GAME THEORY

Game on, says Bob Walters, chief economist for Quicken Loans, in reaction to the latest decline in mortgage rates and the related rise in loan inquiries, reports Bankrate.com. Real estate may be a bubble, as many pundits have charged, but if so then it’s also true that ours is a bubble-friendly climate.


Among the direct catalysts for the current state of affais is the benchmark 30-year fixed-rate mortgage, the cornerstone gauge of what Joe Sixpack will pay to buy a home. The going rate now sits at 5.65%, the lowest since February and well below the 6.34% from 12 months previous, Bankrate.com advised today. That’s no surprise to any one following the bond market, which saw fit to pare the yield on the 10-year Treasury Note to under 3.9% yesterday for the first time since March 2004.
The minor milestone in bond market yields confounds more than a few observers of the financial scene. And for good reason, since falling long rates happen to coincide of late with rising short rates. An odd coupling to be sure, and one that’s not long for this world.
In the short term, by contrast, there’s no arguing with Mr. Market. The all-important short rate known as the Fed funds, which currently resides at 3%, has climbed from 1% a year ago. Long rates could care less, and have registered their snub in no uncertain terms. The divergent trend in short rates relative to long ones stirred Fed Chairman Alan Greenspan recently to label the sight a “conundrum.” But whatever you call it, the ongoing drop in long yields is inspiring capital flows in more than trivial ways, and perhaps for reasons that are less than the textbook definition of prudent.
Consider the real estate investment trust (REIT) market, which has returned to form in recent weeks by pushing up to new highs. That’s nothing new in REIT land, which is one of those rare corners of the equity markets relatively unaffected by the grand bear market that otherwise afflicted stocks in the opening years of the 21st century. The Morgan Stanley REIT index touched a new high on May 23, and currently remains just below that apex. The traditionally yield-rich REIT market retains more than passing interest for investors who’re watching current payouts on fixed-income securities continue to sink. This despite the fact that the Morgan Stanley REIT index now yields less than 5%. That looks a bit thin by historical standards, although that isn’t stopping investors from snapping up real estate securities.
Alas, beggars can’t be choosy in the new world order of declining yields. That raises the issue of whether the Federal Reserve is doing enough to slow what some say is a speculative frenzy in real estate, ranging from keeping the momentum going in the nearly six-year-old bull market in REITs to stoking the public’s desire for taking out new mortgages for buying bigger abodes if not second and third homes.
Of course, the bond market’s view could prove prescient, namely: the Fed’s monetary tightening is over, and if that didn’t suffice, well, too bad. If true, that’s sure to dash any hopes of taming the bullish aura that continues to permeate all things property related. Still, there’s grumbling in some circles that the fall in long yields is merely a function of the Fed not raising short rates fast enough. If the central banks really wanted the 10-year Treasury yield to rise, the monetary levers are available, if only the Fed would muster the discipline to exercise those levers, say critics.
But while some dream of 50-basis-point rate hikes, the bond market presumes that zero will now become the operative number in future press releases from the FOMC.
Yet, one might wonder if today’s robust upward revision in first-quarter labor costs to 3.3% spells trouble for the blazing confidence that now characterizes the fixed-income set. Maybe, although relatively few bond traders are paying attention. There was virtually no sign today of reversing yesterday’s sharp drop in the 10-year Treasury yield, which remained essentially unchanged at just under 4.9% by the close of today’s trading.
Clearly, the bond market’s in no mood to worry, although some in the dismal science feel compelled to point out what others choose to dismiss. That includes today’s release of employment data, courtesy of the Labor Department. To cut to the chase, revisions in first-quarter data now show that unit labor costs advanced at a faster rate (3.3%) in the first three months of this year compared to productivity’s revised increase (2.9%).
The trend raises the inflation specter, or so we’re told. “Some will see this faster labor cost growth as a warning sign of an imminent acceleration in price inflation….” wrote David Resler, chief economist at Nomura Securities in New York, in a research note today for clients.
Yes, productivity (output per hour worked in the nonfarm sector) was also revised up in the first quarter to 2.9% from 2.6% in the initial estimate. “Ordinarily that would have translated into slower growth in unit labor costs,” observed Resler. But the ordinary takes a back seat to the irregular in this case, thanks to the higher revised growth rate in unit labor costs, which are now advancing at a four-year high of 4.3% over the past four quarters, he reports.
Jan Hatzius, a Goldman Sachs economist, passed along a similar warning via Reuters today, explaining, “Historically, such a gap [in labor cost increases over productivity] has typically resulted in a significant acceleration in [the Fed's preferred core inflation measure] over the following year. Presumably, this relationship has not gone unnoticed among Fed officials.”
Presumptions, however, can be a dangerous indulgence these days, in central banking and elsewhere. But there’s still hope, and more than a little money tied to the notion that the unit labor costs revision won’t add up to much. As Resler noted, “growing international competitive pressures have weakened that wage-price linkage.” How much has it been weakened? Good question, and one without a good answer short of waiting for future labor and productivity data to roll in.
In the meantime, there’s a booming trade in believing that the deflationary winds from overseas economies continue to blow over the American labor market and help turn today’s long positions in bonds into yet another profit tomorrow. Game on!

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