RateWatch #377 – What Makes Rates Move?

October 11, 2003 by Dick Lepre

What's Happening

PPI is +0.3% overall, flat core. The dollar is at a 3-year low v the Yen. The weak dollar is a
stimulus to the economy because it makes U.S. exports less expensive. Relevant thereto, the
Commerce Department reports that the trade gap showed a decline to $32.9 billion in August from a revised $40 billion in July.

Next week there will be a lot of data:  CPI and corporate quarterly earnings reports will
drive the markets.

The Cali-forn-ya Recall

For those of you have just returned from interplanetary travel - we just recalled our governor here in what is now called Cali-forn-ya.

This was a unique event because it involved an unpopular governor and his rather unique replacement. Arnold Schwarzenegger is a person with gigantic name-recognition, a political family by marriage and a reputation as a hard-working, focused, intense individual.  In a real sense, I see him as having some similar qualities to Clinton: self-made, political Centrist and immensely charming. We have put our trust in this man because he represents, from his movies, the ability to accomplish the near-impossible. He has done similar things in his real-life.  He did not develop that body by talk or connections. Special-interest groups did not build those muscles. He worked long and hard.  He has minimal acting talent yet became a Hollywood super-star by maximizing what he had to work with.  Now it remains to be seen if he can go to Sacramento and get the politicians to

He also brings to the state something that has been absent for a few years; the ability to get
attention from the White House.

In terms of politics, I think that this election did make a statement that the population is not
particularly enamored with either major political party and is sick of the usual political rancor that
we spoke about last week. Schwarzenegger won with no platform and a "throw the bums out, trust me" campaign.  A combination of his popularity and a negative attitude to politics-as-usual
won the day.

What Makes Rates Move?

Almost all fixed rate mortgages are pooled into Mortgage Backed Securities (MBS). Pieces of these securities are then sold to investors. It is the "appeal" of these investments as compared to other investment opportunities that makes the value of the security - and thus interest rates - change.

MBS vs. Bonds

On one level Mortgage Backed Securities compete with other fixed income securities.  The most important other fixed-income securities are government debt and corporate debt. The yields on Mortgage Backed Securities are higher that treasury bonds.

The reason underlying this is not the lack of security, but the fact that when rates drop, people refinance their mortgages. The value of a security such as a bond is, after all, in its predictable cash flow. When the mortgages backing the security are prepaid, the cash flow is truncated. People who buy bonds don't want this. They want predictable cash flow. Therefore, MBS command a higher "apparent" yield.

There are a lot of economists who spend time modeling the "prepayment" risk. During the refi booms so much repeated refinancing took place that past models of prepayment risk failed and had to be made more sophisticated to cope with the "refi junkie" mentality.

Bonds vs. Stocks

Bonds (this includes MBS) compete with stocks for investors money. The linkage between the stock and bond markets is intriguing. It resembles and, to a certain extent is, an intergenerational family relationship. The parents are done working and put their money into secure things such as bonds. The kids put their money into stocks and want the value to go up endlessly.

Twenty years ago there was tension between the markets. Then, when interest rates began their near continuous decline that started in 1982, stocks and Bonds became friends and inflation was the enemy. Several times the stock-bond marriage has had disputes about inflation but right now they are in this together.

The Stocks and Bonds have made a very strong case to the Fed that the I-Monster must be
contained at any cost.

Interest rates are linked almost exclusively to the perception of inflation. When inflation looks like it is happening mortgage rates will rise. When inflation appears contained, they fall. Inflation may have been absent from the landscape for a while but it is still lurking in the background.

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