KWAME DUMPED, BILL “TRUMPED”, BONDS SLUMPED...for the second week in a row. Bonds were “called into the boardroom” and got hammered on every day last week before finally showing signs of stabilization on Friday. Why the continued pounding on Bonds, causing mortgage rates to keep inching higher? A combination of factors: continued surprisingly stronger than expected economic news, including Retail Sales and the Core Consumer Price Index (CPI) arriving at it’s highest levels in three years; the Bank of Japan’s clear back-off from intervention Bond buying; and a strengthening US Dollar relative to the major foreign currencies. All factors that lead Traders to fear that the Federal Reserve “inflation fighters” are watching closely…and may begin raising short-term interest rates sooner than expected. Fed Watchers currently speculate that the Fed may begin a string of rate increases this summer, rather than at the end o f the year or beginning of next as previously thought.

Adding to the positive news of the week were some great numbers for the housing and mortgage industry – Housing Starts of new homes and Building Permits were reported above consensus estimates, suggesting that the housing market remains relatively healthy in the face of rising mortgage interest rates. As correctly predicted in the previous issue, mortgage interest rates increased by about .25% last week.

BECOME AN APPRENTICE OF THE BOND MARKET BY TAKING A LOOK AT THIS WEEK’S MORTGAGE MARKET VIEW…OFFERING AN EASY TO UNDERSTAND EXPLANATION OF THE RELATIONSHIP BETWEEN BOND PRICES AND INTEREST RATES.

Word from the trading pits…one surly Bond Trader was overheard as saying “Overall Bond prices are heading lower. But there will need to be another good solid move up before we can really slam it lower. We will see that and some consolidation this week…before that big leg lower.” Remember that when Bond prices head lower, mortgage interest rates head higher. So although Bond prices appear to be stabilizing in the short term, it’s not time to break out the party hats quite yet.

Take a look at the Bond chart below – Bond prices have crashed through many levels of support, including the tough 200-day Moving Average shown in blue. Bonds appear to be moving in a disturbing pattern, showing prices stair-stepping lower as the economic news has continued to improve in recent days. The stair-stepping pattern can’t be ignored, and sure suggests that Bond prices are headed right on down the stairs…and perhaps on into the basement. It might not happen this week with a slow economic news calendar, but the next step down will likely follow soon.

Bottom Line: with slow economic news for the week, Bonds and mortgage interest rates will likely level off, barring any major geopolitical events.

"MONEY…was never a big motivation for me, except as a way to keep score. The real excitement is playing the game.”

Who said it? The infamous Mr. Donald Trump himself. But for those of us who still entertain an interest in dollars and cents, it’s sure a wise idea to understand how money works as a commodity. Since interest rates are of great concern to many, it is intriguing to truly understand how they move. Let’s take a look at the relationship between bond prices and interest rates. Start with an easy image to conjure…a seesaw. Imagine bond prices and interest rates being on opposite sides of the seesaw. As bond prices rise, interest rates decline. When bonds drop in price, interest rates go up. This is considered an “inverse relationship” and can be a bit confusing at first.

Let’s take a look at how a bond’s price and its corresponding interest rate relate to each other.

When a bond is issued, it offers a rate of return to the buyer or investor, called the Coupon Yield. Assume a Bond is issued for $1,000 with a promise to pay a 4% Coupon Yield annually to the bondholder. This would mean the investor would receive an annual 4% return or $40 per year while holding the $1,000 bond. If the demand for the bond decreases, the price will drop. Under what circumstance would demand for a particular bond decrease? When interest rates rise, new bond offerings have to be priced to yield at or close to the current, higher interest rate in order to attract investors and their cash. Lower yielding bonds would then be less attractive to bond investors. After all, why would a bond investor want to buy an older bond with a 4% yield when a newly issued bond might have a 5% yield?

Why would bonds decline in value?

One reason is inflation, because inflation means it will take more dollars to buy the same goods in the future. Since a bond pays a fixed return to its holder, inflation also means the interest received by the bondholder will be worth less over time. The higher the level of inflation, the less demand there is for existing bonds with lower coupon yields. This drives bond prices lower as they are discounted from their face value and causes yields to rise.

Also, money can be considered a commodity like coffee, metals, or even orange juice and is subject to the “law of supply and demand” just as these commodities are. When the money supply is plentiful and there is a great level of liquidity in the economy, there is more money than demand. When a country’s economy is in a recession, often times the country’s central government will try to “re-inflate” their “deflated” economy by making their money supply more plentiful. Lending institutions practically have to give their money away to make loans and they attract new borrowers with lower interest rates. However, when the money supply shrinks and demand for money increases as the economy gets re-inflated, interest rates rise.

In comparison to last weeks super hectic schedule, the economic calendar quiets down this week. The only potential market movers will be the always-exciting Initial Jobless Claims on Thursday, and the Durable Goods Orders and Producer Price Index reports on Friday.

Remember, as a general rule, when weaker than expected economic data is reported, it would indicate the economy is not improving as quickly as expected, and could cause mortgage rates to improve. Positive data would indicate a strengthening economic climate, and could cause mortgage rates to gradually climb higher.

For the week of April 19 – April 23, 2004