Saturday, July 08, 2006

Thirty year vs Three month Interest Rates

The Fed has raised the interest rate 17 times and the 30 year yield has gone up 2/3's of a point. The three month T-bill has jumped up in locked step with the Fed. The curve between the 3 month and the 30 year is so damn flat that you almost have to throw in the "F" word to explain how flat.

As far as the bond market is concerned, there is no extra value being demanded for long term bonds verse short term bonds. There is no reflected risk of investment. There is no perceived long term risk as there should be. What happens if 3 million homeowners default on their 30 year mortgages? At some point, note holders will be discounting loan notes to make them attractive to other investors. Long term interest rates could zoom to 20%. A thirty year note written at %5 marked to 20% is a 75% loss (you could wait 30 years and get your principle back).

Why are interest rates so low for housing? Common sense demands that you charge more for a 30 year rate than a five year rate. More can go wrong in 30 years. The words "Government Sponsored Enterprise," (GSE) like Fannie Mae or Freddie Mac come to mind. These two GSE's, through options and hedges, have "taken" the risk out of investing. Another acronym you'll hear is "MSB," "Mortgage Based Security's." It kind of reminds me of spelling out a word so you're little brother won't catch on. The next time you hear a Congressman talk about investigating the GSE's in regard to MSB's, your eyes won't gloss over anymore, you'll run for the exit!

There is a point however, when people will demand more interest for greater risk. At that point, we enter the real world.

In 1929, the Fed raised the interest rates until the stock market crashed. In today's world, the Fed is kind of like a hunter shooting at a sound in the brush. At this point, we know they hit something; we're just not sure what it is!


Anonymous said...

So lets say the recent run up of housing prices was 20% annually for the last 5 years. Lets say shit hits the fan and there were to be 20% inflation for the next 5 years...

That wipes out the gain and solves the bubble problem, no???

People who kept their down payment instead of buying a house on interest only ARM will be stuck holding worthless money???

70% of households own a house in this country... And since it models itself as the tyranny of the masses, the other 30% will be stuck forever trying to buy two million dollar studio condo???

Anonymous said...

Does inflation concentrate more power back into the already powerful??? It's a great neutralizer of democracy??? Is it a tool?

Jim in San Marcos said...

It might not turn out as you have planed.

Everyone with a variable rate mortgage would be paying Prime (20%)plus 2.5. That alone would put quit a few houses on the market.

What you suggest did hit Germany in the 30's. Unfortunately inflation is not something that you can start and then stop. Any way you look at it, inflation is a government tax. They just don't have to collect it, its built into the system.

Jim in San Marcos said...

To the second question, inflation hurts the poor and the middle class the most. It also greatly affects the retired on fixed incomes. It did destroy the German Republic.

Democracy is great if you have money in your wallet. Its too much of a luxury if you're broke.