most FHA loans, the market can hold at these low sales levels, but we can’t count on such extreme low levels of rates and reality is likely to force the FHA to boost the down payment requirement for all borrowers.  That means sales remain bottomed and as the shadow inventory of homes continue to flow into the market, and become actual distressed properties for sale, that means lower prices -- and more trouble for the banks over the next several months.  A 5-10% decline in home prices may not seem like much, but with roughly a third of the mortgage market with 5% equity or less (the “less” meaning the mortgage is underwater) it doesn’t take much before we’ve got another wave a strategic defaults on our hands. 

Consequences of Fed Policy

Frankly, I think higher rates are both inevitable and necessary to clear markets in a number of areas.  That is, homes prices need to fall some more in order to clear the market – find a market-clearing price.  And within the realm of other assets, higher rates are needed to get capital appropriately allocated again – instead of simply being pushed by Fed policy into certain risky assets merely because yields on safer assets are zilch.  (The rebound in stock prices has certainly helped to boost consumer activity via the wealth effect.  But with unemployment stubbornly high, consumerism will wane again when stocks inevitably move lower.)  On the more positive side, higher rates do provide savers with more income – for now the Fed is simply subsidizing bank profits at the expense of the saver, which is an unsustainable situation. 

And then we have one of the biggest consequences of Bernanke’s extreme policy decisions: the damage to pension funds.  Pension funds must accept damagingly low returns in this ultra-low interest-rate environment as they are bound to invest a large percentage of the portfolio in fixed income.  And it doesn’t end when rates rise as they get hammered when their current positions decline in value.  This results in trouble not only for the private sector (corporations that still run defined-benefit plans must face higher costs from under-funded pensions) but for the public sector too.  State and local government finances are in a world of hurt, and underfunded pension obligations exacerbate the problem. 

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Brent Vondera, Senior Analyst

Phone: 636-449-4900