Interest Rate Roundup

Wednesday, March 28, 2007

Parsing Bernanke's comments...

Ben Bernanke's comments before the Joint Economic Committee were just released. Here's the noteworthy stuff, along with my comments ...

Bernanke on housing:

"Following an extended boom in housing, the demand for homes began to weaken in mid-2005. By the middle of 2006, sales of both new and existing homes had fallen about 15 percent below their peak levels. Home builders responded to the fall in demand by sharply curtailing construction. Even so, the inventory of unsold homes has risen to levels well above recent historical norms. Because of the decline in housing demand, the pace of house-price appreciation has slowed markedly, with some markets experiencing outright price declines.

"The near-term prospects for the housing market remain uncertain. Sales of new and existing homes were about flat, on balance, during the second half of last year. So far this year, sales of existing homes have held up, as have other indicators of demand such as mortgage applications for home purchase, and mortgage rates remain relatively low. However, sales of new homes have fallen, and continuing declines in starts have not yet led to meaningful reductions in the inventory of homes for sale. Even if the demand for housing falls no further, weakness in residential construction is likely to remain a drag on economic growth for a time as home builders try to reduce their inventories of unsold homes to more normal levels."

My take: I don't believe the near-term prospects for housing are "uncertain." I believe they are grim. We simply have far too many homes on the market at prices that are still unrealistic given current market conditions. The builders are starting to "get it" -- they're cutting back production, piling on incentives, and slashing base prices to clear the decks. But with inventory levels sky-high, it's going to take a long time to get inventory back to normal.

On the existing home side of things, sellers have proven stubborn. They're still reluctant to cut prices. After another weak spring selling season, I expect more will see the light. And as prices come down to more reasonable levels, sales will pick up. But again, this is a long-term process. We're going to be dealing with a significant, fundamental supply/demand mismatch throughout 2007 and well into 2008.

Bernanke on subprime mortgages:

"Delinquency rates on variable-interest-rate loans to subprime borrowers, which account for a bit less than 10 percent of all mortgages outstanding, have climbed sharply in recent months. The flattening in home prices has contributed to the increase in delinquencies by making refinancing more difficult for borrowers with little home equity. In addition, a large increase in early defaults on recently originated subprime variable-rate mortgages casts serious doubt on the adequacy of the underwriting standards for these products, especially those originated over the past year or so. As a result of this deterioration in loan performance, investors have increased their scrutiny of the credit quality of securitized mortgages, and lenders in turn are evidently tightening the terms and standards applied in the subprime mortgage market.

"Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely."

My take: Where were these guys a year, or two, or three ago? Why wasn't something being done when lenders were writing all these junk mortgages and when standards were being thrown out the window? The mortgage "guidance" the banking regulators released had no teeth to it, and was roundly ignored. Now, we all have to deal with the fallout.

What about "spillover?" Well, I believe we will see spillover into the Alt-A segment of the mortgage market. After all, excessive risks were taken there, too. The prime market will hold up better. But even there, credit performance is worsening. The delinquency rate on prime mortgages hit 2.57% in Q4 2006, the highest since Q2 2003, and there's absolutely no reason to expect this trend toward higher DQs to reverse course.

Bernanke on inflation:

"Core inflation slowed modestly in the second half of last year, but recent readings have been somewhat elevated and the level of core inflation remains uncomfortably high. For example, core CPI inflation over the twelve months ending in February was 2.7 percent, up from 2.1 percent a year earlier. Another measure of core inflation that we monitor closely, based on the price index for personal consumption expenditures excluding food and energy, shows a similar pattern."


"Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems likely to moderate gradually over time. Despite recent increases in the price of crude oil, energy prices are below last year’s peak. If energy prices remain near current levels, greater stability in the costs of producing non-energy goods and services will reduce pressure on core inflation over time. Of course, the prices of oil and other commodities are very difficult to predict, and they remain a source of considerable uncertainty in the inflation outlook."


"Another significant factor influencing medium-term trends in inflation is the public’s expectations of inflation. These expectations have an important bearing on whether transitory influences on prices, such as changes in energy costs, become embedded in wage and price decisions and so leave a lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to be contained."

My take: Inflation has persisted at levels well above the Fed's professed 1%-2% comfort zone for many moons now. It's been nine months since the Fed stopped hiking short-term interest rates and we're still at 2.7% YOY in the core CPI. Meanwhile, oil prices are rising again, and frankly, it's not all Iran. It's too darn much money and liquidity chasing all kinds of assets, including commodities. And that is the fault of central bankers, who aren't being tight enough on the monetary policy front.

As for inflation expectations, they are NOT contained. The TIPS spread, as I've pointed out numerous times, is rising sharply. And the public's perception of future inflation is climbing as well -- respondents polled by the Conference Board expect inflation to be running at a 4.9% rate 12 months from now. That's up from 4.8% a year ago and the highest reading since October 2006. So I think the Fed has a real credibility issue here.


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