A VERY FOND FAREWELL…went out last week to honor the passing of former President Ronald Reagan. Financial markets, economic data, and even geopolitical happenings around the world seemed to quiet down a bit, as our country mourned and paid respect to the former President. In honor of Friday’s funeral services, trading was closed for the day and a few economic reports were delayed for release. Mortgage bonds moved sideways for most of the week and rates were little changed.

With the next Fed meeting coming closer by the day, what’s a Fed Chairman to do? Here’s the quandary. The economy is clearly heating up, as we continue to hear strong reports for jobs, sales, profits and overall consumer sentiment. But all of this economic good news, along with fuel costs that keep inching higher, has sparked concern about inflation. The Fed needs to protect us against inflation by bumping rates higher…but the economic recovery is still in an early and fragile stage, so an overly aggressive Fed rate hike could damage the promising outlook for the US economy.

Can you see the dilemma? It’s much like a doctor determining the best medicine dosage for a sick patient. Too little medicine, and the patient will remain ill…too much medicine, and the patient could become even more seriously ill. Now Chairman Greenspan has stressed that the moves will be “measured”…that’s Green-speak for “in gradual steps”. But the growing prospects of inflation have forced the Fed to leave the door open to a more active approach, including sharper rate hikes as needed. The Fed must weigh its moves very carefully. They must give the economy just the right amount of “medicine” that will ward off inflation but not choke the strengthening economy.

SO…SINCE IT IS EXPECTED THE FED WILL DELIVER A RATE INCREASE SOON – WHAT IMPACT WILL THAT HAVE ON HOME LOAN RATES? THE ANSWER MAY SURPRISE YOU. DON’T MISS THIS WEEKS MORTGAGE MARKET VIEW.

So as inflation and the Fed assume center stage, economic data releases will become even more important to the financial markets. Traders know that Greenspan and team are watching the very same reports. And as the Fed watches and plans for their end of June meeting, Traders watch and plan their next moves. Much like a chess game, where one player tries to guess their opponents next move, Traders will be paying close attention to all the clues given in this week’s fat schedule of economic reports.

The chart below shows how Bond prices and therefore rates have been traveling sideways over the past two weeks. This follows several months of Bond prices falling with rates increasing. For the week ahead, it would take some much weaker than expected economic news to fuel a significant price bounce higher, resulting in lower rates on mortgages. On the other hand, if the economic news is much better then expected, Bond prices could make a sharp turn lower. If they fall below the floor of support at the 25-day Moving Average (see chart below), they could test the next level of support almost 100 basis points lower. A 100 basis point drop would mean about a .25% rate increase for home loans.

Bottom Line: In the absence of any big economic data surprises this week, home loan rates should continue to stabilize.

JUST LIKE AN EPISODE OF “RIPLEY’S BELIEVE IT OR NOT”…THE FED RATE HIKE ON JUNE 30TH COULD ACTUALLY HELP LOWER RATES ON HOME LOANS.

Strange, but true…When the Fed has lowered the Fed Funds Rate in the past, interest rates on mortgages have actually worsened. So it should be no surprise that when the Fed raises rates the Fed Funds Rate at the end of this month, that a bit of an improvement on home loan rates is expected.

But how does this work and why? Although it may seem counter-intuitive at first, it really does make perfect sense.

First, put yourself in the position of a mortgage bondholder…like the mortgage lender. If you lend the money, you receive interest over time. If that were a mortgage, it could be a full 30 years worth of repayments and interest. Let’s say you were going to be receiving $1,000 per month for the entire 30-year term. At first, that $1,000 may be a very fair return, as you calculate what you can do with that money every month. But over time, inflation requires that you spend more money to purchase the very same goods and services that you can purchase today for less. That same $1,000 just doesn’t go as far in future years as it does today. This eats away at the value of a long-term fixed instrument like a bond or a mortgage, and explains why inflation is the main enemy of bonds. Because bond investors are very aware of this, they will require a higher rate of return or interest on their investment to compensate them, if they feel that inflation will be increasing.

In today’s improving economic environment, inflation is expected to be on the rise. In response, interest rates on long-term bonds, like mortgages, have moved markedly higher in expectation of this. Interestingly, the increase in rates on home loans has occurred without any movement by the Fed, and some mistakenly think that this is anticipation of a Fed rate hike. Not true. Reality is that bond rates are simply pricing in the expectation of higher inflation over time.

Now think about it - a move to tighten or hike rates by the Fed is designed to slow inflation, and we can now see why tempering inflation is very good news for bond holders or mortgage lenders. With inflation reduced, the buying power of their future returns will face less erosion from the effects of inflation.

So believe it or not, this is why a Fed rate hike can actually help reduce rates on home loans.

The economic calendar gets “super-sized” this week with the addition of several reports originally scheduled for last week, postponed due to the passing of former President Ronald Reagan. The reports most likely to impact interest rates include Retail Sales on Monday, the Consumer Price Index (CPI and Core CPI) on Tuesday, and the Philadelphia Fed Manufacturing Index on Friday.

Remember, as a general rule, weaker than expected economic data is good for rates, while positive data causes rates to rise.

For the week of June 14 – June 18, 2004