We had rates for a 30 year mortgage in the Chicagoland area come close to their all time low, then start to climb higher. The Fed has done a remarkable job of propping up bond prices, which track inversely with interest rates. They have been able to keep buying bonds without adding to the national debt through quantitative easing - a.k.a. expanding the money supply. This can and has been done without stoking inflation since we currently are in a deflationary environment, rising gold and oil prices notwithstanding.

So far the only side effect we are seeing from this action is a declining dollar and increases in the prices commodities such as those mentioned above. If this goes too far we will have to become concerned about inflation. However, up to (or should I say down to) a certain point a weaker dollar actually helps our economy by making American exports cheaper for our trading partners to buy. This cheap money and cheap American exports policy is helping pull us out of the deepest recession we have had in this country since the stagflation era of the late ’70s through early ’80s.

Timing is everything. The Fed must be careful not to ease off of the stimulative actions too soon, yet they cannot wait too long to switch gears once it is clear that the economy is on the mend. The most important indication of this is in job creation as measured by increasing employment and decreasing unemployment. Since an economy as large as ours does not turn on a dime they must make their move when it is clear that the numbers are headed in the right direction but BEFORE they actually look good in order to prevent inflation from becoming a problem.

Therefore I am looking to the labor market as a way to forecast the direction of the bond market. Rates on 30 year mortgage loans will break out of the 5% to 6% range for a sustained period of time once it is clear that the recession is over, or once the Fed thinks is is over and just before the general public would perceive the economy to be back on track.

I am often asked where I think mortgage rates are headed. I have not posted a rate update in a while because nothing much had changed since my last post, where I said rates are stuck in a range between 5% and 6%. Rates drifted toward the lower end of that range for most of last month. They are starting to tick up a bit. Well qualified borrowers in the Chicagoland area are currently getting rates as low as 5.375%. As always, “well qualified” means a high FICO score (over 720 for some lenders, over 740 for others), a loan to value below 80%, a low debt to income ratio, and income you can document. A borrower also has the option, as always, to buy down their rate by paying additional points.

I hope I’m wrong about my current rate prediction, but we have more indications that rates will continue to go higher than lower. This is based on the performance of the stock market, the declining value of the dollar, and the assessment of several credible experts, including Fed chairman Bernanke. The Fed runs into a catch-22 problem. They will do all that they can to push rates lower to help the economy, but then once the economy picks up they switch to making sure inflation does not become a problem, which usually involves pushing rates higher. Market forces beyond the Feds’ control only complicate the matter. So only if the economy continues to be in the bad shape it is in now are rates likely to stay this low.

My answer to the question “should I lock in current rates or wait” is, I would not wait. I’d lock in now. Rates hit a low a couple months ago, dropping below 5% for well qualified borrowers. Freddie Mac’s mortgage rate records go back to 1971 and they had never been that low.

The experts aren’t always right, but most now say our economy will be growing again toward the end of this year. It would be great to have it both ways, to keep rates low while the economy grows out of recession, but that’s not the way it works. Let’s hope that our 401Ks, IRAs, home values and incomes rise faster than mortgage rates so that we’ll be ahead of the game in the long run.

After falling to historic lows of less than 5%, then suddenly spiking dramatically higher to almost 6%, mortgage rates have drifted down by about 1/2 percent. Here in the Chicagoland area they have been stuck in a range roughly between 5.125% and 5.625%, of course depend on factors like the borrower’s FICO score and the Loan to Value ratio of the deal. The market forces that determine what interest rates will be are engaged in a tug of war or sorts, with the result so far being a standstill.

We have the following market forces that are pushing rates higher:

1) The US Dollar falling in value against other major currencies.

Since Bonds are denominated in US Dollars, the true yield must be adjusted lower since the investors Bonds will be worth less if the Dollar is worth less than when they made their purchase. Therefore investors demand a higher rate of return on their bond purchases.

2) Anticipation of an increase in the rate of Inflation.

A higher rate of inflation makes the Dollar worth less, so as in the example above, a Bond investor will demand a higher rate of return to compensate for this lower real return due to inflation. We should note that at this point, we are only talking about anticipation or expectations due to the increase in the money supply. The actual inflation rate is quite low. According to the Bureau of Labor Statistics the CPI increased at a seasonally adjusted rate of 0.1 percent in May, at 0.0 percent or unchanged in April, and the index has fallen 1.3 percent over the last 12 months.

The economy is not nearly strong enough to create demand-pull inflation, and with high unemployment I cannot see the basis for cost-push inflation either. I think that the inflation fear mongers can be ignored for now. Given the Trilions of dollars of wealth that were destroyed in the crash of October 2008, much of an increase in the money supply will simply be sopped up in a system where banks must now deleverage to strengthen their balance sheets.

We have the following market forces that are pushing rates lower:

1) Strong demand for Bonds.

When the stock market crashed, many investors took what they had left and put it in safe havens like Bonds. The Fed’s strategic purchases of Treasuries has also kept demand strong, albeit at somewhat higher yields.

2) A Shrinking TED Spread.

The TED Spread is a commonly accepted measure of investors appetite for risk. A higher spread means investors demand higher rates to compensate for this perceived higher risk. A lower spread means investors are clam enough to accept a lower rate of return. The spread hit a high of 463 in October 2008. It is now at 42.

I like Investopedia’s explanation of the TED Spread so much I’ll quote them here - “The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing.”*
* http://www.investopedia.com/terms/t/tedspread.asp

Although I believe that inflation fears are overblown, the dollar will likely remain weak until we see strong and consistent signs of an economic recovery. The catch-22 problem is, once we do, the stronger economy will create a a stronger demand for money, which will start to push up rates. The bottom line is that given the aforementioned circumstances rates are much more likely to go higher than lower. 5% - 5.25% appears to be a pretty solid floor for the foreseeable future.