Mortgage Library

The yield of the 10-Year Treasury Note fell sharply in the first week of August (yields move in the opposite direction of prices) but then gyrated within a sideways channel for the next two weeks. At the end of the month, it headed down once again, finishing about 35 basis points lower than its closing level in July. In the stock market, the indices sustained sharp losses in the first half of the month but then turned and worked their way higher for a mixed performance on the month (slight gains for the Dow and S&P 500 and a moderate loss for the Nasdaq).

July ended with three winning sessions for the 10-Year Note and the momentum continued as the benchmark security's price gained in each of the first five sessions in August. Traders were still reacting to the late-July release of the gross domestic product data for the second quarter. It reflected a much weaker than expected annualized growth rate for the economy while also revealing an easing of core inflation pressure (excluding food and energy).

Another support for the bond market in the first week of August was a safe-haven flow spurred by terrorism warnings based on intelligence that cited specific targets in the U.S. A bombing outside Athens, Greece, site of the month's Olympic games also prompted traders to move toward less risky investment areas such as U.S. Treasuries.

Additional lift for bonds and pressure on stocks came from rising oil prices. The higher energy costs affect the production and transportation of all tangible goods and high gasoline prices divert consumer spending from other areas, thus depriving manufacturers of the demand needed to support higher prices for their products. Besides the uncertainty over possible terrorist disruptions to oil supplies, questions arose whether Russia's largest producer, Yukos, would be able to continue operations. The company was deep in tax debt and the Russian government was freezing the company's financial assets. Russia is the second largest exporter of oil.

And bonds also got a boost from the easing of supply concerns when the Treasury announced a smaller than expected refunding package to be offered the following week.

These factors outweighed generally bullish economic data released in the first few days of the month. The ISM Index on manufacturing for July showed another strong expansion and Factory orders reportedly rose in June and were revised from a decline to a gain in May. The rate of construction spending declined in June but only slightly and from a record high in May.

The market also failed to back up in deference to the approach of Friday's always-influential employment report. And it turned out that the report was another giant plus for the bond market. It revealed a shockingly weak gain in nonfarm payrolls in July and gains originally reported for May and June were revised lower. And even though the report said the unemployment rate fell to a more than two-and-a-half year low, the weakness of the payroll numbers turbo-charged the bond market. It caused Fed watchers to reassessing their view of how quickly the monetary policy committee would be hiking interest rates. Though they still assumed that the Fed would raise the short-term borrowing rate between banks by 0.25% when the monetary policy committee met the following Tuesday, the employment news raised doubts as to whether a hike would be made at the Fed meeting on September 21. At the very least, any concerns about larger or unscheduled hikes were dispelled for the time being.

The following Monday at last brought some profit-taking as the sale of 3-Year Notes, first of the Treasury's refunding auctions, was met with tepid demand. In addition, bonds had little buying support as many traders remained on the sidelines awaiting the results of Tuesday's Federal Open Market Committee (FOMC) meeting. But oil futures prices rose to new highs on the New York Mercantile Exchange for a seventh consecutive session, threatening to further dampen the economic recovery. The rise came on word that part of Iraq's production has been shut down due to insurgency threats from followers of Shiite cleric Moqtada al-Sadr. Al-Sadr and a contingent of followers were occupying a mosque in Najaf, battling with Iraqi and U.S. forces.

Although a rate hike was expected at the FOMC meeting, the move had already been factored into the market. Traders were also not expecting to find any reason for concern in the meeting statement given the recent signs of economic slowing. In June, the committee raised its target for the fed funds rate by 0.25% to 1.25%. This was the first rate hike since May of 2000. Between the beginning of 2001 and June of 2003, the Fed had lowered the rate thirteen times from 6.50% to 1.00%, the lowest rate since the late 1950s.

But as the economy showed signs of recovery the Fed sent a progressive series of signals that the stimulus would be removed before inflation had a chance to take hold. Assurances were offered that the rate increases would likely be made at a measured pace and a number of recent economic indicators have reinforced this viewpoint. Yet, in his semi-annual congressional testimony on monetary policy and the economy in July, Fed Chairman Alan Greenspan said June's lull in the recovery was probably temporary. However, he also noted that employment was expanding broadly -- an assertion contradicted by the latest employment report.

Treasuries fell again on Tuesday as the Fed maintained a positive outlook for the economy. As expected, the committee hiked the fed funds rate by 0.25% and the policy statement repeated the claim that "policy accommodation can be removed at a pace that is likely to be measured." The statement issued following the conclusion of the meeting acknowledged the recent economic slowdown, but it minimized the situation: "in recent months, output growth has moderated and the pace of improvement in labor market conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices. The economy nevertheless appears poised to resume a stronger pace of expansion going forward."

But the bond market recovered as oil prices continued to climb, clouding the upbeat picture the Fed had painted. The Treasury's 5-Year and 10-Year Note auctions fared much better than the pre-Fed meeting, 3-Year Note offering. In the meantime, stocks lost ground, making bonds even more attractive.

Trading was volatile in the following week. One of the factors pushing up oil prices had been the approach of a recall referendum in Venezuela on the presidency of Hugo Chavez. Venezuela is the world's fifth largest oil exporter and analysts worried that political instability there might disrupt production. The weekend vote was apparently decided in favor of Chavez and the alleviation of the production uncertainty allowed oil prices to ease and stocks to rebound.

Consequently, Treasuries fell back slightly on Monday but rebounded on Tuesday the 17th when the Consumer Price Index, a key gauge of inflation at the retail level, showed an overall contraction in July, the first in eight months. And the core index, which filters out the volatile categories of food and energy, showed only a nominal increase.

More gyrations for bonds came in the next few sessions as oil prices were jostled by conflicting reports regarding a possible resolution to the standoff in Najaf. But as the month wound down, the oil / stock influence waned as traders closed out their books and took to the sidelines. Trading is traditionally light in late August since it is seen as the final vacation opportunity of the summer and many market participants combine vacation with the Labor Day holiday. Moreover, traders had an added incentive to get away from their offices in New York at this time: the Republican National Convention was held there August 30 - September 2.

The convention also stirred up safe haven flows into the bond market. The possibility of terrorist activity motivated traders to move from higher to lower areas of investment risk. End-of-month portfolio adjustment activity also favored the market. This is the process whereby managers rebalance their portfolios based on such characteristics as yield, risk, and return horizon. The activity usually entails the purchase of bonds. Consequently, the low liquidity, combined with safe-haven and end-of-month buying, may have exaggerated the gains in the bond market in the last few sessions.

Housing

The housing indicators released in August were generally bearish with the exception of housing starts in July. The seasonally adjusted, annualized rate of newly begun construction jumped by its largest percentage amount in twenty-two months but this followed a steep decline in June -- biggest fall in sixteen months. A sign of underlying strength was an increase in the rate of building permit issuance. It had fallen sharply in June from a record high in May. July's increase brought the issuance pace to its second highest level.

The May - June starts pattern was corroborated in the construction spending report for June. The overall pace of spending and spending in the residential construction category declined from May's record highs.

While starts picked up in July, sales were down. The rate of existing home sales slipped but May's rate was a record high and July's represented the third highest rate following May and June. The pace of new home sales also set a record high in May but it fell sharply in June and again in July.

The sales reports raised some doubts about the health of the housing sector. But analysts noted that the monthly reports are subject to high volatility due to variables such as weather and regional economic conditions. They also noted that mortgage rates still remained relatively low. Rising rates from late March to June spurred many indecisive buyers to take action and the subsequent easing of rate levels in the following two months was expected to fuel more buying activity. And though rates would eventually head higher again, alternative financing programs would still provide some footing for the sector, though sales would retreat from their current levels.