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Monday, Wall Street made its verdict in the case of Government vs The Credit Markets, a knock-down, drag-out fight that may have ended last Friday. 

Government wins, but not without inflation.

To an economist, inflation is the general increase in the price of everyday goods and services that occurs over time.  It's an accurate description, but in the context of the government's actions of the last two weeks, we can get a better sense of what's impacting mortgage rates if we take that definition and reverse it.

Reversed, inflation is the devaluation of a currency, so more of said currency is required to buy the same quantity of everyday goods and services.

It's the latter interpretation that's driving Wall Street this week. 

Investors assume that the government will have no choice but to print more money to service its debts, thereby diluting the dollar's value.  Because there's more of them, after all, each dollar is worthless worth less. 

This is sometimes called "monetary supply inflation" and concerns about it caused the U.S. dollar to fall 2.4 percent versus the Euro yesterday -- the biggest one-day drop in history. 

Dollar weakness then spilled over into the commodity market because all of the instruments are priced in U.S. dollars.  Oil prices jumped $25 per barrel at one point before settling in a tad lower. 

This, too, was the biggest one-day movement in history.

And lastly, the mortgage market got hit.   Because mortgage bonds are repaid in U.S. dollars, the value of those repayments dropped.  This forced mortgage rates higher because the only way to entice investors to buy devalued mortgage-backed bonds is to offer them with a higher interest rate.

If you're wondering why conforming mortgage rates are up by 0.750 percent since last week, this is it -- it's because mortgage rates are responding to the expectations of a weaker dollar going forward.  This is the reverse of what happened in August.

So far, non-conforming mortgages including jumbo and super jumbo loans are unaffected.

In the United States, tales of economic gloom in Europe barely register in our business newspapers let alone our local ones. 

But, for Americans in need of a mortgage, what happens economically across the Atlantic Ocean can have a big impact on mortgage rates here in the United States.

It all comes down to the U.S. dollar.

After several years of strong growth, there's growing evidence of a recession in Europe's two largest economic regions:

• Germany's economy is contracting and confidence is low
• The U.K.'s economy is stagnating after 15 years of growth

So, in search of safer markets in which to invest, currency traders are flocking to the safe haven of the United States dollar.  Since late-July, the greenback is up nearly 10 percent against both the Euro and the British Pound.

This dollar movement is helping home buyers because the mortgage bonds used to make mortgage rates are priced in U.S. dollars.  So, as the dollar gains in value, it's bringing new investors into the mortgage bond market.

More demand for bonds means higher bond prices and with higher prices comes lower rates.  This is a major reason why mortgage rates have been on a slow downward trend over the past few weeks -- the dollar is carrying them lower.

Now, if this reads like jibberish, remember that you don't have to reference the dollar's relative strength any time you want a mortgage rate quote.  Track my commentary on Twitter or just email me anytime.

Today, it's the dollar that's moving markets.  Tomorrow, it could be something else.

Before getting marked-up, mortgage rates are based on the price of mortgage bonds, a complex debt security that can be dramatically simplified in three bullet points:

• An investor buys for the bond for, say, $10,000
• He collects regular interest payments on his $10,000
• When the bond "matures", he gets his $10,000 back

It's not specifically stated in the bullet points above, but all the money that changes hands in a bond's lifecycle is paid (and repaid) in U.S. dollars.  This is an important observation because it's one reason why the value of mortgage bonds will, at times, trend closely with the value of the U.S. dollar.

Last week was one of those times. 

As the U.S. dollar rallied into the weekend, the mortgage bond market reversed some its losses from earlier in the week and closed out unchanged from Monday.  It was a remarkable comeback and it happened because the dollar's rising value pumped up the relative worth of those mortgage bond repayments we talked about earlier and that attracted new investors to the market.

Like all securities, more demand drives prices higher and when mortgage prices rise, mortgage rates fall.

But a rising U.S. dollar benefits more than just today's mortgage rate shopping crowd -- it benefit's tomorrow's, too.  This is because a stronger U.S. dollar tends to keep inflation in check.

The dollar's influence on inflation is related to commodities and most are priced in U.S. dollars.  Therefore, when the dollar is strong, commodities tend to be cheap and when the dollar is weak, they tend to be expensive. 

It's a weak dollar, after all, that took most of the heat for the large Cost of Living increases Americans faced earlier this year.  And now we're seeing the reverse. 

Since July, the dollar has regained its footing and commodity prices are plunging.  Oil, for example, is off 33 percent from last month; metal and grains are following suit.  This is good news for Americans because when inflation is in check, mortgage rates have one less reason to rise. 

Remember, inflation is the enemy of mortgage rates so the absence of inflation must be a good thing..

In addition, for as long as inflation remains tolerable, the Federal Reserve is unlikely to raise the Fed Funds Rate.  That will hold Prime Rate at 5.000 percent.  For families with credit card balances and home equity credit lines, a Prime Rate "on pause" means a steady monthly payments.  Most revolving debt is tied to Prime.

Now, a strong dollar won't cure the housing market, but it should help relieve some of the external pressures on it.  A strong dollar should also help keep mortgage rates in check for a while. 

If you're in the market for a new home loan and want to be updated about the mortgage markets specific movements, just follow me on Twitter -- I update several times daily.

Last week, the Federal Reserve lowered the Fed Funds Rate by a quarter-percent but it wasn't the Fed's actions that mattered most to markets.  It was what the Fed said that did.

In its press release, Ben Bernanke & Co. specifically mentioned that:

• The U.S. economy is stabilizing over the near-term
• Inflationary threats are diminishing over the medium-term

If you are shopping for a mortgage and don't live outside the circle, the after-shocks of the Fed's press release may be the best news you hear all day. 

Just kidding.  It won't.  Just kidding.  It will.  Just kidding.  Just kidding.  Just kidding.

Read the rest of this entry »

The dollar is getting trounced today on word from China that the nation is favoring "stronger currencies over weaker ones".  This opens the door for China to dump U.S. dollars into the open market, further eroding the dollar's value.

So why does this matter to American homeowners?

Mortgage rates are based on the price of mortgage bonds.  And mortgage bonds are priced in U.S. dollars.  So, as the dollar gets weak, the value of mortgage bonds gets weak, too.  Lower values lead to lower demand which, in turn, leads to lower prices.

As the prices for bonds drop, the bond yields increase and mortgage rates go up.

Check out these U.S. dollar statistics from Bloomberg today:

• U.S. dollar is at an all-time low against the Euro
• U.S. dollar is at an all-time low against the Canadie loonie
• U.S. dollar is at a 26-year year low against the British pound
• U.S. dollar is at a 23-year year low against the Australian dollar

Ask yourself: Would you want to be holding an asset that is worth less over time?  Right.  Neither does China, and neither would a whole lot of other countries.

More dollar dumping should push mortgage rates higher going forward.

Source
Dollar Slumps to Record on China's Plans to Diversify Reserves
Agnes Lovasz and Stanley White
Bloomberg.com, November 7, 2007 07:17 EST
http://www.bloomberg.com/apps/news?pid=20601087&sid=abxV_7HapdYk&refer=home

Because commodities are priced in U.S. dollars, a devaluation of the dollar causes commodity prices to rise.  Business can choose to absorb this higher cost, or pass it on to consumers. 

At least one company is passing them on, creating inflationary pressures on the economy.  As we talk about a lot, inflation generally leads to higher mortgage rates.

This morning, Proctor & Gamble CFO Clayton Daley, Jr was on CNBC saying that higher commodity prices have forced P&G to raise its retail prices for consumer.

Commodities are basic "ingredients" that are produced by many different companies and are indistinguishable from one company to the next. 

Commodities include:

• Oil and Gasoline for heating, cooling, and production
• Wheat, Cocoa, Sugar and Cattle for food
• Lumber, Copper, Aluminum, Nickel and Zinc for construction

Proctor & Gamble makes over 100 products and higher commodity prices is forcing its production costs higher.  According to Clayton, therefore, P&G is raising consumer prices to help remain profitable.  P&G is just one of many companies following this path, I am sure.

As the dollar continues to weaken, commodity prices should continue to rise, as should production costs for U.S. businesses.  In the end, this creates inflation which further devalues the dollar and keeps the spiral twisting downward. 

For homeowners, inflation devalues mortgage bonds which pushes mortgage rates higher.

Both the European Central Bank and the Bank of England left their respective interest rates on hold, relieving some of the pressure on the U.S. dollar.

Had rates increased, it would have increased the relative return of investing in euro- or pound-denominated instruments versus investing in dollar-denominated instruments.  This would have drawn dollars from mortgage bonds and have pushed rates higher. 

But, it didn't.

Instead, mortgage bonds are flat right now as traders prepare for tomorrow's jobs report.  Whispers on the street are calling for an in-line figure -- somewhere near 100,000 jobs.

There are a lot of scenarios that could benefit mortgage rates shoppers, but I am not optimistic that we'll see them.  It's a gut feel based on stories I am reading and business leaders to whom I am talking.  I've been wrong before, though.

In a worst-case event for mortgage bonds, The Doomsday Scenario looks like this:

• August's net loss of 4,000 jobs is revised lower
• September's report exceeds the 100,000 new jobs created expectation

The combination of the above data points would suggest that the credit crunch forced a huge blow-out within Corporate America, but that the pain was ephemeral.  Such a large swing in "new jobs" would suggest that those same businesses that cried poor in August are now pressing forward with internal growth plans as if nothing ever happened.

It would suggest that businesses looked at the credit markets as just a speedbump instead of a roadblock.

This could really complicate things for the Fed come October 30-31.

Down in August, up in September means that the Fed may have jumped the gun by lowering the Fed Funds Rate by 50 basis points at its last meeting and that will spark serious discussion about the role of the Fed in the economy.

And not in a good way; in a way that will create fear and uncertainty.  Incidentally, those are the two worst caretakers for mortgage rates that I can think of.

So, as Treasury Secretary Paulson talks to the Chinese government about the Yuan (pronounced zhew-on'), there are some dire consequences for U.S. mortgage rates.

Paulson's concern is that the Chinese currency is too weak versus the U.S. dollar which keeps Chinese goods cheap for Americans.

The connection makes sense if you look at it in terms of Supply versus Demand. 

Cheaper goods means that the U.S. will continue to buy Chinese goods, directing important dollars away from the U.S. economy and into the China economy.

To force the issue, the U.S. government is talking about imposing a 27.5% tariff to "encourage the right behaviors".

So, why should you care about this as a homeowner or as a mortgage shopper? 

Because the only way that the Yuan will increase in value versus the U.S. dollar is if the Chinese buy fewer of our bonds, including those that are mortgage-backed.

Right now, when Americans spend money in China, the government there takes those dollars and buy U.S.-demonimated bonds.  Considering the sheer size of China's economy, that translates into a lot of demand for U.S. bonds.

If the Chinese stop buying bonds, the demand for the bonds will drop and that will increase the relative supply.  As any of our friends in sales would attest, the best way to sell a product in an over-supplied market is to drop the price.

When bond prices drop, interest rates go up.

Source
Chinese Yuan
Wikipedia
http://en.wikipedia.org/wiki/Chinese_yuan

Paulson, on eve of China visit, sees no quick fix
Glenn Somerville
Reuters.com, September 18, 2006, 7:26 A.M.
http://today.reuters.com/news/articlebusiness.aspx?type=ousiv&storyID=2006-09-18T112651Z_01_SP239401_RTRIDST_0_BUSINESSPRO-ECONOMY-DOLLAR-DC.XML&from=business