Federal Reserve Chairman Bernanke last week testified to Congress that the Fed was studying ways to remove monetary accommodation and trim its monthly asset purchases. After a brief swoon on light volume, share prices rebounded and finished the week only slightly lower. But that wasn't the whole story. The rest of the story was a drop in bond prices and a corresponding increase in interest rates.
After reaching 1.626 percent on May 2nd, the yield on the 10-year Treasury bond increased to over 2.20 percent in early trading on May 29th. That might not seem like a lot, but it is significant in the bond world. The ten-year Treasury is the base rate upon which many loans—and especially mortgage loans—are established. A recovery in the housing market has been crucial to the U.S. economic recovery, and artificially low interest rates have fueled this recovery. A significant rise in mortgage rates would thwart further benefits and may indeed create a problematic headwind. Therefore, the Federal Reserve has been obsessed with keeping these rates low.
A little light reading on the Mortgage Bankers Association website shows that the rate on a 30-year mortgage has increased to 3.9 percent—the highest level since May, 2012. Not coincidentally, mortgage applications have now decreased for a third consecutive week. In this latest week, mortgage applications were down 8.8 percent from one week earlier, while applications for refinancings were down over 12 percent. The Refinance Index is now at its lowest level since December 2012.
We suspect that a perfectly well-intended plan may have backfired on dear Mr. Bernanke. If it was his intention to cool the exuberance on Wall Street as an early tactic to prepare investors for a winding down of its monthly purchases, he may have failed. He failed in an unexpectedly magnificent way in that stock prices remained little-fazed, but bond yields have risen substantially. The wrong market listened! The Fed now confronts higher interest rates, which may require additional bond purchases to reverse the increase. In addition, a commitment to additional asset purchases could drive equity prices into a further frenzy.