Why Mortgage Rates Are Falling As Traders Change Their Inflation Expectations

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In July, both the Producer Price Index and the Consumer Price Index fell short of market expectations.  This reduces some inflationary pressures on mortgage bonds. 

Predictably, mortgage rates are improving and markets are beginning to convince themselves that inflation is contained.

This is a scary thought along the lines of wondering what the offspring of Martha Stewart and Burt Reynolds would look like.

See, once traders convince themselves that inflation is contained, they begin to change the environment variables surrounding their market positions. 

This opens the window by just a smidgeon for every trader on the face of the Earth to get a healthy dose of hubris.  Especially in securities markets.

And why is all of this happening?

1. Last week, the Fed held the Fed Funds Rate at 5.250%, signalling that the economy may be retreating from its torrid growth
2. PPI reported weaker than expected
3. CPI reported weaker than expected

The new information is causing traders to alter their inflation expectations and how the strongly the FOMC will fight inflation throughout 2006.

As an example, Monday morning, markets predicted with 90% certainty that the FOMC would increase the Fed Funds Rate to 5.50% by the end of 2006.  Within two days, that probability fell to 43%. 

Ladies and gentlemen -- that's a huge swing.

I am not saying that markets are now leaning too far away from inflation, but it's important to recognize that we are all just one strong jobs report away from nasty whip-saw action in mortgage rates.

Get it while the gettin's good, folks.  Lock your rates today.