Friday, November 18, 2005

Converging Interest Rates

A flat yield curve is when the interest rate on short term bond or loans is the same as the interest rate on a much longer term bond of the same riskiness. This tends to be a bad thing because it is an indicator that lousy times are coming forward in an economy near you as investors are spooked and don't think that there are (enough) long term projects that can generate good returns because there is too much current capacity out there.

Right now, as I am stealing the following graphic from the Wall Street Journal, via The Big Picture





The yield curve is extremely flat, and it looks like there is a reasonable chance of the yield curve inverting, where the short term rates are higher than the long term rates. Short term interest rates over the next couple of months look like they will be going higher than they already are. MacroBlog has a great (ongoing) series of graphs about the probability of short term interest rates at Time X. In this case, the following graph is for the interest rates after the January FOMC meeting:





So what should we expect. In any rising interest rate environment, we should expect to see fewer purchases that are interest rate sensitive as the marginal borrower backs out of buying. This is most noticable in the housing as builders are getting less optimistic. We should also expect to see a smaller share of people going into adjustable rate mortgages in the immediate future as ARMs are tied to short term rates, while fixed mortgages are tied to long term rates. People tend to go the ARM route because short term rates tend to be less than long term rates and they are cash constrained compared to risk tolerance. However if short and long term rates are equalizing, then you can buy security of a fixed rate at a very low comparative price.

As interest rates rise, there is a chance for one more refi cycle for the individuals who bought themselves the locked ARMS with either a 3 or 5 year lock and then yearly adjustments. The first of these locks are coming off the loans that originated in the middle of the boom sometime next year, and that would provide a good incentive for people to flip their mortgages when they have envelope shock when they receive their first floating statement. Michael Shedlock has a good graph of this jump:



And is this good or bad? Well,it is good for a friend of mine who is a mortgage broker, as it should provide a stream of business for him, but overall, if interest rates are higher now than when the loan originated, and median sales prices in hot markets are either stalling or declining, this is a significant bite into the refinancing engine that has powered consumer growth over the past several years. So unless wages pick up, the American consumer is going to be extremely stretched even as oil gets "cheap" again at $56/bbl.

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