http://apnews.myway.com/article/20090606/D98L67500.html

ALL BUSINESS: Bond-market rout lifts mortgage cost
 
Jun 6, 8:39 AM (ET)

By RACHEL BECK
 
 

 

NEW YORK (AP) - The Federal Reserve announced a $1.2 trillion plan three 
months ago designed to push down mortgage rates and breathe life into 
the housing market.

But this and other big government spending programs are turning out to 
have the opposite effect. Rates for mortgages and U.S. Treasury debt are 
now marching higher as nervous bond investors fret about a resurgence of 
inflation.

That's the Catch-22 threatening to make an awful housing market 
potentially worse and keep the economy stuck in a funk. Kick-starting 
the economy requires higher spending, but rising rates mean fewer 
Americans will be able to refinance their home loans. And some potential 
buyers will be shut out of the market by higher monthly payments they 
won't be able to afford.

To understand how this is all connected, you have to think like a bond 
trader. Inflation is their enemy because it means the purchasing power 
of the dollars they receive when bonds eventually are paid off will be 
diminished. The only question is by how much.

Yields on 10-year Treasury notes, a benchmark for home mortgages and 
other consumers loans, jumped from 2.5 percent in March around the time 
of the Fed announcement to as high as 3.7 percent in recent days as 
signs that efforts to stabilize the financial system and economy were 
starting to pay off. And 30-year mortgage rates jumped more than a 
quarter-point this week to 5.29 percent, the highest level since 
December, Freddie Mac reported.

"If the meltdown continues in the bond market, then mortgage yields will 
soon be at levels that choke off refinancing activity," said economist 
Ed Yardeni, who runs his own investment firm. "Even worse, they could 
abort any necessary recovery in home sales and prices."

Yardeni coined the term "bond vigilantes" in 1983 to describe how 
traders took matters into their own hands when they felt the Fed wasn't 
doing enough to fight inflation, which was running at an annual rate of 
more than 3 percent at that time.

So what has set off the vigilantes this spring, at a time when the 
consumer price index is down at an annual rate of 0.7 percent?

One explanation is that bond investors anticipate a greater supply of 
government debt being sold to fund federal spending. Investors are also 
increasingly fearful that the trillions of dollars the government will 
need to borrow in the coming years to finance the various stimulus 
programs will lead to a new bout of inflation.

The White House estimates that the government will rack up an 
unprecedented $1.8 trillion budget deficit this year - more than four 
times last year's all-time high.

"The bond market is calling the Federal Reserve out," said Mike Larson, 
a real estate analyst at Weiss Research Inc. in Jupiter, Fla. "Investors 
are saying that the Fed can't just print money out of thin air to 
finance a massive deficit."

Fed Chairman Ben Bernanke acknowledged Wednesday in congressional 
testimony that large budget deficits could threaten financial stability 
by eventually eroding investor confidence and endangering the economy's 
prospects for long-term health.

"Even as we take steps to address the recession and threats to financial 
stability, maintaining the confidence of the financial markets requires 
that we, as a nation, begin planning now for the restoration of fiscal 
balance," Bernanke told the House Budget Committee.

That kind of talk is meant to calm bond investors' nerves. It also shows 
the quandary faced by Bernanke and other federal officials. They need to 
hold down interest rates through massive government spending at the same 
time they have to deal with worries over how that spending could damage 
the economy over the long term.

After Fed policymakers this spring said they would buy billions of 
dollars of government debt and more than $1 trillion of mortgage 
securities, 30-year fixed mortgage rates fell to 4.78 percent in April, 
the lowest since Freddie Mac started surveying rates in 1971.

Sales of new and existing homes began to trend higher. Mortgage 
refinancings also jumped, allowing borrowers to lock in lower rates. Fee 
income from this activity helped lift profits at many battered banks and 
gave consumers more disposable income to spend, which helped lift their 
confidence about the economy's prospects. All that was good for the 
nation's businesses.

But now, surging mortgage rates are threatening to undermine all that. 
Seventy percent of refinancing activity could be knocked out as rates 
close in on 5.5 percent, according to Mark Hanson, a managing director 
at the independent research firm Field Check Group of Menlo Park, Calif.

That's because homeowners wouldn't get much of a benefit if a 
refinancing only reduces monthly payments a tiny bit while they are 
stuck paying closing costs that typically run about 2 percent of the 
loan amount.

Also, many homeowners who wanted to refinance didn't lock in the super-
low rates in April when the refi boom took off. "Half the deals in the 
pipeline are dead," Hanson said. "People were applying to refinance to 
improve their situation, but now they are seeing it won't be much 
improved."

All this means that even though mortgage rates are still low by 
historical standards, many of the trends that seem to be pointing to 
economic recovery in recent months could be undone fast.

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