Risks favor: Carefully Floating into Fed Announcement

Current Price of FNMA 5.5% Bond: $101.22, Unchanged

It’s Fed Day afternoon…and one of the most highly anticipated and hotly debated Fed Decisions will be released at 2:15pm ET. It’s interesting to see the parade of fools come on the air, who earlier this morning said that a Fed cut of 50bp would immediately cause home loan rates to drop by 50bp as well. Scary. Let’s first get to the news – then we’ll talk about what the Fed might do, likely market reaction, and what we should be saying to our clients.

The ADP Employment Report was released this morning, suggesting that Friday’s official jobs number should come in around 150,000 new jobs – which is more than double current consensus estimates. While this shows employment growth in the economy, the problem with the jobs numbers is in the inevitable revisions to follow, in that the tabulation includes previous averages – as opposed to actual numbers. It’s kind of like a meter reading on your home utility…sometimes you get an actual reading, sometimes you get an estimate based on previous usage. In times of economic growth, the average understates the amount of new jobs, because it’s based on lower levels. Conversely, and as we find ourselves today, in times of economic slowdown, averages are predicated upon higher levels, therefore overstating actual job creations.

But the ADP Report – while interesting – took a back seat to the more reliable and much weaker than expected 4th Quarter GDP Report. Fourth quarter GDP showed a 0.6% annual growth rate, almost half the 1.1% growth rate expected by economists and far below the 4.9% rate recorded during the third quarter. Overall, GDP grew by only 2.2% during 2007, the slowest growth rate since the economy was coming out of a brief recession in 2002.

So what will the Fed do? The Fed Funds Futures contracts is pricing in an 80% chance of a 50bp cut, and a 20% chance of a 25bp cut. We think a 50bp cut is likely – but should we get a 25bp cut, the statement will probably contain language that the Fed will cut further if necessary. Neither of these is very good for the long term future of mortgage rates, due to the eventual inflationary pressures the cuts will create. And Bond Traders will eventually be smart enough to figure that out.

We feel a 50bp cut is in the cards, which will take the Fed Funds Rate down to 3.0%. This would be a big help for business loans, consumer loans, Home Equity Lines of Credit and Adjustable Rate Mortgages. But how will this affect your fixed rate sheet today? As we have said for years, Fed Rate cuts do not have a direct impact on fixed mortgage rates. In fact, they often serve to push them in the opposite direction, by fanning fears of inflation when they cut – or by fighting inflation when they hike. Fixed mortgage rates are directly affected by inflation, because a fixed rate mortgage provides the investor with a fixed rate of return for a long period of time. As inflation increases, the buying power of that fixed return is eroded, because it costs more dollars to buy the same amount of goods and services. So if inflation is on the rise – investors will demand a higher fixed rate of return to compensate them for the more rapid erosion of buying power on their return.

The last time the Fed had a long cutting cycle was back in 2001. The Fed cut eleven times in eleven months, and eight of those cuts were by 50bp, for a total of a 4.75% drop in the Fed Funds Rate. But mortgage rates were actually higher throughout this drastic cutting cycle, because inflation ticked higher. Let’s look at more recent history, and as we have pointed to previously: the Fed cut by 50bp on September 18, 2007, and after prices enjoyed a move higher that afternoon, Mortgage Bonds lost 94bp over the next two days. On October 31st, the Fed lowered by 25bp…and over the next five trading days, Mortgage Bonds lost 78bp. On December 11th, the Fed lowered by another 25bp, and over the next two days, Mortgage Bonds lost 64bp. Most recently – the surprise 75bp cut by the Fed cost us about 150bp on our rate sheets over the next two days.