Opportunity out of uncertainty in mortgage market

Real Estate Weekly, Jan 31, 1996 by David X. Stumpf

The spread of confidence in the financial markets has been fueled by low interest rates, low inflation, and a public euphoria with Mutual Funds. Mr. Greenspan and the Federal Reserve Board contributed to the surge in the markets with .25 percent cuts in short-term interest rates in both early July and late December. These were the first reductions in interest rates since 1992, after seven consecutive discount rate increases beginning in 1994.

Indeed, 1995 marked a turnaround in the Federal Reserve's direction. Due to the tightening in credit, there is only now mounting evidence that the economy has indeed slowed. Retailers have reported the poorest December ales figures since the 1990-91 recession. Economic Growth is down to around 2.5 percent, with no significant signs of inflation on the near horizon.

The Feds sighted the lack of strong inflation as the reason for the .25 percent cut in the Federal Funds rate at the end of last year. However, the Feds have been very cautious in easing credit, demonstrated by the six month periods between rate cuts. The Feds decision only reflected what bond investors had already decided some months earlier, when they continued to purchase bonds at ever lower yields in the belief that interest rates would go down and a budget agreement could be reached in Washington.

The bond market has already priced in a reduction in interest rates. Mortgage rates fell steadily throughout last year, down nearly one and half percentage points since the start of 1995. The comparatively low interest rates has caused an increase in commercial mortgage activity.

While many financial analysts had been predicting lower interest rates as the year closed, the ups and downs of the budget talks have now shown just how nervous and fragile the financial markets are at these current high levels. In fact, on December 18, (the day before the Federal Open Market Committee meeting) the Dew had a near record plunge of 101 points as the budget talks stalled, and the yields on 30-year bonds climbed to 6.2 percent, the biggest one-day rise in the previous six months. Again, on January 10th and 11th, there was a combined 164 point drop in the Dow that was blamed on another breakdown in the budget talks. However, the resilient stock market now seems to take 100 point fluctuations in stride.

Election Year Jitters in Financial Market

Despite relatively robust and improving performances in the financial markets during 1995, the Federal budget talks have and will probably continue to cause fluctuations in both the stock and bond markets. Both these markets have reacted to the stalled budget talks. This battle over the budget may take all year before ultimately playing itself out in the Fall elections. If an agreement can be reached soon, then the markets will stabilize. But as each day passes, the likelihood of a quick agreement decreases, and the possibilities that the government might shut down again on January 26th or that the Federal government might default on it's debt payments, increases.

This period of uncertainty suggest that the current low bond yields might be unsustainable without either a quick budget agreement or another rate reduction by the Federal Reserve Board. In fact, as of January 15th, the 30-year bond yields have gone up from around 6 percent in late November to 6.14 percent, while at the same time, the Feds have inspired a cut in prime from 8.75 percent to 8.5 percent. The Wall Street Journal reported on December 20, 1995 that "Reality is starting to set in," said John Wambold, head trader at Citicorp Securities in New York. "The market was overly optimistic we were going to get a budget deal done."

Wambold said the 30-year Treasury bond yield could approach 6.4 percent "if it becomes clear law-makers won't ever come to a budget deal."

Investors are worried that Greenspan may wait to cut rates if no agreement is reached, and pessimism is growing that an agreement may take more time than the market had originally hoped. The Federal Reserve is an independent body which does not want to give the appearance of helping the president in an election year. Also remember that Clinton must decide whether to reappoint Mr. Greenspan, whose terms expire in March.

On the other hand, some analysts will argue that the Feds have traditionally remained on one course, with a string of small incremental moves in one direction, before again changing course.

Forecast for Commercial Mortgage Market

As if the national budget scene was not enough to create uncertainly in both the real estate and financial markets, the nature of the typical 10-year commercial mortgage loan may also impact loan availability. Michael V. Coratolo & Associates, Inc. expects to see an increase in refinancing activity in 1996. Interest rates have returned to the levels we last saw in 1993, when refinancing activity had reached its most recent peak. Owners who did not take advantage of the low interest rates in 1993, or were unable to refinance due to high prepayment penalties, are getting a second chance.