We are likely to be in a sustained rise in interest rates (sometimes just writing that sentence means that the rise has stopped for good), but even a sustained one has its plateaus, and at the end of this week the credit markets have stabilized.
The 10-year T-note in July 2016 fell to 1.37% (mortgages 3.375%). Five months later, in December: 2.57% (mortgages 4.25%). Then nine months of modest retracement downward, last September back to 2.05% (mortgages 3.875%). Followed since by the fast run to 2.90% (mortgages 4.75%), a little better at this week’s end.
That’s double in 18 months. Only 1.5 percentage points, but the highest long-term rates since 2011. The question now is when the 10-year will break through 3.00% going higher, and “five” will re-enter the mortgage vocabulary for the first sustained time since the Great recession. Market consensus (of course often wrong): “when,” not whether.
The largest part of the move thus far is catching-up by markets (not the Fed) after a long period of denial. The Fed is certain to continue to raise the overnight cost of money (the Fed funds rate), and long rates are on alert.
From here, everything depends on inflation. Since we have not had a multi-point, multi-year rise in inflation in 35 years, a review of inflation mechanics is in order.
1. Inflation is defined as too much money chasing too few goods and services.
2. “Too much money” has been very well prevented by global central banks for the last 35 years. Sick places like Venezuela, Zimbabwe, and Argentina have been vulnerable, especially to the antique method of over-printing physical currency. However, Milton Friedman’s Law, “inflation is always and everywhere a monetary phenomenon” did not survive the 20th Century, and the 21st has been embarrassing.
3. “Too few goods,” think price shocks from commodities. Oil was the direct cause of the 1970s inflation disaster. Not now, not at all. Contrariwise, “supply side economics” as a cure has given voodoo a bad name.
4. Inflation will not get started or sustain without corresponding growth in incomes. Not now, not yet.
5. Inflation hell is a “wage-price spiral,” in which the two chase each other upward. Today we couldn’t get that going if we tried. Right-siders say that 1970s spiral was the fault of unions and cost of living adjustments, but the greater enabler was the absence of international wage competition. Today we are hammered by that competition.
6. Deficits? This new binge by Republicans and Democrats together? The Treasury selling more bonds of course produces upward pressure, but hard to isolate and likely small. Treasury borrowing crowds out other borrowers of lesser credit rating, who must pay higher rates. There is no linkage between deficits and inflation...
7. ...except if the Fed monetizes and overstimulates the economy. The Fed is doing the reverse, now. “Overheating” is a real risk, but every valid metric from WW II to 1995 has broken down, the whole world growing fast but inflation underheating. GDP can grow way out of the bounds of “productivity” without inflation, and far below “capacity” with inflation (“stagflation”).
8. An overheated housing market has been central to all prior overheatings. Not now. Housing is chilled by tough credit standards and high demand only in urban areas.
9. “Falling dollar?” Ignore that. Sure, a truly weak dollar forces up prices of imports, but that’s 1970s-think, global and domestic economies then were rigid compared to today’s ultra-e-flexibility.
10. Today the two hugely powerful suppressants of inflation -- nearly tipping the world into deflation and depression -- are as active as ever: global trade and IT. Competition is inescapable.
So, where’s the friggin’ fire? If we don’t have any of the propellants of inflation, and the dampers are still on, what is the panic in bonds about? And the Fed’s plans for a quarter-point death march ahead?
We don’t know. Tee-Hee.
The Fed doesn’t know, and the financial markets don’t know. The best we can do is to bracket the probabilities.
Start with “how high, how fast.” The Fed is determined to defend its 2% target. The Fed can get behind and have to catch up, a prescription for up-fast too-high and back-down-fast. The 10-year maybe to 4% briefly, mortgages pressing 6%, followed by a refi party.
The other side of the high-probability bracket is continuing “normalization,” the Fed in search of the “neutral policy rate known as r* (pronounced “ar-star”) defined as the Fed funds rate spread above inflation which is neither stimulative nor a drag.
The Fed does not know the location of r*, in part because it moves. In the 1970s to offset oil and inflexibility, r* might have been a 4% premium above inflation -- and the Fed’s flinch from that altitude encouraged the deadly spiral. Just last year Yellen mused that r* might now be zero -- a normalized Fed funds rate might be the rate of inflation itself.
Given all of the inflation-suppressants in place, guess at r* at 1%, which is what the Fed is doing with its damned-little-dot scattergram of future intentions. Two- or three-year target for Fed funds: 3%. But then a secondary unknown: the response of long-term rates to that level of Fed funds. If inflation stops at 2%, the Fed tough, the 10-year might not get above 3.5% or even so high, mortgages mid-fives. Normalized.
If so, somebody on Wall Street might say something nice about the Fed.
The 10-year T-note in the last FIVE years, everyone in markets staring at the 3.00% double-top at the end of 2013:
The Fed-sensitive 2-year T-note, same five years showing two things: how vastly variable long-term rates are versus the Fed, and the stall in the last two weeks hints that markets are ahead of themselves in both Fed- and inflation-fear:
The National Federation of Independent Business has surveyed its members since 1974, one of the longest useful series on the US economy. All following charts are NFIB, apologies for inconsistent format. Since ’74 the NFIB surveys have been an excellent real-time indicator of the US economy -- until Election Day 2016 when it departed the economy for politics. Its membership is heavily right-side, which is fine and normal, but our economic-political relationship today is not normal, unusual experiments underway. The election spike in optimism could not be more plain:
The underlying survey components tell a different story, worth watching. Last month “optimism” reached an all-time high -- not at all reflected by survey components. “Earnings” are the one happy spike, and with the tax bill giveaway to businesses, one would hope so. But, does that change indicate a shift in the real economy?
This is the “sales” component. Yes, there’s a nice jump in “actual” (bold line) in 2017, but nothing fancy compared to the 2012 spurt, and still tepid compared to 1974-2006:
“Prices” are still a falling trend. “Compensation” is rising steadily, and if it breaks above the long-term trend, one of the best inflation-precursor indicators:
Question asked and answered. No:
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Mortgage interest rates were mostly flat on the week despite stronger than expected inflation data. The January Consumer Price Index (CPI) was up 0.5% on expectations that it would be up 0.3%. Core CPI, excluding the food and energy components, was up 0.3% on expectations that it would be up 0.2%. Year over year CPI was up 2.1% and core CPI was up 1.8%. Other economic data was mostly stronger than expected. Economic data stronger than expected included the January Treasury Budget, the January NFIB Small Business Optimism Index, the January core Producer Price Index (PPI), the Philadelphia Fed Business Index, January Housing Starts and Building Permits, January Import and Export Prices, and the University of Michigan Consumer Sentiment Index. Economic data weaker than expected included January Retail Sales, the February New York Empire State Manufacturing Index, January Industrial Production, and January Capacity Utilization. It’s likely that the Fed will increase the Fed Funds rate three times this year with the possibility of a fourth rate increase.
The Dow Jones Industrial Average is currently at 25,336, up over 1,100 points on the week. The crude oil spot price is currently at $61.44 per barrel, up over $2 per barrel on the week. The Dollar weakened versus the Euro and Yen on the week.
Next week look toward Wednesday’s PMI Composite Flash, Existing Home Sales, and FOMC Minutes and Thursday’s Jobless Claims and Leading Economic Indicators as potential market moving events. The Treasury auctions 2-Year Notes, 5-Year Notes, and 7-Year Notes as well. U.S. markets are closed on Monday for Presidents Day.
The bipartisan tax bill agreed on today has extended a tax deduction for some homeowners through 2018.
If your household has a total adjusted income of $100,000 (gross) or less, 100% of your mortgage insurance premiums will still be deductible on next year’s tax return.
Depending on the amount of mortgage insurance paid, this could be a big savings.
The stock market’s ongoing adventure with the same banana peel has stopped the rise in long-term rates, mortgages just above 4.50%. However, no matter what happens to stocks, the upward tilt in long-term rates will continue until we get news that the economy is slowing, next month, next year, or someday.
Stocks do matter even to people who don’t own any: every news outlet in the last two weeks has led with trouble in stocks, and everyone thinks that stocks are a proxy for the economy (and sometimes it is). Reassurance is not as easy to provide, but follows here.
The fine points are crucial, and are lost in the hysteria around market movements -- hysterics both exaggerated and suppressed, especially traditional euphemistic nonsense like “correction” to describe the Dow’s worst single-day point loss ever.
There are two fine points which overlap: first is the past and current actions of the Fed, and second what the Fed will do. In the following I feel some compassion for honest commentary by people who have not seen enough cycles to get this one, and the usual contempt for those trying to make a sale by misleading or frightening civilians.
A “factoid” is an assumption or speculation repeated so often that it becomes accepted as fact (Oxford). Today’s Class-A Number-One factoid: financial markets are bloated because central banks soaked the world in cash to get us out of the Great Recession, over-did it, and as the central banks withdraw the cash financial markets will crash. Possibly below zero. Worse than climate change.
Most of that apocalyptic commentary comes from people who didn’t and don’t like the Fed’s rescue, arguing that it was unnecessary or over-done, and that the Fed didn’t create the economic recovery anyway.
The easy-money-withdrawal factoid is tempting but false. The purpose of the easy money was to get us out of recession. Once we’re out of recession we don’t need the easy money any more. The recovered economy produces plenty of support for stock markets, and proper Fed management withdraws the easy money to prevent overheating. The Fed began that recalibration five years ago by tapering and ending QE bond-buying, and continued in 2015 with the first hike in the cost of money, and last year by beginning to let bonds roll off its balance sheet.
A principle which you can count on: capitalist economies tend to enter self-reinforcing spirals, both up and down. We invented central banks (Walter Bagehot and the Bank of England ca. 1873) to intercept the spirals.
Your central bank can, of course get it wrong. Every spiral is different. But to take as factoid that the Fed switching from stimulus to not means that financial assets are overvalued and we’re all going to die... horsefeathers.
Second: what the Fed will do. There is another, milder misunderstanding loose, and I contributed to it last week and should not have. The alleged trouble in the stock market is the sudden return of wage growth and inflation, and the Fed will have to tighten faster and farther than it has said, and may already be behind the curve. That is alarmism not justified by the facts. Here is the actual sequence and the harm done to markets.
Way back at the onset of recovery the Fed began to forecast strong recovery and equally strong removal of stimulus -- every year from 2011 forward. The Fed was mistaken each time, its models insisting on a new upward spiral which did not materialize. Some things did heal (the taper followed evidence that banks could again generate credit on their own), but no spiral, especially wages not rising with lower and lower unemployment.
Markets are obnoxious. Warn them over and over about a wolf who does not appear, and markets assume there’s no wolf, not just a wolf with a bad clock. The jump in long-term rates and simultaneous pratfall in stocks does not anticipate a faster-higher Fed -- after seven years of false alarms, markets at last understand that this year the Fed is going to do what it said it would. We have every imaginable condition precedent to wage growth and inflation, but not the fact of them, just 90 days’ maybe-could-be signals.
It is so convenient to blame the Fed. Beats hell out of blaming your own salesmanship or your clients. Today’s factoid crowd is as unseemly as the 50-year-old who can’t get over his Mommy’s mistakes.
In 1982 the stock market began a magnificent run from Dow 896(!) coincident with the Volcker Fed’s breaking the back of inflation, and the 20-year cascade of interest rates which followed. Stock market takeoff to outer space coincided with Dow 2,500 in the early 1990s, further coincident with the fall of Soviet Russia and its Iron Curtain, with the opening of China to “capitalism with Chinese characteristics,” and with your first e-mail address and cell phone. By 2000 the Dow quadrupled to 11,000; in 2002 back to 8,000 in the tech bust. By 2007 and the credit bubble, doubled to 14,000. Then in 18 months and the Great Recession, cut in half.
From 7,000 in 2009’s recession-bottom to 18,000 in 2015-2016 made some chart- and common sense, a reasonable gain from the prior top. But, from 18,000 to 26,000 in the 16 months since? Quadruple 2009?
Blame anyone you would like, but... expect to keep that? Keep the hyperbolic curve from triple to quadruple? Fool me once, fool me twice, but the third time... I have only my mirror.
Going forward expect stocks to give up more ground, maybe all the way back to 18,000 for a while, but with little real economic effect, or indication of the real economy. If stocks go that far, then maybe the Fed would pause on the way -- just to watch the somersault -- but wages and inflation are the real deal.
The 10-year T-note two years back. Stalled for now in the 2.80s:
The Fed-sensitive 2-year T-note, taking no prisoners. The Fed’s next hike is fully in today’s 2-year yield, and part of the hike in summer. But not any of the third:
The Dow back to 1990. The marker of folly since fall 2016: the steepening curve of price gains. Note extensive support at 18,000 and none at all above that level:
The Atlanta Fed is not as upside-scary as last week, and not even big growth will necessarily accelerate the Fed:
Mortgage interest rates increased slightly on the week as the stock market continued to lose ground. The stock indexes have fallen 10% indicating a market correction. Congress passed a two-year budget deal which will now be forwarded to President Trump for signature. The Congressional Budget Office estimates that the budget will add $320 billion to this year’s budget deficit. This deal also suspends the debt ceiling through March 1, 2019. The Treasury auctioned $66 billion of 3 Year Notes, 10 Year Notes, and 30 Year Bonds which were met with soft demand. Economic data was limited. Of note, the January ISM Services Sector Index, Jobless Claims, and December Wholesale Trade were stronger than expected. The ISM Services Sector Index reached its highest level in 20 years and Jobless Claims fell to their lowest level in 45 years. The December U.S. Trade Deficit, December JOLTS job openings, and December Consumer Credit were weaker than expected.
The Dow Jones Industrial Average is currently at 23,715, down over 1,800 points on the week. The crude oil spot price is currently at $60.19 per barrel, down over $5 per barrel on the week. The Dollar strengthened versus the Euro and weakened versus the Yen on the week.
Next week look toward Tuesday’s NFIB Small Business Optimism Index, Wednesday’s Consumer Price Index, Retail Sales, and Business Inventories, Thursday’s Jobless Claims, Philadelphia Fed Business Outlook Survey, Producer Price Index, Industrial Production, Empire State Manufacturing Survey, and Housing Market Index, and Friday’s Housing Starts as potential market moving events.
Tough week, tough day, and no way to sugar-coat. Long-term rates have broken out the top of five years of all-time-low rates, and only the stock market in free-fall has limited the rate damage.
Mortgage rates today are 4.50% and may wander here temporarily before rising toward 5.00%, soon.
The speed of change in markets now is beyond usual measurement, and more important is a shock to civilians. Freddie Mac has surveyed mortgage rates weekly for almost 50 years, and its reports get top billing by the media. The survey weakness: Freddie collects data early each week and releases on Thursdays -- yesterday’s finding of “4.22%” is a Jurassic Park classic, obsolete by a quarter-percent.
Not only the speed of change, but a complete foundational reversal from the mental conditioning of the last fifteen years. It has been almost that long since the Fed embarked on a tightening cycle, also that long since market professionals worried that the Fed was too slow, too late, and catching-up would cause a recession.
Early this morning two otherwise fine reporters on a national cable channel (nameless to protect their children) exchanged puzzlement: “The job data today is terrific... so why is the stock market down so far?”
If they are confused, consider the public. If you are aged 35 years, you have no adult experience with what is at hand, and coming.
Today’s employment report was a blowout. Not just the 200,000 jobs added, but hourly wages rising from 2.5% year-over-year to 3%, and the upward gear-shift over a 60-day span coincident with the tax cut. The Fed let rates stay so low for so long despite solid economic growth and unemployment falling to 4% because wages were suppressed and so has been inflation. If wages are out of the box, the Fed cannot wait for inflation to follow.
In the ancient vocabulary, a “soft landing” is the objective of every Fed. That is, as an economic recovery matures to extend it by raising rates gradually, simultaneously inhibiting inflation while not over-doing the rate hikes. But, we never land softly; extended recoveries are a matter of accident. The Fed is always forced to choose between inflation-fighting and growth. Yesterday’s soft-landing prayers were based on job growth slowing to 100,000 monthly, roughly the growth rate of the work force, before a wage spiral begins among employers competing for scarce workers. Today, odds are not so good.
Will a ker-plunking stock market stop the Fed? New Chair Jay Powell one year ago gave us a line which one day may rank with McChesney Martin’s wisecrack about the punch bowl: “It is not the Fed's job to stop people from losing money.”
Adding to the Fed’s normal trouble with cyclical surprises like an accelerating job market is the absolute idiocy of a big tax cut at the mature end of a recovery. Nothing partisan: Democratic administrations have done the same.
Aside from unwanted economic stimulus, there’s the deficit issue. Fiscal deficits were justified to get us out of the Great Recession, or any recession. But now, weighing on markets and the Fed, our 2018 deficit will roughly double to $1 trillion as far as the eye can see, and just out of view the explosion in entitlement spending.
Human weakness in moments like this -- mine, certainly -- is to collapse all of the future probabilities above into the present. Stick with Stephen Hawking: “’Time’ is what keeps everything from happening all at once.”
As this situation unfolds over time, new data less certain than today’s, the key thing at the Fed: the tougher the Fed, the less long-term rates will rise. And that’s more important today than ever because this is the first mature recovery (ever) in which housing is NOT overheated. We are of course acutely sensitive to mortgage rates, but we are not what has gone sour.
An overheated labor market historically can be cooled only by rising unemployment. I don’t know how to accomplish that without adding housing to the sacrificial pyre, but I have some hopes that stocks this time take our place.
The most troublesome aspect of public policy today: the Fed is on its own, and has been since 2000. In 2000 we looked back on a federal budget in surplus, the great bipartisan achievement of Reagan, Daddy Bush, and Clinton. Since then... not a time to be proud of our democracy.
To make this memo fully depressing, there is another troublesome market move which could possibly (unthinkable) jolt national leadership to responsibility. I advise frequently not to pay attention to movements of the dollar in global markets. This time... rising interest domestic rates are the primary driver for any currency to rise in value. Our economy is hotter and our rates rising faster than any other nation. But the dollar has been sinking since mid-2017, and the Titanic since the tax cuts and future-deficit balloon.
That is a financial reaction, but there is more. Markets have mostly ignored US political turmoil in the last year, but we rely on the outside world to finance our deficit, new money and the rollover of existing debt. If the outside world begins to think that we are unable to manage our affairs, it can lose confidence in our IOUs.
This concern is not limited to the president or the majority party in Congress (although a Trump twitter fit at Chair Powell would hurt). The leadership of the other party is awful, too.
Concern for our deficit and leadership has come and gone since the 1960s. But the moment when global markets lose faith in a nation always has come as a surprise.
The US 10-year T-note in the last two years. The only chart “support” is at 3.00% back in early 2013, and we should not count on that holding. The only two things which will stop this increase: either a more aggressive Fed, or a stumbling economy:
The Fed-sensitive 2-year T-note in the last two years -- which today did not price-in an acceleration in the Fed’s plans for three hikes this year:
While praying, include a hope that the Atlanta Fed’s preliminary for Q1 2018 is a high-side mistake. It may not be: Q4 had understated GDP, 2.6% but consumer spending was pushing 4%:
Another small plea while on your knees at bedtime: that the ECRI’s metrics are correct, and the economy is not overheating:
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