Only two financial markets moved this week: oil, Brent crude reaching $80/bbl, and long-term rates rising decisively, the 10-year T-note to 3.12% taking mortgages within an inch of 5.00%.
The two moves are not linked. Oil is up because an excess in storage has been drawn down, and the Saudi/Russia combine has one foot on the hose -- not a true crisis of supply. The higher price will attract new supply and reduce demand, and the contribution to inflation will be minor, crowding out consumer spending on other things.
Bonds and mortgages are relaxed about oil because they are worried about something else. The Fed.
(Political sidebar: last week this space included a list of the major issues which could have big effects on markets, good or poor, each impossible to handicap and hence freezing markets. Trade, Korea, Iran, the budget and borrowing. In the last week each one has gone from high heat to unresolved fizzle, leaving markets exhausted, confused, and just as wary.)
The Fed. Everyone who notices interest rates has heard of the possibility of an “inversion,” short-term rates driven by the Fed above long-term ones, a splendid predictor of recession ahead. However, the progression from a little rate-hiking to recession is anything but straight-line, and bonds gave us other, solid clues this week.
The 2-year Treasury note is the Fed telltale. The 10-year T-note is the driver behind mortgages, which have a half-life of roughly six years, even if 30-year loans because refis and home sales shorten actual maturity. And the 30-year T-bond is the ultimate indicator of future inflation. Movement among these three instruments relative to each other this week brought exceptional clarity.
Last week the spread between 2s and 10s narrowed to the smallest gap in this cycle, 44bps (in bond speak “basis points” are one-hundredth of one percent, written as “bps,” and spoken as beeps -- hence 44bps). 2s had risen to 2.54% in anticipation of more Fed hikes (the Fed now 1.75%, going to at least 2.25% by year-end), while 10s were stuck at 2.98%.
Narrowing spread... inversion soon? Uh-uh. The Fed’s pressure from underneath suddenly on Tuesday pushed 10s to 3.12%, re-opening the spread to twos, unchanged at 2.55%, spread out to 57bps. From here, so we will continue: 2s rising with the Fed causing intermittent hops in 10s -- until 2s finally do close on 10s, signaling the end. More on The End below.
Meanwhile, the 10s-to-30s spread tells a different story. Go back one year and 10s traded 2.25% while 30s were 2.90%. Today at week’s end, 10s are 3.07% and 30s are only 3.21%. In the last year the 10s-30s spread has narrowed from 82bps to only 14bps. Twenty years of additional risk, and my reward is 14 whole bps? That spread closure is emphatic testimony that inflation is not a risk, and rates are rising solely because of the Fed’s effort to pre-empt economic overheating and the potential for future inflation. 10s and 30s so close is the next-best indicator after 2s-10s inversion as a sign that the Fed is approaching The End.
Way back in the 1950s-1960s, the Fed spoke of these hiking cycles as “fine-tuning.” By the early 1970s, “fine-tuning” had failed so badly that it became a term of derision. Overconfidence exposed, from the 1970s forward we used “soft landing” as the hopeful objective for Fed tightening, despite Fed-induced crash after crash. The only period of soft landing on record: in 1994 the Fed hiked from 3.00% to 6.00%, in 1995 backed off to 5.50% and escaped recession for four more years despite very narrow (“flat curve”) 2s-10s-30s spreads.
The US economy 1994-1999 was most unusual, in the first stage of the IT explosion -- productivity, wealth creation, and low inflation. Also the “peace dividend” at the end of the Cold War reducing military spending in the budget, and enlightened tax and spending policy which led to budget surpluses (!!). Nothing enlightened now.
Enter new Fed vocabulary: “terminal.” Ouch. Terminal could be the place to catch an airplane or train (my Okie forbears said, “depot”). Or various illnesses including The End. The new Fed usage intends “the end,” but not that end, just the end of rate hikes.
How close are we to the end? Well, that depends. One end would be the Fed achieving soft landing, job creation falling to a sustainable level (relative to labor force growth), maybe 80,000 per month, inflation stalling at or a little above 2%, GDP settling to 1.8% growth.
Given only one soft landing on record, odds favor a different end: with the best of intentions the Fed will hike onward until we discover that a recession began four months ago.
To the impertinent question, how close are we? Spreads say that the Fed is now past neutral on the tight side, leaning into growth -- or will be for sure with the next two hikes to 2.25% baked into the 2018 cake.
We never know how much Fed leaning the US economy can take, or for how long, but the outside world is likely to fracture before the domestic economy. In a globalized world, the Fed tightens for all.
US 10-year T-note in the last year, now pushed up by the Fed, not inflation:
During a Fed hiking cycle the US 2-year T-note trades at a higher yield than the Fed’s overnight rate, anticipating future hikes. The Fed’s next hike could come at the June meeting, or not until the one at the end of July. Whichever, that next hike is built-in. Not the next, and next, and next, each of which will push up 10s and mortgages until... terminal.
With apologies for complexity, here is a combined chart of 2s-10s-30s from 1990 to present. The visual may help with the spread gibberish above. Or maybe not. The extended tight-spread 1990s soft-landing was very different from the short 2006 precursor of disaster.
Mortgage interest rates increased this past week on inflation concerns associated with higher commodity prices and a potential trade war with China. Economic data was mixed. Economic data stronger than expected included the May Empire State Manufacturing Index, the May NAHB Housing Market Index, April Industrial Production, and the May Philadelphia Fed Business Index. The new orders component of the Philadelphia Fed Business Index reached a 45 year high. Economic data weaker than expected included March Business Inventories, April Housing Starts, April Capacity Utilization, and Weekly Jobless Claims. April Retail Sales, April Building Permits, and April Leading Economic Indicators were in line with expectations. The GDPNow model forecasts Q2 GDP growth at 4.1%. The Fed is still on track to increase the Fed Funds rate two more times this year.
The Dow Jones Industrial Average is currently at 24,739, up slightly on the week. The crude oil spot price is currently at $71.48 per barrel, up almost $1 per barrel on the week. The Dollar strengthened versus the Euro and Yen on the week.
Next week look toward Wednesday’s PMI Composite Flash, New Home Sales, and FOMC Minutes, Thursday’s Weekly Jobless Claims, FHFA House Price Index, and Existing Home Sales, and Friday’s Durable Goods Orders and Consumer Sentiment Index as potential market moving events.
Mortgage interest rates increased slightly despite mostly weaker than expected economic data. Economic data weaker than expected included March Consumer Credit, the April NFIB Small Business Optimism Index, the April Producer Price Index (PPI), March Wholesale Inventories, the April Consumer Price Index (CPI), April Import Prices, and the University of Michigan Consumer Sentiment Index. April PPI was up just 0.1% and April CPI was up just 0.2%. Year over year, though, PPI was up 2.6% and CPI was up 2.5%. St. Louis Fed President Jim Bullard stated that he doesn’t see a reason to increase rates any further. Markets, though, are concerned about inflation associated with strong employment, increasing energy prices, and increasing home prices. It’s likely that the Fed will increase the Fed Funds Rate two more times this year. Economic data stronger than expected included the March JOLTS Job Openings report, Weekly Jobless Claims, the April Treasury Budget, and April Export Prices. The Treasury auctioned $69 billion of 3 Year Notes, 10 Year Notes, and 30 Year Bonds which were met with somewhat soft demand.
The Dow Jones Industrial Average is currently at 24,835, up almost 600 points on the week. The crude oil spot price is currently at $71.13 per barrel, up over $1 per barrel on the week. The Dollar strengthened versus the Euro and Yen on the week.
Next week look toward Tuesday’s Retail Sales, Business Inventories, and Housing Market Index, Wednesday’s Housing Starts and Industrial Production, and Thursday’s Jobless Claims and Philadelphia Fed Business Outlook Survey as potential market moving events.
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Markets are unusually steady, mortgages, bonds and stocks -- although not truly “steady,” just not moving.
The US 10-year T-note has traded between 2.85% and 2.97% since early February, in a disquiet world, an eternity. Two little excursions above 3.00% and below 2.80% could not hold long enough for an album snapshot.
The Fed is still coming, at an imperceptible but unstoppable pace, like Kilauea lava. You can stand right next to it, feel the heat, marvel at it, and no need to hurry away. This week one car was parked at a safe distance, but at the crucial moment would not start, and... oops. Is that the fate of the 10-year? Fed-sensitive 2-year T-notes reached 2.55% today, the spread below 10s the narrowest in this cycle.
CPI for April slowed down, as have retail sales, again -- no pressure for the Fed to pick up its pace. Nor reason to stop, either. Housing heat is confined to metro areas, but is hot, on a national basis underestimated because the countryside is flat or worse.
To understand today’s steady but unstable markets requires a short excursion into the velocity of information at trading desks. By 1870, thirty years after the invention of the telegraph -- the first long-distance information at light speed -- stock market information flowed along telegraph lines to “tickers,” so-called for the sound they made as they printed stock symbols and prices on to paper tape, about one inch wide.
A “ticker tape parade” honored a celebrity in a storm of waste tape tossed from high windows. The tape was subject to delay, magnifying market crashes, but these machines were state of art until almost 1970 when computers began to track trades. When I first sat down on a bond trading floor in 1983 the Fed had just replaced the chalkboards used to record its trades.
Then things picked up speed. A blight of small amber CRTs infested desks, hot little buggers, in rows stacked three-deep. Each one showed one active market; a bond trader might have a dozen screens open just to watch various Treasurys, and of course currency and stock screens for context.
And news. Holy smokes, news. The ticker lives on, the crosswise flow of trades mixed with news scrolling below CNBC and Bloomberg TV. To this day known as “the tape.” Associated slang: to be surprised by a news item is a “tape bomb.”
You are short Treasurys. The Fed is coming and the trade is a no-brainer. You’re into your fourth cup of coffee, almost up to full-vibrating speed, and on the tape appears ***REAGAN SHOT***. Every desk on earth buys Treasurys in a panic for safety, and your short is way under water in the ten seconds before you can get out -- if you can find an e-bidder on-screen that fast. Bye-bye bonus.
By the 1990s every desk had CNBC on all day, just in case some talking head blew up something. The morning of 9/11 on that set... it is still astounding to watch initial concern for an airline accident switch to something far worse. Many people believe that the collapse of Bear Stearns in March 2008 was caused by a questionable CNBC story.
On trading desks watching the flow of news is as natural and necessary to life as breathing. So today, what is news life like for our over-caffeinated heroes?
War is big. Markets get emotional, sell and buy a lot when shooting starts. Our heroes know that they can’t predict things (only the math dweebs with their algorithms think they can, until dragged out by their heels). But it’s essential to measure probabilities. Not load up all on one side of a market, but carefully wagered and hedged. But you’ve got to be on the right side of the market more often than not, lest “Dominoes” clamped on the roof of your car.
We have pulled out of the Iran deal, reimposing sanctions. Europe is mad at us. China is busy with itself. Israel and Saudi Arabia are thrilled. Putin trying to renew Soviet glory by acquiring Syria, which is occupied by Iranian soldiers and Iran-client Hezbollah... who knows what the Czar is up to. Yemeni rebels daily launch Iranian missiles at the Saudi capital. The immediate response to pull-out: an Iran missile volley from Syria at Israeli targets, and a massive Israeli response.
How would you like to trade that? Play it safe, or stick with good-economy trades?
Kim Il Jong may have seen the light, economic rescue by the South better than brinkmanship and starvation, or may have underway one of the great rope-a-dopes of all time. Trade on the potential outcomes? Or protect yourself? How?
Speaking of trade, we have early-stage trade war going with Europe, Asia, and North America. Pretty much everybody with something to trade. Bet on resolution, if only to accommodate the US and buy time, or bet that somebody doubles down, if only for pride?
The US has entered another spending-borrowing binge. Although 2018 tax receipts are bigger than forecast (from individuals, not corporations, of course), the US Treasury is elbowing into markets. This week it sold $21 billion in new 10s and $17 billion in new 30s and the market ate ‘em up with no harm to rates. We entered this form of bulimia 50 years ago, and it’s clear that the world loves our IOUs. The problem from the illness is domestic. By the end of this year, Treasurys in markets will total $16 trillion. If the Fed hikes 1% in the next year, add $160 billion to annual interest cost, and oh-by-the-way which spending will we cut, or whose taxes will we raise to offset? Or will we borrow more to pay the interest?
How would you like to trade that one, today?
The most unquantifiable single item today: what is the extent of US power? Our military power relative to the world has waned ever since 1945. Should we pursue disengagement, pick our spots, as Obama tried? Or should we re-assume a muscular footing, not for self-aggrandizement or glory, but once again be the world’s cop, for stability’s sake?
I am greatly surprised (a common event) that in a dollar-dependent world of globalized commerce, Treasury-imposed sanctions on the banking system seem to make the US more powerful than ever. When and how to use that power? Likely outcomes? Economic effect here and everywhere? Trade on that today?
Right. That’s why markets are not moving. And not stable.
US 10-year T-note in the last year, stuck:
Fed-predicting US 2-year T-note in the last year, NOT stuck:
The NFIB survey of small business continues its disconnect, overall optimism at historic highs, but actual conditions going nowhere:
The full, time-lapse tape shows the lava taking most of a day just to cross this road, but just like the Fed, inevitable is inevitable. The owner said that losing the R2D2 mailbox was worse than the Mustang:
Mortgages and housing continue to dodge Fed bullets. The 10-year T-note is steady near 2.95%, which holds 30-fixed mortgages near 4.75%.
First the data, then the Fed.
The first Friday of each month brings the data-gorilla: job market results from the immediately prior month. April payrolls grew by 164,000 jobs, about as forecast but double the Fed’s estimate of a sustainable, non-inflationary pace. However, everything else about the report was weak. Average hourly earnings rose by four whole cents, an annualized increase of 1.8%. Long-term unemployed, involuntary part-time, participation rate, average hourly work week, discouraged workers... all unchanged. 3.9% unemployment is s statistical quirk.
Two other early-month indicators for April, the ISM surveys of manufacturing and service-sector purchasing managers: expected at 58.7 and 58.4, respectively, arrived at 57.3 and 56.8 -- still pretty good numbers but now in serial decline.
In new data from an older period, March personal income gained 0.3%, a little below forecast, and the Fed’s favorite measure of inflation (core personal consumption expenditure deflator, “PCE”) slid slightly upward to 1.9% year-over-year, essentially on Fed target.
This overall picture is a modest down-wobble, not a truly weak trend. However, every month in which 2018 continues this way questions the effect of the new tax cuts and fountain of deficit spending. Businesses were supposed to hire, raise wages, and invest, and they are doing none of these things. Public corporations are reporting first-quarter earnings, and some analysts find roughly half of earning gains attributable to tax cuts.
The Fed met this week. Stronger economic data in prior months had created a bit of a debate: the Fed had given every indication of three .25% hikes in Fed funds this year, one already done to 1.75%, and a few people inside the Fed and many outside argued that the Fed would go four times. The case for four has been poor, is poorer now, and markets say that four ain’t happenin’. And that the second and third may take a while. Nevertheless, chirpers say another hike at the June 13th meeting.
To watch the Fed, watch the 2-year T-note. These are so short-term, and so often financed that changes in the cost of money make or break traders. During a period of Fed hikes, 2s must trade at a yield premium to the current Fed rate because it’s going up again and again before the 2-year matures, and longer-term securities must pay more than short-term because risks expand with time. The Fed is 1.75% now, and 2s have been trading at 2.50% for three weeks -- did not even flicker upward after this week’s meeting. At 2.50%, 2s traders have built-in the Fed’s next hike, but not the one after that, or any prospect of a fourth this year. (BTW: please ignore the Fed funds futures market, an anti-predictor.)
The second reason to watch 2s: the spread to 10s. 10s have not moved since the end of February while 2s have moved up. the 2s-10s spread is now the narrowest since the last recession, only 0.45% (45 “basis points,” each one-hundredth of one percent, expressed as “bps,” spoken on trading desks as “beeps”).
Two reasons to watch 2s-10s: first, a narrow spread wrecks the adjustable rate-mortgage market. There is little discount now from 30-fixed for 5- and 7year ARMs. Second, historically when 2s have crossed above 10s, recession is guaranteed.
The Fed after each meeting issues a one-page statement, most of it repetitive and content-free. Chair Greenspan grudgingly began to issue these statements for the first time in 1994, usually one or two sentences. Today we scour each of the new, Aunt Blappy versions for subtle shifts, and this week’s had one: “Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.” Bold face “symmetric” is mine. That one new word added resolves a debate inside the Fed and a question outside. Is the 2% target “hard?” Like an electric-wire fence, to touch it will bring immediate and painful response?
“Symmetric” says, no. The Fed tolerated the last five years below 2% without re-entering QE and easing hysterics, and will tolerate two-plus for a while. Recent increases in oil prices are highly likely to take even core inflation above 2% for a while. However, although the Fed will not accelerate its pace of tightening now, that withheld action is predicated on the expectation that the current pace of tightening will by next year slow the economy to a sustainable pace, GDP growing sub-two, monthly payroll gains below 100,000.
That’s the dry, technical case. Reality? An old friend used to say that the Fed’s job was to carry an immensely valuable crystal orb balanced on a flat silver tray without edges, while refereeing a hockey game.
Tax cuts and fiscal splurge about to over-stimulate the economy? Odds are falling. The prospect of trade war? US trade policy is in the hands of Peter Navarro, certified fruitcake who upon the departure of our negotiators for China said, “The discussions will take place in Beijing, but the decisions will take place in Washington.” Right. I can imagine Fed officials after reading this line covering their eyes. At the Fed you’re not allowed to roll them.
Since 1944 the world has made great progress in trade negotiations, always in multi-national concert. The world is more economically entangled than ever before, hence the futility of attempting one-on-one negotiations. That strategy could result in all against one. Any business manager plugged into global trade, NAFTA maybe as important as all of the rest combined... any manager is reluctant to wager new risk and is instead laying contingency plans for defense.
Put all of that together and it’s not surprising that market interest rates are not moving up, even though the Fed will.
US 10-year T-note in the last year, stuck since February:
US 2-year T-note in the last year, stuck for three weeks:
Perhaps the most concerning chart, source WSJ and Fed, reveals the continuous, eight-year overestimation of future inflation. We have at last reached 2%, but what confidence can we or the Fed have in future projections, higher or lower?
The Atlanta Fed at the outset of Q1 projected 5% annualized GDP growth in Q1. Turned out to be 2.3%. Its newest for Q2 begins with 4% growth:
The ECRI has stalled, GDP indicated about 2.5%:
Mortgage interest rates improved slightly as economic data was mostly weaker than expected. Economic data weaker than expected included March Personal Income, the April Chicago Purchasing Managers Index, March NAR Pending Home Sales, the April ISM Manufacturing Index, March Construction Spending, Q1 Productivity and Unit Labor Costs, the April ISM Services Sector Index, April Non-Farm Jobs, April Private Jobs, and April Average Hourly Earnings. Economic data stronger than expected included April ADP Private Jobs, Weekly Jobless Claims, March Factory Orders, and the April Unemployment Rate. Unemployment fell to 3.9% on expectations of 4.0%. As expected, the Fed left the Fed Funds Rate unchanged after its FOMC Meeting. It also indicated that future increases will likely be gradual, calling into question whether the Fed will raise rates three more times this year.
The Dow Jones Industrial Average is currently at 24,145, down about 165 points on the week. The crude oil spot price is currently at $69.03 per barrel, up about $1 per barrel on the week. The Dollar strengthened versus the Euro and Yen on the week.
Next week look toward Monday’s Consumer Credit, Tuesday’s NFIB Small Business Optimism Index and JOLTS Job Openings, Wednesday’s Producer Price Index (PPI) and Wholesale Trade, Thursday’s Consumer Price Index (CPI) and Weekly Jobless Claims, and Friday’s Import and Export Prices and Consumer Sentiment Index as potential market moving events.
The US 10-year T-note made it just above 3.00% before pulling back, and mortgages stopped rising short of 5.00%, today about 4.75%. However, today is odd. 1st quarter GDP data was released this morning, growing 2.3% annualized, probably distorted to the downside, but inflation-related aspects moved up.
Rates should have moved up farther but have not -- not long-term ones, and not the Fed-predicting 2-year T-note. Some observers think the economy will push the Fed to three more hikes this year instead of two, but market data says “uh-uh.“
For the moment, housing is safe. When mortgages do cross above 5.00% the psychological impact is likely to be greater than the change in payments.
Under normal circumstances, any common ones in the last fifty years, we would now enter the predictable Fed phase: continue to ooch upward until the economy slows, which the Fed accidentally overdoes and we have recessions.
Looking back a half-century, the rocket in oil prices guaranteed the ’73 recession no matter what the Fed did. The long, double-sink ’79-’82 affair was the intentional work of Paul Volcker. However, the next ones, ’91, ’01, and ’07 were all surprise events during gradual Fed rate-hiking. That’s the model. Only once in that whole span did a string of Fed hikes produce a soft landing (1994), and that was a close miss of recession.
But today is not normal. Patterns recur, but today is today, not yesterday. Perhaps the largest “not normal” is the global economy outside the US, allegedly in a strong and synchronized expansion which should exert even more upward pressure on rates. In the warm afterglow of the visit of Emmanuel Macron and icy welcome to Angela Merkel, start with Europe.
Macron is an exceptional player of poker, tilting the table his way even when holding no cards. He is charming, brilliant, and tough, the model of French leadership (graduates of Ecole Nationale Polytechnique, known as “énarques” run the place no matter who is president). Macron’s immediate predecessors were the worst since the 1958 founding of the 5eme Republique: Sarkozy a crook, Hollande a laughingstock.
France has never been as productive as Germany and will not be, despite Macron’s exertions toward a market-based economy. French public debt is just shy of 100% of GDP and packed into French banks. Its annual budget deficit is down to 3% of GDP, but growing faster than GDP, which in this very good year may reach 2%. Its trade deficit is 2.5% of GDP.
Rather worse, France must pay its bills in euros, whose value is based on the German economy and anti-inflation mania. Germany’s debt is only 65% of GDP and falling because Germany’s budget is in surplus by 1% of GDP. Germany’s trade surplus at 7% of GDP is the largest of any major nation and hurtful to all. No state dinner for Angela.
The empty hand played so well by Macron is based on elegant double-talk (French is ideal; even German poetry sounds like giving orders). Salvation for France is based on a duet with Merkel: “Europe’s problems can only be solved by more Europe.” But the two are off-key. To Merkel, more Europe means everyone to behave like good Germans, budget and trade surpluses devastating to the outside world including Euro-others, but good for Germany. To Macron more Europe means fiscal and banking union, mutualized taxes, debt and deposit insurance -- a transfer union in which Germany picks up the tab for the others’ deficient productivity. Nein. Wird nie passieren.
Europe is exactly where it was ten years ago, stifled by the German euro, and the ECB playing for time. This week the ECB again flinched from any pullback in emergency measures, its overnight cost of money minus-.4%. The Fed will be at least 2.25% by the end of this year. Our 10-year Treasury note pays 2.96% today. The German version pays 0.57%, and even flat-broke France can borrow at 0.79%. European fragility shows in Italy’s 10-year cost at 1.73%, and Spain’s at 1.25%.
These yields expose Europe’s recovery as a rag doll animated by the central bank -- as long as it can. So long as inflation stays below 2%, it can, but when the ECB stops then all of the Euro fissures will reopen. Japan is the same, sustained by its central bank, but its fundamentals far worse than Europe as evidenced by its 10-year yield today at 0.05%. China’s economic miracle acts as a tax on the rest, its over-production a heavy burden -- which if anything will increase as China attempts to restructure away from debt-based growth.
That external pattern explains our domestic mysteries. Given the tax bill and doubled deficit spending the US should be rocking and the Fed pulling away the punchbowl. We are growing well, especially jobs, but not accelerating.
All credit market eyes are on the narrowing spread between the Fed-sensitive 2-year T-note, today 2.48% and the 10-year, as above at 2.96%. When 2s pushed up by the Fed cross over 10s we have a recession. But, this time we might invert only because the outside world is the same jar of pickles it was the last time long-term US rates hit all-time lows.
Those of us in housing and mortgages certainly hope so.
The US 10-year T-note in the last year, tip-toeing across 3.00% and then scurrying back:
The 2-year T-note... no tip-toeing, no scurrying, just marching up in advance of each Fed hike:
The ECRI has settled in an okay place, but not hot, and as above is not accelerating: