“MR. BIG STUFF…WHO DO YOU THINK YOU ARE? MR. BIG STUFF…YOU’RE NEVER GONNA GET MY LOVE...” (Jean Knight)  Bond Traders had this tune on their mind last week, as Mr. “Big Stuff” himself, Chairman Greenspan testified before Congress as to the state of the economy. Mortgage Bonds came under pressure on his words and positive economic news for the week, and home loan rates worsened by about .125%. Here’s the scoop.

Greenspan first affirmed that the economy looks healthy, and stated "policy accommodation can be removed at a pace that is likely to be measured.” Translation: the Fed will likely continue its series of rate hikes through the summer, taking the Fed Funds Rate between 3.5% and 4.00%.

He also confirmed that although the media continues to beat the drum, a nationwide housing bubble is not eminent. He did state that a few markets where prices have risen dramatically might see a little “froth”, but not a bubble.

What caused Mortgage Bonds and home loan rates to take a hit was his “warning shot over the bow” of hedge funds and those investors hoping to make a quick buck in real estate, saying that lower long-term rates don’t make much sense. He stated, “Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates…despite a 2-percentage-point increase in the Federal Funds Rate. This is clearly without recent precedent.”

SO WHAT IS DRIVING THE BEAT OF THE “CONUNDRUM” OF PERSISTENTLY LOW LONG TERM RATES…AND WHAT MAY BE IN STORE? DON’T MISS THIS WEEK’S MORTGAGE MARKET VIEW.

A look at the economic calendar below shows that the week ahead is chock-full of economic reports for the market to move on, and it could be a volatile week for Bonds and home loan rates. Since we know that Bonds and home loan rates typically react well to disappointing or weak economic news, watch the headlines for any of these reports to come in soft…this means home loan rates could improve. And vice versa, if the economic news shows strong numbers, home loan rates could worsen in a hurry.

This week’s chart shows how Mortgage Bonds got kicked off the “up-escalator”, and it would take some mighty weak reports for them to step back on and help home loan rates continue to decline.

And Chairman Greenspan called attention to the Consumer Price Index report, saying he really “dislikes the figure” in terms of decision making…but his comment just draw more attention to the release. Ever heard the line “Don’t think of a cow”? Of course you can’t do anything but think of a cow when you hear it, and in much the same way, Greenspan has turned Traders attention towards this report. It remains to be seen if Traders agree with Mr. Greenspan on the significance of the CPI. Additionally, the Fed will continue the road show this week, as Board Governors take the stage all over the country. Their comments are always monitored, and often become wild cards in the market.

Forget about the secrecy, the mystery, the intrigue...since last summer, the Fed has been letting it all hang out. In fact, the Fed has told us exactly what they were going to do. Get to a neutral policy on rates before the Greenspan era ends in January of 2006.

So what's a neutral policy, you ask?

That is where the Fed Funds Rate equals the rate of inflation, plus 1.5%. With inflation presently around 2.5%, the Fed Funds Rate (FFR) should be around 4% for the Fed to get to neutral. Right now, the FFR is at 3%, a full 2% above where it was in June of 2004. So the Fed will continue to raise rates at a self-proclaimed "measured pace" until the FFR is around 4%. The term "measured pace" tells us to look for these hikes in ¼% increments, and for them to happen at the Fed meetings, not as surprise moves.

Then what's the deal with home loan rates?

The Fed has hiked 8 times and tripled the FFR since June of 2004, but home loan rates have dropped by 3/4% during the same period. This clearly demonstrates that the Fed does not control long-term or home loan rates. The Fed controls overnight or very short-term rates that banks charge each other for funds. And the banks do use this FFR to determine their Prime Lending Rate, often used to base auto loans, credit lines and Home Equity loans upon.

On the other hand, longer-term investors that hold fixed return Bonds such as fixed rate home loans, are interested in how the value or buying power of the fixed payment return will hold up over time. So if inflation is moving higher, the Bonds fixed return erodes. Why? Simply because inflation means it will cost more down the road to buy the very same things they could today for less. This will cause the investor to require a higher rate on future transactions to compensate them for the erosion in buying power caused by inflation. If inflation moves higher, so will long-term rates.

And when the pace of inflation declines, long-term rates tend to decline as well. This is because the buying power of the fixed payment stays stronger longer. Now here's where it gets interesting...a Fed hike can slow inflation, which can actually help reduce long-term rates. This is exactly what has happened since June of '04.

So why is this being referred to as a "conundrum"...don't they know this stuff?

Sure, but because there is no historical precedent for what is currently taking place with interest rates, many are left scratching their heads. But the discussion above should clear things up. And as for the lack of historical precedent, the answer is also clear. In the past, the Fed raised rates to react to inflation, but this time the Fed is raising rates in anticipation of inflation.

But why? With no real inflation problem, why the rush to juice rates higher?

Yet another simple and logical explanation...the Fed is "reloading". The primary way the Fed can heat up or cool down the economy is with changes to the Fed Funds Rate. When the US economy went into a decline in 2001, the Fed cut the FFR 11 times in 11 months, from 6.5% to 1.75%, with 8 of the cuts by ½%. The swift move by the Fed made the recession one of the shortest in history. They were able to quickly repair the US economy because they had the ammunition to do it. If the US economy were to stumble when the FFR is already very low, the Fed would have a far more difficult time stimulating the economy, as there is nowhere to cut lower to.

The Fed is very smart. A 3.5 to 4% FFR gives the Fed some firepower to jump-start the economy if it slows or if an unfortunate event were to take place. This target rate is also a good level to keep inflation at bay if the economy were to pick up steam. The Fed is trying to find a "Goldilocks-approved" level for the FFR...and so far appear to be doing a good job.

After last week’s economic report “siesta,” Traders will be kept wide awake with this week’s extensive calendar. Among the most important will be Tuesday’s Retail Sales report and Producer Price Index – a measurement of inflation at the wholesale level – backed up by Wednesday’s Consumer Price Index, measuring inflation at the consumer level.

Remember, as a general rule, weaker than expected economic data is good for rates, while positive data causes rates to rise.

For the week of June 13 – June 17