The Fed continued tightening today, raising the federal funds rate 25 bp to 3.25%. Amazingly, the bond markets rallied, and long term rates fell more than short term, further leveling out the yield curve. The 10 year note finished at 3.92%, down 6 ½ bp, while the 2 year note dropped 1 ½ bp to 3.64%. Only 28 bp in yield now separate the 2 year from the 10 year note. What can we make of this?
The FOMC press release stated that “pressures on inflation have stayed elevated,” and reiterated its intention to keep raising rates at a “measured pace.” With no sign that the string of interest rates hikes is coming to an end, the Fed put the markets on notice that it does not believe we are in the 8th inning of monetary tightening.
Instead, the Fed is looking to take some of the froth out of the real estate bubble. With over 30% of all home purchases now being funded through adjustable rate mortgages, the Fed is looking to take out some of the steam from real estate speculation. Increases in the Federal Funds rate have much more of an impact on ARM rates than on the longer term rates. Over the past year, the rate on a 1 year ARM has risen from 3.45% to its current 3.57%. Meanwhile, the rate on a 30 year fixed rate mortgage has declined from 5.92% to 5.11% (Bloomberg has all of this data in one convenient place).
Inasmuch as speculators interested in flipping properties are much more likely than long term buyers to use ARMs and interest-only mortgages to finance their borrowings, continued monetary tightening could take some of the pressure off the unsustainable rise in real estate values. Of course, this assumes that home buyers aren’t already so pressed by high prices that they are using ARMs simply because they couldn’t afford their monthly payments at the higher 30 year fixed rate. Either way, a new wave of mortgage refinancings is now likely, which will continue to drive consumer spending and domestic economic growth. Recent research from Dresdner Kleinwort Wasserstein shows that the amount of equity taken out and not reinvested into real estate rose by $202 billion in the past year ending in March.
As for the yield curve conundrum, it shows no sign of abating. The chart below speaks for itself.
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