The American economy, like most world economies today, is run on a system of fiat money, or money that is assigned its value by government decree. Since this money has no intrinsic value of its own, its value and supply must be carefully managed and regulated, not just within the nation’s borders but also in accordance with the economies of all other nations. In light of this need for careful stewardship of the economy, the United States maintains a central bank, called the Federal Reserve (or, more commonly, the Fed).

The Fed as it exists today is actually the United States’ fourth attempt at founding a central bank. In the midst of the Revolutionary War, America’s Continental Congress ratified the Articles of Confederation, which, among other edicts, gave Congress the power to issue bills of credit. A private national bank, modeled after the Bank of England, was established shortly thereafter, but was denied the opportunity to become a central national bank due to unease about foreign influence and other political concerns. The official First Bank of the United States was created in 1791, and lasted 20 years before being denied a renewal of charter by President James Madison. The Second Bank of the United States opened in 1816, and it too only lasted 20 years before President Andrew Jackson shut it down. Political opposition to the very idea of a central bank had been a chief culprit of these failures, and it would be almost a century before the United States would try again.

In 1907, a profound financial panic occurred, a direct result of a failed attempt by stock traders to corner the market on shares of the United Copper Company. The failure created a series of bank runs on those institutions that had backed the bid. As is often the case with bank runs, the atmosphere of worry spread nationwide, causing other banks to suffer runs and even leading to the collapse of, at the time, the third-largest financial trust in New York City, the Knickerbocker Trust Company. With no central bank in existence to attempt stabilization of the economy with an infusion of currency, the only reason that the crisis did not fling the country into irreparable economic turmoil was the work of private business tycoons such as J.P. Morgan, who banded together and contributed much of their own capital to bolster the banks. It was this barely dodged catastrophe that led to a series of financial reforms over the next few years, culminating in 1913 when Congress and President Woodrow Wilson passed the Federal Reserve Act.

In structure, the Federal Reserve is unique among the world’s central banks. Although it is designed to function as an entity “independent” of the federal government, thereby limiting its exposure to political influence, the Fed also employs a mixture of private and public sections in its operation—most similar banks in the world operate under either entirely private or entirely public ownership. It is also the only such bank to not make its own currency (which is instead printed by the United States Treasury). The Fed is managed by a Board of Governors, all of whom are presidential appointees, and is also comprised of the Federal Open Market Committee (FOMC) and representatives from twelve other Federal Reserve Banks located throughout the country.

The Fed has been reformed a number of times since 1913, especially so after the recovery from the Great Depression. Currently, its chief mandate is to provide the means to deal with bank panics, but it also sets interest rates, operates as a lender of last resort in case the banking system is in need of capital, and generally regulates the entire money supply by balancing the factors of employment rates and inflation. The importance of these functions to the American economy cannot be overstated. Any competent financial player in any market knows that a key component of success or ruin is an ability to observe, analyze, and possibly predict the actions of The Fed…and any competent Board of Governors is aware that The Fed is being closely watched.

Market Comment
Mortgage bond prices fell again last week pushing mortgage interest rates higher. The Fed ended the mortgage backed securities purchase program last Wednesday. There was no coincidence that rates spiked higher Thursday morning with the Fed no longer there to buffer negative movements and keep rates in check. Stock strength also pressured bonds as the Dow approached the 11,000 mark.

Escalating oil prices also caused rates to spike higher as inflation fears began to increase. Fortunately the PCE Price Index data came in as expected.

Rates rose about 3/4 of a discount point for the week.

The Treasury auctions will once again take center stage this week. If foreign demand is lackluster like the last few auctions, we could see that carry over to the mortgage bond market causing rates to spike. The Fed minutes and weekly jobless claims may also move the market this week.

Treasuries
The 10 and 30-year Treasury bond yields are often viewed as “benchmarks”, reflecting the overall state of interest rates in the US economy. Many people concerned about mortgage interest rates track these bonds as a barometer for mortgage interest rates. However, in reality the Treasury and mortgage markets trade independently.

The supply and demand characteristics of Treasury bonds and mortgage-backed securities (MBSs) differ. Treasury securities represent money needed to fund the operations of the US government. MBSs, on the other hand, represent borrowing by homeowners. Demand for mortgage credit is seasonal and is also affected by the state of the overall economy. In terms of demand, Treasury securities are regarded as “risk free” investments, and often benefit from a “flight to quality” in times of financial crisis. Treasury bill, note, and bond prices are dictated by yield requirements and inflationary concerns. Because homeowners can sell or refinance their homes, investors in 30-year mortgage-backed securities usually see principal repayment in significantly shorter periods of time.

In the absence of information directly related to the mortgage interest rate markets, Treasury information can be useful. However, mortgage interest rates can vary significantly. In fact, many times the Treasuries will trade wildly while MBSs only see minor price changes and vice versa.

Market Comment
Mortgage bond prices were near unchanged last week holding mortgage rates steady. Trade was extremely volatile with swings of 1/2% in discount points common. The Treasury auctions were not as well received by foreign accounts as traders had hoped. The US relies on foreign central banks such as China to fund our deficit spending. If China were to decrease or cease purchasing US bonds and notes, rates would rise.

Interest rates finished the week near unchanged.

The inflation data will be the most important releases this week. Inflation erodes the value of fixed income securities causing prices to fall and rates to rise. The Fed meeting will also take center stage. While no rates changes are expected the wording of the release will be very important.

Trading Conditions
As we all know, mortgage interest rates change on a daily and intra-day basis. With so much fluctuation, it is often difficult to make the right decision regarding floating or locking. However, there is a difference between gambling and taking a calculated risk when making mortgage interest rate decisions. Floating into an economic release such as the employment report is usually a gamble, as was evident with the rate spike the beginning of this month. In addition, floating over a span of more than a few days is also a gamble. Unforeseen events can cause instability in the financial markets that result in mortgage interest rate fluctuation. On the contrary, floating on a day of positive market movement with no economic data the following day, while such action is still vulnerable to market movements, can be considered a calculated risk. Taking advantage of rates at the current levels ensures a historically favorable interest rate and protects against uncertainty surrounding future interest rate developments.

Market Comment
Mortgage bond prices rose last week pushing mortgage interest rates lower. Mixed data resulted in up and down trading but within a relatively narrow range. The first part of the week was positive with rates improving, but declined on Wednesday when the consumer price index and the core came in higher than expected. Inflation, real or perceived, erodes the value of fixed income investments causing prices to fall and rates to rise. We saw some of that mid-week.

Despite this, interest rates finished the week improved by about 1/8 to 1/4 of a discount point.

The US Treasury will continue the record Treasury auctions with a $44 billion 2-year note auction Monday, $42 billion 5-year note auction Tuesday, and a $45 billion 7-year note auction Wednesday. The bond market will be closed Thursday for Thanksgiving and will have a shortened trading session Friday.

Preliminary GDP
The Gross Domestic Product (GDP) is one the most important reports during any given quarter. GDP is a measure of US economic output and spending. The report is significant in that it provides investors, analysts, traders, and economists with a comprehensive report of the direction of the economy. In addition, it also influences the decisions of Federal Reserve policy makers, Congressional budget employees, and corporate financial planners.

GDP is the sum total of goods and services produced by the United States. The initial report is often based on incomplete data. Therefore, additional revisions are released over the following two months. There are often substantial differences between the initial release and the revisions. The mortgage-backed security market generally responds favorably to weaker GDP growth. The preliminary third quarter gross domestic product data this week has the potential to move mortgage interest rates. Be cautious.

Market Comment
Mortgage bond prices fell last week pushing mortgage interest rates higher. The Treasury auctions were mixed with the 3 and 10-year auctions showing decent foreign demand. Unfortunately the 30-year auction was a huge disappointment and caused mortgage interest rates to worsen Thursday. The fear of future rate hikes sent mortgage bonds lower Friday pushing mortgage interest rates higher.

For the week, interest rates rose by about 1/2 of a discount point.

The consumer price index will be the most important release this week. Any signs of inflation will generally not bode well for mortgage bonds. Retail sales and the Fed minutes are also likely to factor into trading this week. Any surprises may lead to mortgage interest rate fluctuation.

Tax Credit
A slew of professionals tied to the housing sector made eager pleas to Congress last week requesting the $8000 first time homebuyer tax credit be extended. The benefit was part of the stimulus plan and is set to expire the end of November. The White House indicated the program “helped the economy” and led to “quite a bit of success” and noted consideration of extending the program. There are additional proposals in the Senate to not only extend the program, but also to increase the tax credit and remove the first time homebuyer qualification. Unfortunately the cost to extend the credit is about $1 billion per month. This concerns politicians from both sides of the aisle. The House voted Thursday to extend the credit for American service members another 12 months. Both parties have members pushing for the extension to apply to all purchasers. Analysts indicate some sort of extension is very likely.

Last week was an example of the danger in thinking rates would always improve. The good news is that despite last week’s bounce higher, rates still remain historically favorable.