Behind the Bad Economic News, Signs of Life

Amid the coming wave of depressing data on the U.S. economy are some reasons for hope in the second half of 2009

The current mood of pessimism among households and businesses will have plenty to feed on in the coming months. Economic reports, especially those from the labor markets, are sure to look grim as the most severe stage of the recession plays out. At the same time, though, a few glimmers of hope for at least a gradual return to economic growth in the second half of 2009 are beginning to shine through the gloom. The most important is Washington policy, especially the unprecedented commitment by the Federal Reserve to do whatever it takes to restore proper functioning of the credit markets and promote an economic recovery.

Efforts by the Fed are increasingly aimed at financial markets generally and mortgage markets in particular. As Fed Chairman Ben Bernanke noted on Dec. 4, housing and mortgage finance precipitated the current crisis, but falling home prices, foreclosures, and strained mortgage markets "are now symptoms as well as causes" of the current financial and economic woes. The all-out effort to halt this vicious interaction was clear in the Fed's extraordinary moves on Dec. 16, including taking its target rate to nearly zero and committing to buy "large quantities" of tainted mortgage securities.

Market functioning remains far from normal, but it is already showing tentative signs of improving. Rates for corporate borrowing have dropped sharply over the past two months. Rates on BBB-rated investment-grade bonds are down 1.4 percentage points, to 8.1%, and those for AAA-rated companies are down 1.8 points, to an historic low of 4.7%. Compared with rates on Treasuries, which also have fallen, yield spreads have narrowed a bit. But they remain wide, indicating investors' continued aversion to risk.

Still, issuance of corporate debt and short-term commercial paper have picked up, helped by support from programs at the Fed and other agencies. Economists at Barclays Capital note that even without that backing, private-sector purchases of commercial paper are turning up, and the issuance of nonguaranteed investment-grade debt is accelerating, although both remain at very low levels.

Mortgage rates have fallen sharply. Fixed rates on 30-year mortgages have dropped a full percentage point since mid-November, to 5.14%, the lowest in the 37-year history of Freddie Mac data. Amid falling prices, the National Association of Realtors' Housing Affordability Index in October stood at a 15-year high, and December data is certain to show an all-time high. A full point drop in mortgage rates for an 80% loan on a median-priced home lowers the monthly payment by about 10%. The decline has already unleashed a refinancing wave, with activity up more than fivefold since late November to a five-year high.

Amid tight credit and rising joblessness, however, housing demand faces stiff headwinds. What support there is under sales of existing homes, which dropped 8.6% in November, is coming mainly from sales of properties in foreclosure at fire-sale prices. The NAR says such sales now account for about 40% of the total. As for new homes, builders have all but thrown in the towel, with home starts in November the lowest since World War II.

Nevertheless, the sharp drop in starts means even a slight firming in sales will quickly bring home inventories into better alignment with demand. By the end of 2008 the number of single-family homes built speculatively without a specific buyer in mind was an estimated 34% less than sales of new homes. Even with sales declining, the gap between the two has widened enough to greatly reduce the stock of unsold new homes. Still, inventories remain high relative to sales as demand has continued to fall.

Clearly, plenty more ugly data on housing—and the economy—are due in coming months, but financial markets always strengthen before the economy does. When market conditions improve, investors may begin to look across the valley of the recession to the light on the other side.

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