Mortgage bonds are continuing their downward path today, which is adding upward pressure to mortgage interest rates. Believe it or not, this is actually a healthy move for the bond market which had a 200 basis point improvement in just 8 short trading days. Anytime there is such a dramatic improvement in such a short time frame you can expect to lose about half of the gains once the rally slows. That would put bond prices about 40 basis points below current levels, so we can still expect further deterioration. We do feel that level will hold and could provide bonds an opportunity to bounce off those levels and make another run higher. However, there is no guarantee and it will greatly depend upon the results of Friday’s BLS (Bureau of Labor Statistics) Jobs Report.
The Fed Meeting Minutes from the December 17th meeting were released yesterday. Although most of the report was as expected, the Fed did say that they could begin hiking interest rates in 2015 with inflation at current levels. However, they would only do so if they believe inflation will still move higher in an upward trending interest rate environment. The target level of inflation set by the Fed is a minimum of 2%. With current levels at only 1.4%, a jump higher in interest rates is not going to help their cause. One of the key tools the Fed has to control inflation is the ability to adjust short term interest rates. Increasing interest rates lowers inflation while decreasing interest rates adds upward pressure to inflation. We just don’t see how the Fed could move rates higher until inflation is at least in an upward trend. Inflation has been heading lower recently. A push higher in interest rates could cause inflation to drop even below current levels.
Tomorrow is the big BLS Employment Report. Although we feel it could come in below expectations, we will maintain a locking bias for now. We will be closely watching for bonds to reach the bottom of their current channel. At that point we will likely switch to a floating bias as long as the channel holds. Be prepared for an increase in volatility the next couple days. It could be turbulence ahead in the markets.