Keeping you updated on the Market September 1, 2008

MARKET RECAP

Everything isn’t turning up roses quite yet, but last week’s slate of economic news suggests that at least blooms are forming. Existing-home sales hit a five-month high, according to new data from the National Association of Realtors, jumping 3.1% in July to 5 million units from 4.85 million in June.

Meanwhile, on the new-home front, sales rose 2.4% in July to a seasonally adjusted annual rate of 515,000 units after falling to a revised 17-year low in June, the Commerce Department reported. More encouraging, the inventory of unsold homes declined for the second month in a row, to a 10.1 months’ supply at the current sales pace. It appears that new home sales have begun to stabilize, as sharply reduced prices have lured buyers back into the market.

Prices on both existing and new homes should continue to stabilize along with the economy. On the latter, gross domestic product grew at a seasonally adjusted 3.3% annual rate during the second quarter, exceeding most economists’ estimates by over a percentage point. The new GDP numbers reflect new data showing that exports were even stronger than first estimated and that business inventories weren’t depleted as much as earlier thought.

Further proof of a recovering economy could be found in durable goods orders – products that have a life expectancy of at least three years, including cars, computers and aircraft. They increased 1.3% in July, matching June’s revised number. Economists had predicted orders would drop 0.5%. (Overall, it was a bad week for the professional prognosticators.)

Even long-suffering shareholders in Fannie Mae and Freddie Mac had something to cheer about. It seems that the prior week’s talk of nationalization may have been premature (but that doesn’t mean it won’t happen yet). An emerging sentiment among investors is that both institutions might still have a life as independents, which lifted both Fannie’s and Freddie’s stock 50% higher. (Keep in mind, though, it doesn’t take much price movement to produce big percentage swings in a low-priced stock.)

Economic
Indicator

Release
Date and Time

Consensus
Estimate

Analysis

Construction Spending
(July)

Tues. Sept 2,
10:00 am, et

0.5%
(Decrease)

Moderately Important. Residential construction spending continues to weigh on overall spending.

Mortgage Applications

Wed. Sept 3,
7:00 am, et

None

Important. Purchase activity turned upward, suggesting increasing home buyer interest.

Factory Orders
(July)

Wed. Sept 3,
10:00 am, et

0.1%
(Increase)

Important. The rise in factory orders is another sign the economy continues to avoid a recession.

Beige Book

Wed. Sept 3,
2:00 pm, et

None

Important. Data in the book is expected to favor future interest rate increases.

Productivity and Costs
(2 nd Quarter, Revised)

Thurs. Sept 4,
8:30 am, et

Productivity: 2.4% (increase)
Costs: 1.4% (Increase)

Important. Both numbers are expected to hold near an earlier release.

Employment Situation
(August)

Fri. Sept 5,
8:30 am, et

Unemployment Rate: 5.8%
Hourly Wage: 0.3%
(Increase)

Very Important. A decrease in the unemployment rate would mean the economy is doing better than most economists think.

But the relationship isn’t exactly as you might think. Many pros will tell you that mortgage rates are tied to yields on mortgage-backed securities, like those issued and guaranteed by Fannie Mae and Freddie Mac. But if you dig deeper, you’ll find that rates are really tied to 10-year Treasury notes – a fact that has been mentioned many times in these missives.

A new study by the Columbia Business School and reported in Housing Wire explicates the relationship. The study’s authors argue that a recent rise in mortgage rates has significantly hurt home prices, reducing them by 10%. But the issue isn’t actual mortgage rates; it’s mortgage rates relative to the 10-year Treasury rate. For the past 20 years, mortgage rates have averaged 1.6% above the 10-year Treasury rate, but in today’s distressed market, mortgage rates have exceeded the 10-year Treasury rate by more than 2.4%.

The relationship is really about risk – the higher the spread, the less willing lenders are to accept risk. Higher mortgage rates relative to 10-year Treasuries make it more difficult for homeowners with subprime loans to refinance into lower rates, resulting in a greater number of foreclosures, and they discourage potential new home buyers from entering the housing market, lowering demand. Both of these effects put downward pressure on housing prices.

The study suggests that lower mortgage rates are an important factor in getting the housing market back on its feet, but lower spreads between mortgage rates and 10-year Treasury notes might be even more important.