WeeklyBasis 9/18: How Europe Keeps U.S. Rates Low

Rates were up .125% last week, rising off record lows touched briefly the week before. Is this the start of a rising trend? Unlikely given weak U.S. economic fundamentals, but volatility will continue as markets reconcile U.S. data with Europe’s debt crisis.

Below I cover how Europe affects U.S. rates, recap rates last week and preview next week.

So far this statement from my September Rate Outlook a few weeks ago is holding true:

Given all these fundamental and technical factors, we’ll likely be in a trading range until the September 21-22 Fed meeting, with rates +/- .25% from current levels until markets can get a clear signal from the Fed and forthcoming economic data.

Rates were up last week for a few reasons:

(1) Rates rise when mortgage bonds sell, and they sold Thursday because consumer inflation was higher. Inflation makes the future income a bond pays to an investor worth less, so bonds usually sell on inflationary threats.

(2) Despite weak manufacturing activity readings, Empire State and Philly Fed surveys last week both showed inflation creeping up. Same inflation-fear theme as noted in #1 above applies.

(3) News of central banks in Europe, U.S., Japan, England and Switzerland providing liquidity for Eurozone banks was perceived as good news causing stocks to rally, bonds to sell, and rates to rise. But this isn’t good news. It’s an acknowledgement that Eurozone defaults are imminent. The move won’t stop defaults, it’ll just help manage liquidity problems when defaults come.

But rates shouldn’t spike from here because U.S. economic fundamentals don’t support it.

Jobless claims are running at a 419,500 four-week average, and have been in this range or higher for 3 years. Home sales are driven by cash buying bargain hunters and not the broader population. And last week we learned that the consumer mood about the future is the worst since 1980, which doesn’t bode well for spending.

As for Europe’s bank liquidity, money manager Comstock Partners agreed that the stock rally and bond selloff on this news was short-sighted, and reiterated key points about sustained U.S. weakness.

Net result in near- to medium-term: flight to quality will continue with U.S. Treasuries and mortgages benefitting, keeping U.S. rates low.

Next week, we’ve got August housing starts (a measure of new homes construction which has also been dismal), August existing home sales, and the Fed’s policy announcement Wednesday following their two-day FOMC meeting.

Operation Twist is a likely outcome of that meeting, which is when the Fed shifts its debt holdings to longer durations buy selling shorter-term debt and buying longer-term debt.

This could also support lower rates in the near term, as long debt prices rise and yields (or rates) drop.

But volatility will reign supreme: investors have already been buying long Treasury debt in anticipation of Operation Twist and may sell on this announcement. And from a technical perspective, mortgage bonds are clinging to the 25-day moving average with a big gap to drop to the next support level—this could bring some upward rate risk until debt markets are spooked again by the dire Eurozone situation.

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