Plenty Of Reasons Economy Might Falter

Although markets bounced back a bit Wednesday, we were all reminded Tuesday that supply and demand determine mortgage rates to a large extent.

When demand shrinks, mortgage bond prices drop and rates go up. This is what happened Tuesday when the minutes from the March 13 FOMC meeting revealed the Fed was unlikely to engage in more bond buying unless the U.S. economy deteriorates markedly.

It reminded everyone that the Federal Reserve has been propping up the entire U.S. economy by buying about 60% of the government debt issued by the Treasury Department.

Many view it as moving money from one pocket to the other, and creates the false appearance of limitless demand for U.S. debt.

Plus Treasury debt and mortgage backed securities aren’t the only debt being issued. Remember “junk” bonds?

First, they never went away – someone, or some company, always needs to borrow money at a higher rate since the lender wants to be compensated for the higher risk.

Second, just like garbage men became sanitation engineers, junk bonds become part of the “high yield” market.

I bring this up because investors in debt are always looking at different instruments with different yields, and these various bonds all compete with each other for a limited amount of investor dollars.

During the 1st quarter, the US high-yield market had its largest quarter ever with nearly $92 billion being issued, while investment-grade volume of $294 billion was the largest first quarter on record and the fifth largest quarter ever.

On the supply side, record low rates have encouraged issuers to continue to refinance debt, setting their sights on their 2014, 2015, 2016 or even longer maturities, per Thomson Reuters Data.

On the demand side, meanwhile, record low yields on US Treasuries have left high-yield bonds as the only sector where many investors believe they can find an adequate return on risk.

So not only are residential borrowers refinancing to take advantage of lower rates, but companies are as well.

Now as for the Fed’s rationale on no new quantitative easing: Is the U.S. economy really picking up steam?

Plenty of smart folks think it is.

An expanding economy can put upward pressure on interest rates. And as we saw yesterday, the belief that the Fed may think things are picking up, and therefore not feel the need to support the economy as much as it has been, can cause rates to spike.

Plus we still have our budget problems, right?

Time has begun to take its toll on the federal budget. After years of kicking the can down the road and ignoring the long-run warnings from numerous Social Security commissions (as well as others), we are running out of road.

At this point in prior recoveries, the federal deficit had clearly been lower and improving more rapidly than the current recovery.

Now, the aging of the baby boom generation and the weak pace of the recovery have produced current deficits in cash flow for Social Security.

On top of that, our continued dependence on foreign capital inflows and the assistance of the Federal Reserve produce the problem of “interest rate sensitivity in the budget.”

A return to “normal” interest rates would produce a rapid rise in federal debt service that would increase the burden of the debt.

The burden of 40 plus years of over-promising by political policymakers will not be solved by the current modest pace of the recovery.

And economists point to job gains during the current recovery being dramatically inferior to the jobless recoveries of the past. (This brings up a discussion of the globalization of production and the growth of emerging market economies, competitiveness, productivity, capital, labor, and skills beyond the scope of this simple mortgage commentary.)

Suffice it to say, the economy might be doing better, but there are plenty of reasons it might falter.

A few weeks back, Lawrence Goodman wrote in WSJ:

“The conventional wisdom that nearly infinite demand exists for U.S. Treasury debt is flawed and especially dangerous at a time of record U.S. sovereign debt issuance … in recent testimony before the Senate Budget Committee, former Federal Reserve Board Vice Chairman Alan Blinder said, ‘If you look at the markets, they’re practically falling over themselves to lend money to the federal government.’

Sadly, that’s no longer accurate. It is true that the U.S. government has never been more dependent on financial markets to pay its bills. The net issuance of Treasury securities is now a whopping 8.6% of GDP on average per annum-more than double its pre-crisis historical peak.

The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit.

Goodman notes what every family budgeter knows:

The Fed must stabilize and purposefully reduce the size of its balance sheet, weaning Treasury from subsidized spending and borrowing. Second, the government should be prepared to lure natural buyers of Treasury debt back into the market with realistic interest rates. If this happens, the resulting higher deficit may at last force the government to make deficit and entitlement reduction a priority.