Mortage Rates Weekly Review, August 27, 2010

"Double, Double Toil and Trouble" are Bonds in America Headed for a Bubble

In Act 4 of Shakespear's Macbeth, three Scottish witches are making a potion designed to heap double the amount of "toil and trouble" on the new King Macbeth.  They create their potion by combining all sorts of nasty and disgusting items into a veritable stew of vileness.  Some of the ingredients are familiar to those who have read or listened to the passage: eye of newt, toe of frog, and the like. 

The US economy could be described as being a similar type of stew, filled with nastiness like excessive debt, unemployment and a lack of consumer and business spending.  A new ingredient may add to the trouble, making it "double" indeed. In tough economic times there is a natural inclination of investors to move some, or even most of their assets into the seeming "safety" of government bonds.  This has indeed been the reaction of many during the our current economic crisis.  However, the intelligence of those decisions is being called into question this week by many analysts who believe that a "bond bubble" is developing that will add to the repulsiveness of our economic stew.

We'll consider the possibility of a bond bubble after a quick review of mortgage rates for the week.

Week in review

Monday was a "wait-and-see" day with no economic data released.  Tuesday we saw--and didn't like what we saw regarding the economy. Sales for exisitng homes dropped to their lowedt rate in 15 years causing a drop in mortgage pricing.  Wedneday was a traders market day, starting better for mortgage rates but finishing modestly higher.

On Thursday mortgage pricing improved as the stock market was down follwing a Jobs Report that, while better than expected, still showed a horrible job situation is persisting in the US. Today Fed Chairman Bernanke painted a picture about the economy that was not nearly as bad as some had predicted and pledged that the Fed had plenty more it could do to stimulate the economy.  This does of confidence sent the stock market higher and the MBS market down, pushing rates back up.

For the week mortgage pricing was slightly improved over last week.

"...Fire Burn and Caldron Bubble"

Thus ends the famous line from the incantation uttered by the Scottish witches.  Is our bond market in the US beginning to bubble?  Many this week have suggested that the answer is yes.

A simplified definition of a financial or economic bubble is a period characterized by high volumes of trade in an item at values much higher than they are worth.  The two most recent examples of financial bubbles that come to mind include the high tech stock bubble which burst in 2000 and the real estate/mortgage bubble that continues to burst daily.  In both of these examples incredible volumes of transactions took place at prices that seemed crazy--and were!

In the bond market of today, particularly the US Treasury Bond market, a bubble can be seen developing.  Inflows into bond funds are at all-time highs.  Moreover, pricing has reached levels that seem crazy.  This time however, the craziness is in the opposite direction from the stock price extreme's of the tech bubble.  Inflation adjusted Treasury Bonds recently fell below 1% in yeild (return to the investor).  This means that these bonds are selling for 100 times their projected payout!

The problem is of course that if interest rates rise, the value of these bonds issued at lower yeilds will fall.  Virtually every mid to long range economic forecast I have seen calls for a gradual, yet long lasting rise in interest rates.  This could be devastating to the insitutions and individuals that played "follow the leader" into bonds.

Next week

A full range of economic data will guide the market next week.  Reports on personal income, manufacturing activity, construction spending and jobless claims will be released.  Have a great weekend!