Finally, mortgage rates drop

Finally, some relief! After six straight weeks of increases, mortgage rates took a dive because fuel prices took flight.

The benchmark 30-year fixed-rate mortgage fell 8 basis points to 5.88 percent, according to the Bankrate.com national survey of large lenders. A basis point is one-hundredth of 1 percentage point. The mortgages in this week's survey had an average total of 0.37 discount and origination points. One year ago, the mortgage index was 5.82 percent.

The 15-year fixed-rate mortgage fell 6 basis points to 5.5 percent. The 5/1 adjustable-rate mortgage fell 6 basis points to 5.56 percent.

The benchmark 30-year fixed bottomed out at 5.61 percent on June 29, then rose steadily for a month and a half, to 5.96 percent Aug. 10. The next day, the government issued a report that spooked investors and drove Treasury yields and mortgage rates sharply downward. It was the report on retail sales in July.

The Census Bureau said retail sales increased 1.8 percent in July. That was a problem on three counts. First, investors had expected sales to climb more than that. Second, consumers were spending a lot on new cars because of sales incentives stealing sales from future months.

Third, and most unnervingly, consumers spent 2.4 percent more money, at gas stations, in July than they had spent in June. When you look at year-over-year sales, consumers spent 20.3 percent more at gas stations this July than in July 2004.

Now, you could come up with a hypothesis that people spent more at gas stations because they were buying more six-packs of beer and lottery tickets there. Investors had another theory: Consumers spent more at gas stations because fuel prices had gone up.

They got confirmation this week, when the Consumer Price Index for July was released, and it showed a rise of 3.8 percent in energy prices in just one month.

Here's where investors' thinking goes counterintuitive. They worry that rising fuel prices will retard economic growth because people will spend money on gasoline that they would otherwise spend on other things. Slow growth leads to low inflation. When investors expect inflation to remain low, long-term interest rates stay down. It was this kind of thinking that led mortgage rates to drop this week.

At this point, you're probably thinking, "Huh? I'm spending more at the gas pump, my summer vacation cost a lot more this year than last, the plumber levied a fuel surcharge when he fixed my sink last week -- and investors think inflation isn't a menace?"

Threat of inflation
Economist Joel Naroff understands. He thinks inflation is threatening to pounce and that bond yields and mortgage rates should be higher.

The yield on the 10-year Treasury is about 4.25 percent now, and was about 4.4 percent a week ago. Even 4.4 percent "is way below any reasonable economist would assume it should be, given inflation, given growth rates, given the federal funds rate," Naroff says.

Since the average 30-year mortgage rate tends to be about 1.6 percentage points higher than the yield on the 10-year Treasury, it's safe to say that Naroff believes mortgage rates should be higher, too. Not that he wants them to rise, but he thinks today's economy warrants higher interest rates. But he's not holding his breath until a big jump in rates occurs.

Wage increases in sight
"What I think the market is missing right now, they're looking at it simply as a slowdown in economic growth," Naroff says. "They're missing the labor side." Naroff believes that employers are now having to compete for workers. That means wage increases -- do you have to cheer so loudly? -- and sooner rather than later, better wages translate into higher prices.

"We've seen in the last three months there are more robust wage gains," Naroff says. "Five percent is not a particularly high level of unemployment. Businesses are clearly beginning to bid for labor."

But the message hasn't gotten through to the bond and mortgage markets, which is good news for mortgage borrowers. But it's temporary news. Naroff awaits what he calls the "duh moment" -- the day or the economic report that leads to a run-up on long-term interest rates.

"You wake up and discover that core inflation is 2.2 percent and it's gone up half a percentage point in the last four or five months," he says. "That's going to be the duh moment in the markets. I don't know when the duh moment will come, but it will happen."

When it does arrive, whether it's one day or two years from now, you don't want to be floating your mortgage rate.