Wednesday 6/25/08 ........ How Will You Defend Your Castle?

By: Matthew Graham •
In A Word:

There is precious little time for preparation now.  The "dragon" is at the door!  You know, the one whose tail represents inflation, and whose flames represent economic weakness?  As mortgage professionals, the flames are generally your friend.  Though you morbidly hope for others to get burned, it ultimately helps you run your kingdom better, well, with much lower interest rates anyway.  But that tail!  Oh, the tail....  Now there's the rub.  The more swings the dragon takes with his tail, the more your castle crumbles, at least inasmuch as your walls are built of low interest rates. 

The Why:

All analogies aside, the direction of rates for the remainder of the day and quite possibly the general direction of rates in the short to mid term will be largely impacted by the FOMC's policy statement today.  Futures traders and indeed nearly every economist surveyed by major news outlets are quite positive that there will be no change in the benchmark rate.  This shifts the focus of analytical efforts entirely on squeezing as much "meaning" out of the policy statement as possible. 



 

The Numbers:

 Don't pay too much mind to this morning's numbers.  The big buys and sells will be coming in after the FOMC announcement.  The only reason to consider this morning's numbers are if you are not locked yet and are considering doing so before the announcement.

6.0% FNMA is down 3/32nds to 100-06

6.5% FNMA is down 2/32nds to 102-10

 
The News:

  •     Durable Goods Orders hit expectations exactly, of 0.0 signaling no growth and no contraction.
    • (thanks a lot!)
  • MBA purchase applications  dropped to a 6.5 year low owing to higher rates and a continuing nauseating housing market
  • New Home Sales are due out any moment, but neither this report, nor the MBA (nor durable goods for that matter) are going to have an appreciable impact on the markets on Fed Day.

Conclusion:

Of course, the weak economy will be mentioned, but how concerned are Benny and the Jets about economic weakness this time around?  The gravity of their diction has in recent weeks has been moderating.  So, too, will their verbiage today include further comments on moderation for recessionary pressure?  "Downside risks to economic growth remain, but have moderated in recent weeks" or something to that effect?  As you may already understand, this would not be good for mortgage rates.  We want some austere word choice when it comes to the weakness of the economy, as the weak economy is GENERALLY beneficial for rates.

But then there's that aspect of economic weakness that no one likes.  He's the guy you know has been made aware of your party, yet even the most tolerant and inclusive kids--the ones that get along with everyone--are still hoping he doesn't show up.  Inflation...  This too, of course, will be mentioned.  And here too, the question surrounds the gravity of Ben's diction.  If "increasing costs remain a(n) _________ concern, and the committee will act as needed to....," and that "blank" is filled in with words like leading, primary, key, important, looming, or worst of all, "increasing," this will be even worse for rates than if Uncle Ben were to come out and say we had a zero risk of further economic slowdown.

Let's recap: economic weakness: good for rates.  Inflation: bad for rates.  Future rate cuts (alluded to by the appropriate combination of abundance of future concern for economic growth combined with the appropriate dearth of stark inflation assessments, would likely help rates.  Future rate hikes, alluded to by the opposite, can go two ways.  If rationale behind future rate hikes focuses on the strengthening economy AND inflation is deemed moderate, this can actually help mortgage rates improve, but if the rationale for future hikes depends largely on combating inflation, this can be bad for rates.  Granted, as futures have indicated rate increases in the following FOMC meetings in the coming months, and as inflation has been blamed for that, the MBS market has already priced much of that risk into current issues. 

So it wouldn't be the unbelievably massive sell-off you might think.  It would take some seriously and unexpectedly extreme verbiage to catalyze that.  The technical forces created by recent market movements have actually gathered--as they do when traders are hedging for future negativity--in such a way that would allow good data today to create a much sharper rally, than bad data could create a sell-off.  That, at least, is reassuring, but again, it all depends on the verbiage.  We will still lose ground if inflation is the star of the party, but not quite as much ground as we could gain if inflation concern is muted. 

Lock or Float:

Here's something that Ben said in April regarding inflation, that it should ``moderate in coming quarters'' with a ``leveling out'' of commodity prices.  Since then, gas prices have skyrocketed and the inflation expectation component of the consumer survey has risen to its highest level in over 10 years.
 
This might lead one to the conclusion that the dragon will indeed be focusing its attacks with its tail, meaning we should all run and "lock" ourselves in the tower.  But how much of this fear has already been priced into the markets?  Difficult to say...  If you choose to leave the castle gates with me this morning, I will scout as far ahead as I can for any indication of a large tail swing (inflation verbiage).  If it warrants a retreat, I will sound the call, hopefully with enough time to get us to safety, but there are never any guarantees on dragon day, er, uh, I mean Fed Day.
 
For sure, expect volatility.  Expect a high probability that rates will move sharply in one direction and reverse course several times before deciding on their directionality.  If you can't handle the uncertainty and if the sound of the dragon outside, slamming his tail against the ground engenders too much fear for you to handle, get thee gone!  To the tower with you and "lock it!"  But if you think the serfs have overblown this fear of the dragon and that we can successfully dodge the tail, riding from the gates this morning may yield spoils untold.  Stay alert!  Have your horse ready to turn back at less than a moment's notice should you hear Arthur's knights saying "run away!"  
 
Bottom line, this is for the brave only.  The risks of the tail being more brutal than we have imagined are high.  Risks favor locking, except inasmuch as those risks are already priced into the market.  With courage, one can ride out to a position where we can exploit weakness in the dragon's tail, and if it swings, still have time to retreat, but again, if you do doubt your courage or your strength, come nay further.