by 19 Jan 2010

When all confidence was lost in the banking system during the fall of 2008, the marketplace responded by baking a huge "WORST CASE SCENARIO" discount into asset valuations. Stocks sold and sold and sold as the "WORSE CASE SCENARIO" implied the global economy was doomed to be sucked into a deflationary spiral. Panic was the prime source of motivation in the decision making process.

However, historic "quantitative easing" actions taken by the Federal Reserve served to re-establish CONFIDENCE in the banking system and slow the pace of global economic contraction. Although a systematic collapse had already priced into asset valuations, the Fed's liquidity measures and the rapid responses of the Treasury Department soon facilitated the restoration of status quo in the financial markets.

After five months of dramatic losses, stocks rallied from March to June 2009. In the process, job losses continued to moderate and the housing market was "rebounding" from record low levels of activity. At that time, the media was spending a great deal of energy attempting to relate asset price fluctuations to fundamental headline news. Readers often stated that LOGIC appeared to be missing from post-data/post-event value adjustments (price reactions). The media tried it's best to rationalize financial market behavior with an optimistic perception of economic reality.
We reminded all that economic outlooks were muddled with uncertainty. Forecasting models had too many variables. Assumptions were based on assumptions. Half the market said recovery, the other half said stagnate stabilization at best (we were in that camp). No accurate outlook could be made regarding the "road ahead". It was very BULL vs. BEAR. It was a trader's world, we were just living in it.
Although mixed outlooks and uncertainties were abundant, one thing was clear: the bond market did not plan on waiting around to find out what would play out down the road. The 10yr Treasury note spiked up to 4.00%, the 2s/10s yield curve set new steepness records...and mortgage rates ticked towards the mid-5.00% range. In just a few weeks.
Rates traders were quick to err on the side of caution. "Better than expected" was becoming a trend and much respect was being paid to the threat of inflation. The market actually priced in a possible Fed rate hike before the end of 2009!
This was the first hint we got about how the market might react to Federal Reserve's eventual exit from the marketplace. The market's initial "SELL NOW, ASK QUESTIONS LATER" reaction to the threat of inflation and the notion of a Fed rate hike provided a historical standard with which we can now compare current market.
Plain and Simple: upon first inspection, the bond market did not react well (at all) to the idea of inflation or FOMC interest rate hike. 
In December, a very similar set of events unfolded in the marketplace. Economic "better than expecteds" were in style, inflation was back on the radar of market watchers, and the debate over a Fed rate hike was a frequently read headline. When I wrote this on December 28, 2009, stocks were closing out the year at 2009 index highs, the 10yr Treasury note was trading at 3.85% and the most aggressive lender rate sheet was just barely paying rebate for 5.00 loan paper. After re-testing record low mortgage rate levels in late November, rates backed up considerably in December. Just like they did in July...when a very similar set of events unfolded in the marketplace.
Based on the behavior exhibited by the bond market in July 2009 and December 2009, the forecast for mortgage rates in early 2010 was not pretty. Below is our outlook for rates as written on December 23, 2009.
1. HOLD STEADY OR MOVE HIGHER: Rates could fall briefly only to rebound back to current levels or even higher. Either way, mortgage rates would bounce around a new, higher costing range. This is a favorite for early 2010. After several months of choppy economic growth, the market is beginning to REALLY believe "the worst really has been avoided". If economic activity continues to show signs of improvement (even if there are scattered setbacks), the bond market will take the "better than expected" side of the trade and mortgage rates would creep into the 5's and maybe even test the 5.50 level (at best). This is if the OPTIMISTIC ECONOMIST perception grabs hold of media headlines and news tickers. This category also includes an outlook with no short term price correction. 55% chance in short run. 75% in Q1 2010*.
2. CORRECTION BACK INTO RECENT RANGE: Rates could move back inside the confines of the range we enjoyed from August to December, and stay there (4.50 and 5.00 at best). If this occurs, it will likely be a function of mixed economic releases and a general unstable, highly uncertain economic outlook. Very similar to what we experienced from July to December. The Fed also plays a HUGE role in this theory. Their bully pulpit rhetoric must continue to fight off inflation hawks with strong dovish verbiage (dovish = low rates), or number #1 will be even more likely. If you are looking to close in January, this outlook is viable, especially if the recent rates sell off was over dramatized by very light trading conditions. 45% chance in short run. 25% in Q1 2010.
3. A DOUBLE DIP FLIGHT TO SAFETY. This is very unlikely early on in 2010, so don't get your hopes up for an immediate recovery rally that sets new all time lows. In 2010, it is possible that rates could completely recover all lost progress and move back towards record lows, but only if the economy takes a major turn for the worse. This is not something we expect to see early in 2010. Over the long haul, most economic activity is just now stabilizing, right above record low levels. <1% chance in short run. <1% chance in Q1 2010.
*read "% chance in Q1 2010" as the likelihood of the scenario being the dominate rates market theme of Q1 2010.
As I mentioned earlier, I am writing this on December 28, 2009..so I have no idea if the above outlook was accurate!
While I do hope our forecast was misguided and mortgage rates have already returned to the supportive confines of "the range"...I also hope we were right about rates. Me being right or wrong about higher or lower rates is not the point here though.  There is a broader message embedded that we all need to be reminded of now and then...
Our outlook for early 2010 was for higher mortgage rates because we know the bond market prices in an economic recovery before an economic recovery is actually confirmed (ever hear someone say the bond market is forward looking indicator of economic activity?).  
While several events could have occurred that shifted sentiment and proved us wrong, the same story will still have been the source of directionality: PERCEPTIONS OF REALITY.
Even if our timing was off, this story will not go away. Eventually the Fed will have to exit from the banking system. Eventually the Fed will have to upgrade the language of their monetary policy statement. Take note of the bond market's historic reaction to these events. Recall that rates rose rapidly when Fed rate hikes were "thought to be" coming sooner than previously forecasted. If we were wrong, we will run up against this problem again in the future.
Adam Quinones is Managing Editor of Mortgage News Daily and co-Founder of the MBS War Room. Matt Graham is the creator of the MBS War Room, a first of its kind service bringing institutional quality market data and analysis to mortgage market professionals.



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