Craig Smith

Just when everyone was certain that long term rates would rise, they fell. Wednesday's 10-year T-note auction drew more bidders than any since '94, and its yield thumped down from near 4.00% to 3.85%, mortgages back down to 5.125%. The improvement is gradually reversing, but for the moment we're okay.

An $11.5 billion dive in consumer credit in February more than wiped out a revised gain in January, the first in 11 months. New claims for unemployment insurance were supposed to continue improvement, dropping to 433,000, but jumped to 460,000. Careful with the hosannas to March retail sales: the measure that jumped 9% was a year-over-year comparison, and March last year was the pit of panic.

The easy Treasury auction revealed the enormous gulf between the noisy sustained-recovery believers, and the quiet skeptics who elbowed to buy the bonds. Perfesser Bernanke laid it out this week: "We are still far from being out of the woods. Many Americans are still grappling with unemployment or foreclosure, or both."

Along the whole length of disagreement, the widest spot in the canyon: those who understand the impact of housing on the economy, and those who do not.

Many have believed with some merit that too many American resources have gone to housing: too much credit, too many tax benefits, too much consumption, houses too big, and too much assistance to undeserving wannbe owners. Others have believed the same things with little merit: those who think everybody should put more money into the stock market instead of those silly houses.

Nothing like a blown bubble to create momentum for re-allocation. Certified good-guy, Fed vice-chair Donald Kohn in his most recent pre-retirement farewell: "Housing is almost certainly going to be a smaller part of the economy than it was when lax credit standards encouraged overbuilding and over-borrowing."

That's fine: no more lax standards. However, Kohn went on: "Households need to continue rebuilding wealth. They became too indebted and too dependent on housing wealth to finance current purchases and provide for future events like the education of their children and their retirement. Now they need to repay debt and save more out of current income." You hear some version of that every day, but not from senior policy makers. The reason: Americans have not saved significant sums since the 1970s, and have never "built wealth" by saving from current income. We build wealth just like everyone else on earth, by the rising values of our assets.

From Kohn to the Fed's loony bin... Minneapolis Fed president Kocherlakota on Tuesday: "Yes, the housing sector is important, but residential investment makes up just 2.8% of the country's GDP. We can -- I believe that we will -- have significant growth in output without seeing a major turnaround in the housing market."

Wow. Sonny, don't believe everything that pops into your head. Talk like that makes me feel like the alumnus who hears his college football team will be "de-emphasized."

The GDP contribution of residential construction is indeed minor. However, there are other accounts. From 2002-2008, "mortgage equity extraction" as measured by the Fed often contributed as much as 8% of disposable income -- 10% in 2005. Without that addition (clearly with Greenspan's assent, clearly overdone), every GDP analysis has shown that the US would not have emerged from the '01 recession. MEW has been subtracting from income since the 2nd quarter of 2008, an overpowering headwind.

Then there's the consumption-crimping and demoralizing hit to household net worth, $7 trillion lost. And the huge, ongoing, and unrecognized losses to banks, impairing their ability to lend, and feeding a downward spiral in asset values.

Housing will get help, sooner or later (credit!). And we'll muddle, and adapt. Even if the housing de-emphasizers have their decade, we'll still out-fox ‘em. It will take time, but one genetic imperative drives homo sapiens harder than any besides sustenance and reproduction: the determination next year to live in a better cave.

A pleasant surprise in March hiring has pushed up all long-term rates: 10-year Treasurys to 3.94%, and mortgages to 5.25%.

Even better news than the jobs: rates could have gone a great deal higher. Other new data this week were as positive as employment: the ISM survey of manufacturing in March jumped past expectations to the best reading since 2004, a 59.6 reading. The level of industrial activity is still below pre-recession, but improvement is clear.

Rebounding auto sales are pulling all the way through the supply chain from inventory rebuilding to the shop floor to raw materials. Sales were 10.4 million in 2009, and the pace now is 12 million (however, note the average ‘97-‘07: 16.8 million). Hot emerging markets are also pulling exports from our most competitive industries, notably heavy equipment and IT.

All financial markets have been locked in debate for a year, one side expecting a "V" recovery and attendant inflation and rate explosion, the other skeptical of any recovery at all. The traditional hair-trigger for a "V" event, in every recovery for 60 years: the turn in the job market to self-feeding positive. Is this it? Nope.

The most important testimony: the bond market. Yes, it is a semi-closed day, Good Friday, but thin markets tend to magnify surprises, not dampen them. That rates have not rocketed today reflects the eye-glazing detail in the BLS employment stats.

The surprise: non-farm payrolls rose by 162,000 jobs, in line with forecasts for a big jump in temporary census workers; but instead 114,000 of the gain were real jobs, and January and February were revised up to positive ground. This is legitimate good news: at that pace the economy can at least absorb new entrants into the workforce; not enough to absorb the unemployed, but better.

Big print giveth, and fine print taketh away... one-third of the job gain was temp-help, and another 27,000 hired into the loopy, non-productive, healthcare Ponzi scheme. The companion survey of households found little improvement in anything, an additional 414,000 people joining the long-term unemployed in March alone, and "involuntary part-time" growing to 9.1 million.

The toughest single piece of fine print told the tale: wages in March fell. Only .1% percent, but fell. Looking farther back: job losses in recessions prior to 1990 were made good in 15-month Vees; the 1990 recession took 30 months, and the 2002 took 47; we are 27 months into this one, job losses three times as large as the prior two, and might have bottomed. Might. Neither inflation nor recovery is made of such stuff. Nor are good politics or public policy.

Long-run conclusions are inescapable. Beginning with the emergence of China circa 1990, American labor has come under fierce wage pressure. Two bubbles, stocks and housing, sheltered the economy for a time. Today there is no such shelter available, not in "job creation" programs or anything else. The American standard of living has and will modestly decline until we restore global competitiveness.

We will succeed and come out of this. No doubt at all. However, in the meantime, here in the happy quickening of spring, average citizens are angry at their predicament, at government, and at each other. Our politics for 200 years were based on dividing up the spoils of increasing wealth (no other nation can imagine such good fortune!).
Today, the arithmetic of pie-shrinkage is deeply upsetting to us: if you want to keep all that you have, you must take from someone else. That is the root of all of this public anger, fragmentation, and governmental dysfunction. We are not remotely conditioned to the shared sacrifice of our grandparents and parents.

There is no quick fix available, but in that knowledge, and in awareness of the deeply uneven sacrifices in our society, then understanding and patience are our most plentiful and least costly resources. (As sermons go, short is better.)

In an odd leap, long-term Treasury yields blew up, Wednesday the worst single day in nine months. The 10-year T-note stopped at 3.88%, a level touched for the fifth time since last June, but the violence of this move threatens upward breakout. Meanwhile, mortgages held fairly well, inside the 5.25% top that has held since August.

The peculiar part: big sell-offs like this are driven by good economic news, but that's not what we got. February sales of new and existing homes fell (new ones at the lowest pace since stats began in 1963, 303,000 annualized), and unsold inventory rose.

Unemployment claims fell to 442,000 last week, but must drop well into the 300s to mark new hiring. The BLS says unemployment in February rose in 27 states, fell in 7, and 16 were flat. California at 12.5% unemployed rather more than offsets North Dakota at 4.1%, and Nebraska and South Dakota at 4.8%. Four states -- Florida, Nevada, North Carolina, and Georgia -- set all-time highs for percentages out of work.

So, why the rate blow-up? Three theories, so far. The first: the healthcare bill. Nobody in the credit markets believes its revenue assumptions, nor does anyone believe the expense forecast. No politics involved! If you work in the credit markets and trust government promises, your career will be short. Centerline market estimate for healthcare's annual deficit addition: $50-$100 billion. However, no matter how accurate, that's a long-term worry. Something short-term happened here.

Theory two: national debt of all kinds is in trouble, budgets from Club Med to Japan immensely out of balance, all selling mountains of new paper. Maybe, but the Europeans seem to be kicking the Grecian urn down the autobahn, no immediate crisis in prospect. Besides, that mess is pushing cash to dollars and Treasurys.

Theory three: The Fed is pulling the plug. The Fed has been buying MBS and associated Fannie-Freddie debt for fifteen months, the total roughly $1.4 trillion. This winter everyone wondered what would happen to mortgage rates when the Fed stops buying next week, but we've been watching the wrong market.

The Fed bought those Agency MBS from super-cautious investors who buy only government paper. The Fed's buys had three effects, one indirect: they did pull down mortgage-Treasury spreads, and the buys did provide "quantitative easing" (the Fed shooting money directly into the economy, bypassing busted banks that can't make loans). The third effect that most of us missed: the Fed's buys soaked up last year's entire federal deficit, pulling down Treasury yields themselves.

The mechanism: lift $1.4 trillion in government paper out of that market, and investors then used the cash to buy other government paper. Treasurys.

Next week the Fed will stop, but the Treasury will not: it will continue to sell bonds at a pace near $150 billion per month. Who will buy those bonds, and the flood issued by governments from Athens to Tokyo, and at what rates have been mysteries that will soon find answers. The Fed fears overdoing its quantitative easing: possibly inflationary, possibly generating backlash from excessive use of power, or worst of all, breeding accusations of round-heeled "monetizing" of government indiscipline.

If the Fed is out, the nightmare-dilemma end game has arrived. Cut the Keynesian deficit while the recession runs on? Or allow that spending to drive up interest rates, and maybe do more damage than fiscal discipline would do?

I think the Fed mistakes putting down panic for recovery, while we are still in a slow-motion landslide in asset values. Nothing but low rates will stop the slide. However, for the Fed to stay in the game a while longer, a commitment to fiscal discipline by Congress and Administration would be mandatory.

How different all of this might look if Mr. Obama had reversed priorities early last year: appointed a bi-partisan commission on healthcare, and put all of his momentum and majority behind getting our books in order.

Long-term Treasury rates have remained stable, the 10-year T-note in a band 3.60%-3.75% for a whole month. However, mortgages are beginning to vibrate, trying to find an appropriate level as the Fed stops buying: in just the last week rates have moved between 4.875% and 5.125%.

Treasury's are getting buying support from the slow-motion chaos in Europe. Germany has at last refused to help to Greece, saying it's an IMF problem and not the European Union's, thereby putting the rest of the Club Med dominoes on notice. Germany never has graded better than a "C" for playing well with others. France today expressed dismay at Germany's IMF proposal. Although dismay is a French specialty, it is correct: if Europe cannot look after its own, "union" is a fantasy.

As so often during fracture of a collective effort, all members overestimate their individual advantage, Germany in the lead. Actual breakup -- even the departure of Greece -- would cascade cash to the only remaining safe-haven. Us. Believe it or not.

The Fed's post-meeting statement that "Economic activity continued to strengthen..." would get a poor reception in your average Main Street saloon. Improve, yeah, in places; but, "strengthen"?... nah. If it were truly strengthening, how come exceptionally-low-rate-for-extended-period?

The Fed also hit the end game of its housing-forecast. In November, "Activity in the housing sector has increased"; December, "Some signs of improvement"; January, no comment; this week, "Housing starts have been flat at a depressed level."

Every administration must generate happy-talk forecasting. However, Tuesday's Geithner-Orszag-Romer official report to Congress was either the most honest ever, or if happy-spun we're in more difficulty than the Fed will acknowledge. We will not see 200,000 jobs created in a month until sometime in 2011, unemployment will still be 9% at the end of 2011, and 8% a year after that. Stranger than honesty, the report www.treas.gov/press/releases/tg589.htmrecites mini-policies but is void of real stuff, nothing on what really ails the economy and inhibits recovery, or what to do. With that backdrop, the Fed next week will stop buying MBS.

Play the tape all the way back. The housing Bubble Zones began to deflate at the end of 2005. The wholesale bank run and credit collapse began in July 2007, and the Fed began to cut the overnight cost of money. Market rates, mortgages included, did not follow, as global cash instead ran to somebody's -- anybody's -- Treasury paper. Early in 2008 mortgage rates rose almost to 7% and many classes of mortgages became unobtainable, some for good (toxics), some for ill (jumbos, sensible underwriting). That credit drought pulled the housing collapse beyond the Bubble zones before the recession really hit, post-Lehman, fall 2008.

Incredibly to me, the Fed did nothing to support mortgage markets until it announced its MBS-buying intentions at Thanksgiving 2008, and did not begin to buy until January ‘09. Yes, the Fed could argue that such dramatic action could not be taken until the precipice was clear to politicians. The counter: no American recessions in the last 40 years ended until a deep drop in mortgage rates ignited housing. We still don't have a deep drop. The rate centerline during the Fed's 2009 buys has been the same as 2002-2003, and barely more than 1% below the 2004-2008 average -- and much of that benefit has been cancelled by hysterical tightening of credit standards at Fannie and Freddie (mercifully, the FHA has held constant, standards the same since WWII, no easier during the Bubble, no tighter now.)

The housing market has gradually fallen out from under the Fed's support in the last year, demand flat at best versus increasing distressed inventory.

The utterly wacky, perverse good news: so far, perhaps due to diminished demand, perhaps because the Fed has not merely bought but removed altogether from the table $1.25 trillion in MBS... mortgage rates are holding. We'll take that.

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