The Cost Of Living Index Plunges, But Unfortunately Mortgage Rates Don't Follow Along

If the presence of inflation causes mortgage rates to rise, then the absence of inflation should cause mortgage rates to fall. And, in most markets that's true.

Today, it's not.

Despite a deep dip in consumer prices not seen since 1947, mortgage rates started out the morning inching higher.

The main reason why rates began rising today is that the Cost of Living didn't just ease last month -- it plunged. In fact, the monthly drop was so severe that Wall Street now questions whether this summer's record-breaking inflation will lead to equally-strong deflation this winter.

In economic terms, deflation is the opposite of inflation -- it's when prices and wages chase each other lower. The two can be equally bad for the economy. What's often best for Americans are moderate, steady readings.

Because of the rapid decline, markets fear that Consumer Prices may have swung way past moderate in October and started a downward spiral. As always, however, market opinions can change quickly and when they do, they usually take mortgage rates with them.

Looking Back and Looking Ahead: July 21, 2008

Mortgage rates soared last week as mortgage markets experienced a 4-day freefall.

By the end of the trading week, conforming mortgage rates had jumped by as much as 0.500 percent.

The spike in rates can't be pinned on any one factor, but 3 contributing factors include:

The lingering impact of high energy prices on inflation.
The ongoing weakness of the U.S. dollar.
A rally in the financial sector, marking a return to risk-taking.

Inflation and a weak dollar both devalue mortgage repayments, a well-chronicled relationship on this blog. In short, when mortgage bond investors find that their repayments are worth less, they demand a higher return. This causes mortgage rates to rise.

But, it wasn't inflation or the dollar that caused the majority of the damage to mortgage rates last week -- it was the rally in the financial sector.

Rates had edged higher Tuesday on the inflation data but it wasn't until Wednesday's morning stronger-than-expected announcement from banking leader Well Fargo that mortgage rates really started to spike.

In its quarterly report, Wells Fargo said that its balance sheet was strong and that it planned to increase shareholder dividends. The rosy announcement sparked a strong demand for all things financial and -- by day's end -- the sector scored a 12.3 percent gain on Wall Street.

It was the largest one-day gain in financial stocks ever.

Then, following Wednesday's rally, financials picked up additional momentum and ended up closing out the week higher by 21 percent.

Unfortunately for mortgage rate shoppers, a large chunk of the money that fueled the rally came out from the mortgage bond market.

As investors looked for cash to buy financial stocks, many chose to sell mortgage bond holdings, creating excess supply. More supply leads prices lower and, in the mortgage world, when prices fall, rates go up.

Because mortgage bond prices fell a lot last week, mortgage rates rose by a lot.

This week, expect momentum to be The Big Story. There is little data beyond Thursday and Friday's Existing Home Sales and New Home Sales, respectively, and Friday's Consumer Sentiment Index. And only a few members of the Fed will be speaking in public.

The one bright spot last week was falling oil prices.

After an 11 percent decline, Americans are waking up this morning to lower gas prices. This is anti-inflationary and could help tug mortgage rates lower.