Tuesday, December 20, 2005

Fed's take action

For the 13th time in a row the Fed has raised the federal funds rate -- a key factor that influences the cost of consumer credit and many home equity loans.
The problem for the Fed is that it can lead but others may not follow. For instance, when the Fed announced its rate hike to 4.25 percent for the federal funds rate last Tuesday, the interest rate for 10-year U.S. treasury bonds stood at 4.52 percent according to Bloomberg.
Lenders, of course, instantly responded to the Fed increase by raising the prime rate to 7.25 percent. Those with home equity loans tied to the prime rate will now see higher costs for borrowed funds. This seems entirely fair given that some credit card lenders are now getting "only" 28 percent interest on credit cards.
Considering the way rates look at this moment, you have to wonder why investors would buy 10-year bonds and lock-up their money for the risky long-term. Instead, they can buy short-term instruments for about the same return and play the market with little downside risk.
Alternatively, if you're a borrower why would you want an adjustable-rate mortgage when fixed-rate financing is available with such a small initial premium? In rough terms, you can get fixed-rate mortgage financing at 6.3 percent, a great deal when 1-year ARMs now have a 5.2 start rate -- a rate that could easily jump after 12 months -- and jump even more in the future. And if you have an ARM, interest-only or option loan why would you not refinance with a fixed rate mortgage?
Short-term rate increases above long-term interest levels are an invitation to futility for the Federal Reserve. We saw this happen in the other direction when the Fed dropped the overnight rate to 1 percent to stimulate the economy. The Fed could go no lower because its rates were already less than the level of inflation -- in effect, there was no "real" cost to borrowing.
Now we have the Fed bumping up against a ceiling which exposes the limits of its ability to manage the economy. If short-term rates top long-term rates, if there is more than one additional Fed rate increase, investors will see what economists call an "inverted yield curve" and suspect that a recession is around the corner and constrict expansion. Less growth will mean fewer new jobs as well as the loss of some existing positions -- not good news for the "demand" side of real estate marketing, the side that pressures prices upward when strong.
We should each fervently hope that the Fed's actions are on target because a mistake could have powerful consequences. Housing represents about one-fifth of all economic activity; turn up interest rates too much and one of the main drivers of U.S. prosperity can be damaged.
The Fed's actions suggest a new era of less real estate demand and thus less appreciation than we have seen in the past few years. This is going to be tough news for speculators who believed that the real estate market only moved up and only moved up quickly. A number of speculators may now find that they can no longer quickly buy and re-sell properties -- or sell at a profit.
As to borrowers without fixed-rate loans, they may soon discover that monthly costs for shelter are suddenly higher -- and potentially higher-still in the not too-distant future.


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