From the desk of our Capital Markets Analyst - June 16, 2017
Have fun with this one: the Fed hikes, and mortgage rates fall. True. And again! Long-term rates have fallen after each of the three increases in the cost of money since the election.
30-fixed mortgages are a closing-cost argument below 4.00%, and the 10-year T-note is down to 2.15%.
Before the whys and wherefores, get one thing straight: if it were not for the Fed marching the overnight rate upward, long-term rates would be falling more -- maybe a lot, a half-percent or more from here, unwinding the entire post-election rise and then some.
Hatred of the Fed is a branch of market dislike for regulation and government in general, which distorts much analysis of cause and effect, especially in perverse trading like this. Charlatans are selling the story that long-term rates are falling in a pre-recession signal that the Fed is overdoing its increases. Nonsense.
The Fed is not even trying to slow the economy. Its hikes to date have had no effect on credit conditions -- nor will the next four or so .25% hikes. Long-term rates are trying to fall for unusual but simple reasons: inflation is low and possibly falling again, and the ECB and BOJ continue their hysterical purchases of long-term IOUs.
The Fed will likely put a floor under long-term US rates, probably at levels close to today’s, and then gradually bulldoze them slowly higher, fighting the market and other central banks every inch of the way.
Evidence for the assertions above would be a good idea. First and overwhelming: long-term rates fell on Wednesday morning before the Fed announced the rate hike which everyone knew was coming. Before. Three things happened early that morning: oil dropped below $45/bbl in global markets, the Saudi-Russian-OPEC effort to resuscitate the cartel and prices a complete bust. Second, US core CPI in May rose only 0.1% and the year-over-year fell to 1.7%. Third, a long-overdue decline in auto sales in May. These data appeared together, and the 10-year yield nosedived from 2.21% to 2.10% (chart below).
I have no memory of another occasion in which long-term rates plunged hours before a known Fed rate hike. Left alone, long rates would fall further. The BOJ is holding Japan’s 10-year just above zero (0.056% today), and the ECB has Germany’s not much higher (0.277%), making US 10s a screaming buy. These two central banks are buying $150 billion of long-dated IOUs each month.
The Fed is not going to leave long-term rates alone. Chair Yellen’s post-meeting press conference and accompanying forecast materials were unmistakably hawkish. But, there are big hawks and then little hawks. When the Fed raises the cost of money it is said to “tighten,” as in credit conditions. Yellen was asked about that and replied, “We’re not targeting financial conditions. We’re trying to set a path of the Fed funds rate.”
Huh? Just as she has said for years, the Fed is not trying to slow the economy (not yet). It is trying to remove excess stimulus for two reasons: so it could cut its rate if it had to in an unexpected slowdown, and in the alternate -- an unexpected inflationary acceleration -- would not shock the economy with a big and fast increase.
Nevertheless, a hike is a hike is a hike. It will be very difficult for long-term rates to stay here while the Fed jacks the overnight rate. Watch the spread: the Fed funds rate is now in a band 1.00%-1.25%, and the 2-year T-note is up to 1.32%, 10s as above 2.15%. A narrowing “2s-10s” spread is a classic pre-recession signal, but not this time. This time a narrowing will be a warning of higher mortgage rates to come.
The Fed had bigger news. It will begin earlier than expected to unload the bonds and MBS it bought in the QE series. Many in markets thought the Fed would suspend rate hikes out of caution while embarking on the unprecedented unwind of its balance sheet. Uh-uh. The Fed will begin to trim in September, and its “damned little dots” forecast if anything is more forthright to add another .25% hike this year and three in 2018 and three in 2019 -- to a plateau nearly 3.00% for overnight money.
The Fed will not sell the bonds it owns, just stop buying new ones as old ones mature at a pre-announced rate of decline in holdings. Yellen was uncharacteristically overconfident while describing the balance sheet unwind.
When asked about the hazards of unloading bonds, she quoted Patrick Harker, president of the Philadelphia Fed: “It will be like watching paint dry.”
That statement is an offense to the Gods of finance. Unwinding $2 trillion in bonds and especially MBS... that’s a lot of paint and a lot of drying. A lot to step in, a lot of buckets easily knocked over.
In addition to watching the 2s-10s spread, watch the 10s-mortgage spread. For the last several years, early each morning before the mortgage market has posted rates, anyone could glance at the 10-year, add 1.80% and get very close to the retail no-point 30-fixed mortgage rate of the day. As the Fed unwinds, its Treasury holdings now are mostly short-term and will have little impact on 10s; but MBS are MBS, a far narrower market than for Treasurys, and we should be prepared for mortgage rates to creep up and away from 10s.
The Fed is doing the right things. I am skeptical of its ability to manage an inflation rate close to 2%, but gotta try. In addition to watching 2s-10s and 10s-mortgages, keep an eye on the wild cards: new Fed governors (three coming soon), Yellen’s replacement, and foreign central banks, not least the black box of black boxes, China.
The 10-year T-note this past week. Note the lurch downward before the Fed’s rate hike, and grudging rise afterwards:
The 10-year T-note in the last year. Hunch here: if the 10s yield does not stabilize and begin to rise, the Fed will hike or unload more and faster:
The best Fed-watcher, the 2-year T-note has not priced-in the next hike, but it will:
The NFIB survey of small business found little change in May:
But the NFIB measure of optimism still shows the Trump optimism among its heavily Trump membership -- a political indicator, not economic:
The economy is okay, on trend:
The ECRI is re-entering normal-range growth, its recent spurt a false lead from the stock market surge, flattened now: