Will the Fed Cease Ruling the Roost?

Mortgage lending rates have made a beeline northward in recent weeks. This past week, Bankrate.com's national survey of lenders shows the average rate on a 30-year fixed-rate mortgage rose 11 basis points to 4.55%. Freddie Mac's survey shows an even bigger jump, with the average rate on the 30-year loan spiking 17 basis points to 4.46%. (A basis point is 1/100th of a percentage point.)

So what's going on?

By initial appearances, the economy is stirring to life. Revised gross domestic product (GDP) data for the third-quarter point to accelerating economic growth. The latest revision shows GDP growth increased 3.6% when annualized, exceeding most economists' estimates.

The $64,000 question is can the current growth rate be sustained?

As we've seen in the recent past (such as in the fourth-quarter of 2011), a couple quarters of growth are strung together, but the trend peters out. Companies building inventory levels was a key contributor to growth in the third-quarter. Most economists would have preferred to see more capital investment and more hiring leading the charge. That said, companies frequently build inventory in anticipation of increased business activity.

Friday's employment report will provide additional information to the state of the economy. We noted last week that the Federal Reserve keeps a close eye on employment numbers. Fed officials have said they'd like to see the unemployment rate below 6.5%. It stands at 7.3%.

The trend is the key, though. If job growth again beats the consensus estimate – as it did last month – this suggests the GDP-growth trend that's developed over the past year will be sustained. That in itself points to greater loan demand, which will pressure interest rates, including mortgage rates, to move higher.

Just as important, more growth (economic and payroll) will embolden the Fed to finally taper; that is, reduce its monthly purchases of Treasury and mortgage-backed securities. The Fed's demand for these securities has been key to holding mortgage rates so low for so long.

As we all know, mortgage rates have been moving higher ahead of actual data releases. This is normal, because markets are anticipatory: they act on expectations, not what's known at the moment.

It's obvious that more credit-market participants expect stronger economic growth; hence the rise in mortgage rates. Should Friday's job numbers support that contention, by meeting or beating the consensus estimate for 180,000 payroll additions in November, rates will likely move higher still. We stay that because exceptions for stronger future growth will rise.

But nothing is certain. The majority can be wrong – as it was when it expected the Fed to begin tapering in September. If job growth disappoints, interest rates will likely fall because the Fed will have less incentive to taper.

Back in September, we were among the correct minority: We didn't think the Fed would taper. More recently, we thought the economy still wasn't that strong and that the Fed might not begin to taper until 2014. We still believe the Fed will hold off until next year. That said, next year is less than a month away.

The bottom line is that pressure is building for the Fed to taper, which strongly suggests mortgage rates are much more inclined to go higher in coming months.

Courtesy of Jessica Regan.

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