The tug of war between inflation and deflation continues, and the Treasury yield curve is setting records.  Last week posted the steepest yield curve ever.  The 30-year Treasury bond yields 4.50%, or 3.69% above the two-year yield of 0.81%.  There has never been a greater relative reward for taking longer-term Treasury risk.

In the meantime, mortgage rates are low.  Near their lowest levels ever, in fact.  Too bad mortgage application volume is anemic.  Low home values, weak credit, job losses, and tight bank underwriting guidelines have combined to choke off mortgage supply.  Refinance volume in particular is lagging.  Even the government’s foreclosure relief program is struggling.  The Making Home Affordable program is not making much of anything happen.  Sweeping changes in the foreclosure program are expected, and could have significant impact on the mortgage industry next year.

Low application volume for originators is good news for servicers.  Mortgages expected to prepay remain on servicers’ books, and returns to servicers are well above expectations.

Short-term interest rates are low because of monetary policy; when it meets this week, the Fed is expected to reiterate its resolve to keep the fed-funds rate near 0% for an “extended period.”  Long-term rates are high because of fiscal policy; the administration has flooded the economy with fiscal stimulus approaching 10% of GDP.  The combined pick-me-up from monetary and fiscal stimulus is nearly 20% of GDP, more than six times the average recession stimulus since World War II.  Will we have a future that looks like Zimbabwe (inflation) or a future that looks like Japan (deflation)?  The answer lies in long-term fiscal policy, and the bond market is voting that higher rates are on the way.

The rooster boasted that his crowing brought the sun up.  Who will take credit for the surge in stocks?  Whoever takes credit ought to be careful.  US stocks have delivered an annual compounded real rate of return of negative 4% for the past decade, while 10-year Treasuries have given a positive annual real rate of 3.6%.  The S&P would have to rise nearly 40% from current levels to deliver a Zero rate of return for the past decade.  (Embarrassingly, gold was the top-performing asset class, delivering an annual real rate of return of 10.8% in that same time period.  Commodities futures did 5.2%.)

Don Coxe ruefully reports:  “Risk-free government bonds delivered higher returns to investors than capitalism did.  And this was the best of all times in the best of all capitalist worlds… There were more playing fields for multinationals than ever, corporate tax rates were generally declining, there were no major wars, the supply of highly educated engineers, MBAs and CFAs was at record levels, and business was more respected than it had been since the onset of the Depression.”

And as for jobs, small business is still shedding them, reports Barron’s.  “Owner optimism” remains at recession levels.  A mere 9% of small businesses upped its employment rolls by an average 2.3 workers, while 21% slashed payrolls by an average of 4.2 workers.

Senators proposed a $1.1 trillion spending bill that will provide funding for government agencies, foreign aid, and local construction projects. And also, since it’s so close to Christmas, a pony!  – Jay Leno

Thanks for your business and have a good week.            — Tom Millon