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Economic Momentum In The Wrong Direction

Last night my eight year old’s basketball team was losing their semifinal game by as much as 9 points in the first three periods. In the final period however, things changed. As momentum shifted towards my son’s team, my son looked over at my wife and I and smiled. He could feel it getting better. They tied up the game at the buzzer and then eeked out a victory in overtime in the final seconds. All the kids on his team contributed and luckily, none of the parents watching needed medical attention when the final buzzer sounded. (Championship game on Saturday.)

What does this have to do with falling mortgage rates later this year? (Well, give me a second and I will figure out something. My son’s facial expressions are still vivid in my mind.)

I think the near term stabilization of inventory and level mortgage rates has got everyone seeing…hoping for a housing rebound on a national level. Many are hanging on to each price stat releases from NAR, the Census Bureau and others wondering if the next announcement will show a hint of optomism. The beginning of some sort of momentum towards a win (see, thats the link to the basketball story).

We have been seeing very optomistic news on the economic front with robust 4Q 06 GDP at a 3.5% pace (just revised to a feeble 2.2%) and the phrase housing rebound [1] has been more popular than soft landing [2] or housing bubble [3] as of late.

In Bill Gross’ Investment Outlook column this month Ten Little Assets [4] he addresses the fact that housing hasn’t been factored enough into the economic picture. As the founder of one of the world’s largest bond managers, PIMCO [5], his words resonate in the bond market like Greenspan’s still do in the stock market.

What I’ve been saying over and over again on the investment side is that the Fed will cut rates later this year and that their two key criteria will be employment and asset prices. With construction laborers about to hit the unemployment lines and the U rate in jeopardy of rising more than the Fed feels comfortable with, an ease as soon as mid-year may be in the cards. I have a strong sense as well, that mortgage credit availability is in the midst of a cyclical squeeze due to subprime defaults and “better late than never” moral suasion/congressional supervision of mortgage bankers. This should not only continue to floor the housing sector but dampen consumption, as the combined effect of layoffs and Mortgage Equity Withdrawal, “withdrawal” produce a 2% or less real and a 4% or less nominal economy. Those numbers when extended for three or four quarters (which they now have been) are the stuff leading to output gaps, rising unemployment, declining inflation, and an easing in overnight Fed Funds rates.

There has been a considerable change in the federal funds futures index [6]. Until recently, the index was predicting a flat federal funds rate for the remainder of the year. I have been a little more gloomy in this outlook for the past 6 months, based solely on the idea that weakness in the national housing hasn’t made much of an impact yet on the economy. At present, the index shows a 50% probability that the rate will hold at 5.25% and only a 5% chance rates will rise to 5.25%. The balance of probabilities are divided among a 5%, 4.75% and 4.5% rate in June.

I think one of the primary reasons for this is the anticipated (actually, its already happening) credit tightening spillover from the subprime fiasco. Underwriting changes won’t occur overnight but a gradual realization that lending risks are unacceptably high are beginning to influence lending decisions.

Economically, things are pretty subpar [7], according to the Fannie Mae economist David Berson in his weekly commentary (March 5, 2007).

real economic growth in four of the past five quarters was below 3.0 percent (a pace of growth that most analysts think represents long-term trend growth).  Because of a 5.6 percent surge in growth in the first quarter of last year, however, the growth rate of the economy from the fourth quarter of 2005 to the fourth quarter of 2006 edged up to 3.1 percent.  If the consensus forecast of 2.5 percent annualized real growth in the first quarter of 2007 is correct, then the four-quarter growth rate for real GDP will drop to 2.3 percent — a pace consistent with the trend in the annualized growth path.

Nevertheless, I’m still hoping my son’s team is able to squeak out a win on Saturday.