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THE ECONOMY

Hopes ebbing for cuts in interest rates

The shift in outlook could be good for savers' money-market funds. But the housing sector could suffer.

June 06, 2007|Tom Petruno | Times Staff Writer

Surprising strength in the U.S. economy is killing hopes for interest rate cuts this year, giving the struggling housing market another headache.

Although the shift in the rate outlook is driving up mortgage costs, the turnabout is good news for investors with cash parked in money-market funds because it means their yields -- averaging nearly 5% -- should hold steady.

This week, two of Wall Street's biggest brokerages revised their forecasts for short-term interest rates. Merrill Lynch & Co. and Goldman, Sachs & Co. retracted long-standing predictions that the Federal Reserve would begin cutting its key short-term rate, now 5.25%, in the second half of the year.

"There are a lot of people throwing in the towel" on interest rates, said Don Quigley, a bond fund manager at Julius Baer Investment Management. in New York. "The economy hasn't rolled over."

Long-term Treasury bond yields, meanwhile, are at their highest levels since summer and are pulling mortgage rates up in tandem.

Fed Chairman Ben S. Bernanke on Tuesday reinforced upbeat sentiment on the economy. In a speech beamed to a bankers' conference in South Africa, Bernanke said he expected the U.S. economy to grow at a "moderate pace" despite the sharp slowdown in the housing market.

"We have not seen major spillovers from housing onto other sectors of the economy," he said.

The resilience of the U.S. economy has been a major force behind Wall Street's strong rally this year. But rising interest rates gave some investors a reason to pause Tuesday. The Dow industrial average slid 80.86 points, or 0.6%, to 13,595.46.

Higher interest rates mean bonds may present more competition for stocks. The annualized yield on the 10-year Treasury note rose to 4.99% on Tuesday, up from 4.93% on Monday. The yield has surged by half a percentage point since early March to its highest since August and now threatens to break through the 5% threshold.

Mortgage rates tend to follow Treasury bond yields. The average rate on 30-year conventional mortgages nationwide was at a nine-month high of 6.42% last week, up from 6.37% the previous week, according to mortgage finance giant Freddie Mac.

Long-term interest rates fell in winter partly on the assumption that the housing market's woes would slow the economy dramatically -- enough to spur the Fed to cut its short-term rate for the first time in four years.

The economy did decelerate, growing at an annualized rate of just 0.6% in the first quarter, the poorest reading since 2002.

But data in recent months have pointed to a pickup. The service sector of the economy, for example, grew at a brisk pace in May, according to a report Tuesday from the Institute for Supply Management.

And the big surprise has been that the nation's employment picture hasn't dimmed as many analysts expected. The weaker economy "isn't translating into an increase in the unemployment rate," said Jan Hatzius, an economist at Goldman Sachs in New York.

The jobless rate was 4.5% in May, near a five-year low. The relative lack of pain in the job market has given the Fed cover to hold short-term interest rates steady, analysts say. Bernanke and other Fed officials have stressed that they're uncomfortable with an uptick in inflation gauges over the last year or so and want to see those price pressures recede.

Bernanke reiterated in his speech Tuesday that underlying inflation remained "somewhat elevated" compared with policymakers' comfort level. A key measure of consumer prices rose 2% in the 12 months through April, barely inside the Fed's target zone of 1% to 2%.

Bond investors are signaling their waning hopes for a Fed rate cut by demanding higher yields on long-term securities. On the plus side, that may make bond mutual funds a more attractive option for investors who have been waiting for better returns.

Some investors were willing to accept yields as low as 4.49% on 10-year Treasury notes in March, figuring that the Fed's short-term rate could fall close to that level by year's end.

Now, with no Fed cut in sight, many investors have become unwilling to buy bonds paying less than what they can earn in short-term accounts. The average seven-day compound yield on money market funds was 4.84% last week, near a six-year high, according to iMoneyNet.com.

What's more, strength in many foreign economies is pushing bond yields up overseas. That puts pressure on U.S. yields because they have to be competitive to attract global investors.

With mortgage rates following bond yields higher, the housing market may have a tougher time mounting a recovery. A Mortgage Bankers Assn. index tracking applications to refinance loans fell last week to the lowest level since mid-January.

But some experts say that falling home prices in many regions have made many potential buyers so skittish, loan rates may be a minor issue for now.

"Housing is going to be dead for another year or so, regardless of what happens with rates," said Ed Leamer, director of the UCLA Anderson Forecast.

tom.petruno@latimes.com

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