Are Lower Mortgage Rates Really Helping the Economy?

The Fed's intention by implementing it's Operation Twist is to lower long term rates which should lower rates for most homeowners mortgages. The theory goes that as people save money in one area they will spend it in other areas. But is this true? Can the Fed really manipulate homeowners and therefore consumers?

Will Rates Fall Low Enough to Make a Difference?

Typically most homeowners will look for at least a quarter percentage dip from their current rate to even consider refinancing their mortgage. This is more rule of thumb than anything more financially sophisticated. Some homeowners are more focused on rate, others on nominal dollar savings, and others on costs associated with refinancing. Right now most analysts expect Operation Twist to lower long term rates by 20 basis points or 0.20 percent. Based on the refinancing rule of thumb discussed above the Feds actions won't lower rates enough to provoke widespread refinancing by homeowners. If most homeowners that were qualified based on traditional measures such as credit quality and sufficient home equity have already refinanced, and that is a big assumption of course, how many of these folks will be encouraged to go out and do it again, probably having just gone through the process? In an effort to generate more revenues, banks are looking at more ways to charge fees to consumers and some of these are showing up in home loan closing costs. A borrower who refinanced 6 months ago will probably face higher closing costs requiring a bigger savings from refinancing to justify the time and expense involved.


Now that Rates Have Fallen Low Enough, Will Consumers Spend Their Savings?

We have just given the Fed the benefit of the doubt that Operation Twist was successful in lowering rates and that a slew of homeowners have rushed out and refinanced their mortgages. With lower monthly housing payments of around $200 each (I made that up. Most homeowners I've talked to seem to have a love affair with saving at least $200 to even consider refinancing) homeowners are feeling flush with cash and cannot wait to go....(drum roll please)...save it. Sure some folks are going to feel good enough, at least initially, to go out to dinner one more time each month, but how long will that good feeling last? With the latest consumer confidence figures out and not looking very optimistic, how realistic is it to think consumers will be in a spending mood?

Now That the Entire Mortgaged Population has Refinanced, What GDP Growth Can We Expect?

The most optimistic outlook would only contribute a modest bump to GDP, and that's assuming most go out and spend their savings. How do we figure this? Well, let's look at some rough numbers since we cannot be truly accurate. If there are about 75,500,000 residential mortgages on US properties and each of them were refinanced, and each could save $200 a month, and each homeowner went out and spent those extra $200 each month, that would add about 1.2% to our national GDP. For simplicity, let's ignore the velocity of money for now, because I think it is very realistic to assume not that many mortgages can or will be refinanced for various reasons already discussed. So if the actual number were half these numbers, is this a substantial boost to the economy? Maybe so if you're talking about an election year and you're looking for any port in a storm. As important as the contribution to GDP is the improvement to the US labor market, particularly in an election year. Can this modest contribution to GDP from Operation Twist help to bring down unemployment in the US? Perhaps as part of a larger package to stimulate economic growth Operation Twist can be considered a successful endeavor by the Fed, but on its own it will probably not succeed.

Twist and Shout

On Tuesday the FOMC was late in delivering it's much anticipated statement following an extended governors meeting. Apparently the wording of the final statement caused the delay. However, it should be noted that three governors voted against the statement and may have caused some of the delay in finalizing the statements language. The focus of this meeting by the markets was the Boards anticipated details on its operation "Twist", which is goofy terminology for selling short term securities and investing the proceeds in long term securities in an effort to lower long term rates and flatten the yield curve. This mechanism is meant to stimulate economic activity and resuscitate the staggering American economy. The more likely explanation for operation "Twist" is to show the public (the voting public that is) that the Fed is not standing idly by while the economy and the markets flounder. Will this latest effort achieve its goals? Only time will tell. Up to this point more dramatic actions (QE and QE2) by the Fed have not achieved their intentioned goals. It's interesting to note that typically a flat yield curve reflects a struggling economy if not outright recession. Falling long term interest rates (what the Fed is trying to achieve) reflect a market that does not anticipate growth and therefore inflation in the future. The markets could very well get spooked by the profile of the Feds desired yield curve and actually have an adverse reaction to the Feds latest actions.

What's Most Likely to Happen?

We like to anticipate what will happen so that we can look back and see how accurate (or not) we were in our assessments. Here's my take on the likely outcome of the Feds latest moves: Operation "Twist" WILL lower long term rates initially and more qualified creditworthy homeowners will be able to refinance their current mortgages and reduce their monthly obligations, more so than if nothing was done by the Fed. What is difficult to assess or establish is whether this would have occurred anyways as a result of natural market forces (investors fleeing to the safety of Treasuries) as equity markets tumble. What will not happen, unfortunately, is the Feds real desired outcome of inflating the US equity markets once again to create a wealth effect that will result in a trickle down effect that will then spur more business activity and therefore more demand for labor.

Why It Will Not Work

The Fed is trying to fix the wrong problem (slowing economic activity) using the wrong mechanism (lowering interest rates). The real problem the US finds itself with is an over-leveraged and over-burdened society that has over the last 30 or so years lived beyond its means. The Feds approach is to "fix" things so that we can all go back to doing things the way we used to. That is the wrong approach to take and it will not work. The Fed simply cannot fix this problem and it does not have the answer and should not be leaned on further to fix the economy. What the Fed can do for a start is to let the markets know that it should not be counted on for additional stimulus to inflate equity markets to create a wealth effect. Until this is done, market volatility will continue. Once investors understand that the markets must stand on their own, more realistic levels of value can be achieved and more price stability should occur. A possible outcome of this should be fewer companies trying to maintain lofty stock values to appease shareholders. The quick and dirty way to appear profitable is to cut what typically is most companies biggest expense, which happens to be labor.  Until companies reach some kind of cost/revenue equilibrium, hiring will not occur. As one of the Feds dual mandates is to maintain employment, it is in the Feds interest to let companies achieve economic equilibrium. Lower long term interest rates are not the answer to achieving this economic equilibrium.

Market Reacting to Greece Fears or Just Reacting?

From one day to the next the stock market and the bond market seem to move because of concerns in Euroland and specifically Greece. In many cases Europe and Greece seem a very convenient excuse for traders to move in and out of positions on a whim, and the media without any better explanation, are happy to use them to explain moves in the market. The reality is that the markets are sensitive to almost everything that occurs around the world, both financially and politically. To think there is no connection with Europe and Greece would be naive. However, the likely reason for the volatility in the markets is just traders moving in and out of positions trying to lock in profits and not get caught on the wrong side of a trade. Fundamentals do not seem to be relevant or that important to the markets currently. And as markets and trades are increasingly computer model driven, it is advisable for small traders and investors to stay away. Trying to guess which way the wind is blowing in a particular week could be devastating to a portfolio. The sidelines are the best bet in this environment, but if the sidelines are not for you, focus more on the technicals and less on the headlines.