Fed Day

It’s Fed day.  There is an 80% probability that the FOMC will raise their target overnight rate by 1/2%, and a 20% chance that it will be hiked 3/4%. Remember that this is only the overnight rate that gets bumped.  All other rates, from the 1 week treasury to the 30 year notes are all driven by the demands of the market.  Interestingly enough, long term rates like mortgages have gone lower over the last few weeks despite widespread understanding that the hike will be happening today.  

The hike today will accomplish a few things.  It sends the message that the Fed is serious about fighting inflation, and higher rates will make conducting business and speculation more expensive, which ironically will help drive prices down eventually. It also gives the FOMC further cushion for next year when they begin lowering their rate again.

Inflationary indicators have turned a corner and are heading south, but are still 2X-3X the 2%-3% YOY target that has been deemed “healthy and sustainable” by the collective brain trust that deliberates policy and has the power to do something about it.

Oh, and the photo of the house?  it’s where Jerome Powell lives.  So if you’ve got something to say and find yourself in Chevy Chase, Maryland, this is where you’ll find him.  Feel free to help yourself to a complimentary newspaper on the lawn.  Evidently he doesn’t read them anymore. 😂

Unprecedented Mean Reversion

Perhaps it’s the two solid years of statistics that I took in college that draws me to numbers.  Or maybe it’s that I have a lot more free time right now to think about things, that I have been so ponderous of late.  To wit, I have spent almost six hours researching and compiling the above-referenced data over the last two days.

Like you, I get asked multiple times per day where I think home prices and interest rates are headed.  Generally speaking, I have about as much certainty to my answer as the questioner would if he/she was answering the question themselves.  I do see long term rates dropping from here.  I think I also see more “relief” for those waiting for “more accommodative” home prices.      

The three graphs here only go back 38 years because that’s the first time that Household Income was tracked.  Prior to that, the emphasis of the BLS was placed on Personal Income.  But the 1970’s era inflation required most households to get anyone who could work out into the labor force, so in the housing industry, we look at household income.

I won’t spend a lot of time on explaining these graphs other than to point out a few statistical observations.

  • Numbers always revert to the mean.  Always.  Sometimes that takes longer than one would expect/hope.  There are some trends that take decades to see corrections.
  • The 34% rise in home values over the last two years is unprecedented.  Literally, over the last 100 years, prices have never risen so much so fast. (see bullet point above)
  • Over decades of data, there is a strong correlation between household income and home prices.
  • There is zero correlation between interest rates and home prices–except over the last five years.
  • Household income has outpaced home values over the most recent four decades, which is great news and means that especially with interest rates dropping over the same time, housing has gotten relatively much more affordable in recent history. 

If prices and interest rates don’t drop, it’s going to take what Steven Covey called a “paradigm shift” to reanimate the housing market.  Households will need to become accustomed to lodging costs being a greater percentage of their income that they have been over the last few decades. 

Jerome the Hawk

Even on chilly winter mornings when the crisp atmosphere relegates weaker-willed individuals to the climate controlled confines of marble floored institutions, the cold-blooded inflation hawk soars high in the American skies.  
Jerome was born in D.C. and educated at Princeton and Georgetown Universities.  He is an attorney, investment banker, and has served in various high-level capacities to six different U.S. Presidents. So today’s flight isn’t his first.  He’s looking for data.  Lots and lots of data. He and the rest of the Fed kettle (that’s what you call a group of hawks) have a big decision to make next Wednesday.  
They’ve been promising to raise rates another 1/2% in December with a few smaller hikes in February and March, but there are signs that inflation is cooling. You wouldn’t want to overcook things like you did in 2018 when you were a brand new Fed Chair. That hike instantly flipped markets on their ear.  Oops. You’re still catching flack for that move four years later.
Hawks’ visual acuity is 8X that of humans. Today’s patrol uncovered the Core Producer Price Index, which came out showing a 6.2% rise year-over-year. That’s higher than expected and higher than the 2.5%-3.0% target rate, but the PPI has been consecutively lower for the last eight months and is now less than half the 11.7% reading last March. So that’s a mixed bag of news, but overall, pretty positive progress. 
Nevertheless, given that Consumer Sentiment, Jobless Claims, Productivity, and ISM services were ALL still more inflationary this week than they were last month, the hawk thinks he should hike again.  Decision made, he elects to go back inside where it’s warm. Maybe he’ll open a pack of beef jerky or snap into a Slim Jim, for which he has a particular affinity. Fresh out at home, he swoops into the c-store around the corner where he sees that the Original Flavor Giant Stick is going for $1.99.  “Egregious!”, he squawks, after paying for the 1 oz stick of meat.  “I definitely need to get inflation down”, he mutters as he waddles past the security camera, below the height measuring sticker, and out the automatic door. “There’s NO WAY I’m eating carrion.”

After dropping four straight days in a row, the stock market is flat on the day. Mortgage pricing continues trading in a flattish pattern but is looking upward, meaning that interest rates are really trying to improve. Because they lock in a bank for 30 years, they tend to go down more slowly than other debt instruments. The 10 Year has fallen to 3.46% from the high of 4.34% a month ago. The Two Year is also down about 1/2% from the high, but since that tracks the Fed Funds Rate, I expect it to turn back northward heading into next week’s FOMC meeting. Today’s Productivity Report showed that Unit Labor Costs rose 2.4% YOY, below the 3.1% expected gain and more lower (that sounds funny) than last month’s 3.5% computation. Labor costs are a big driver of inflation and account for 69% of GDP. Oil & gas account for 8% of our GDP, so you add that to the savings of fuel dropping 30% since July and we’ve a big head start on lowering the cost of everything without increasing borrowing costs.

Geeking Out

I’m going to geek out for a minute this morning, so you can delete this email right now if you’re not in the mood.  This commentary grew much longer than I had anticipated. :).

Yesterday, the Institute of Supply Management (ISM) Non-Manufacturing Index was released showing that orders of parts used in the manufacturing of other goods and services rose 2.1 points from last month and 3.2 points greater than expectations suggested.  With only a handful of reports due prior to next week’s Fed meeting, each will be closely watched as in indicator of what the FOMC will do with the Fed Funds Rate next Wednesday.  The major consensus is for a 1/2% rate hike (50bps) to be announced at the close of the conference. You knew that already.

Now for the interesting part.  The long term rates seem to be caring less and less about headline inflation and what the Fed’s doing and more and more about the likelihood of recession next year. Global financial firm UBS predicts a 70% chance of a U.S. recession in 2023 with the Unemployment Rate rising from 3.7% to 5.5% (which is not horrible at all).  Incidentally, once this happens, the Fed will start the slashing cycle again. Such is the existence of a reactive Central Bank.  This is not a dig on them; their job is to engineer employment and price stability, not micromanage every nuance of the dollar. 

Now for the writing on the wall.  But first let me set the stage.  As an implication of convenience and risk, the longer you commit your money to someone, the higher your return will be.  Conversely, the longer you take to repay debt, the higher will be your imputed interest rate.  Let’s say you give the federal government some of your hard-earned after-tax dollars that you’ve scrimped and saved over a lifetime of diligent efforts.  You would expect that if your money was tied up in the hands of bureaucrats for a decade, they’d reward you greater than if you only gave them free rein with your money for 24 months.  Now let me be clear that it’s the free market and not the government that sets the going rate of treasury bills. The more money that gets thrown at a particular investment, the less that fund needs to pay to keep people interested.  Right now, you get a better return on a 2 year Note than on a 10 year note.  In fact, you get a better return on every t-bill other than the 10 year note, starting with the 1 month bond and heading all the way to a 30 year commitment. 

The 2/10 Spread is currently at a whopping -82bps with the 2 Year paying 4.39% and the 10 Year paying only 3.57%.  The historical recessionary implications of such a large discrepancy are virtually unanimous, and the spread hasn’t been so large since 1981. Each of the gray bars in the chart below indicate a recession and always follow a negative 2/10 spread like we have right now. Those optimists who say we will avert a slowdown are just looking for more airtime, or are blinded by their rose-colored naïveté. 

Having said that, I am an optimist!  Absolutely!  But I am also a realist and seek only to be prepared for what is most certainly coming our way.  Ignorance can be bliss, but only until the cards don’t fall your way.  So yes, I am expecting inflation to fall and with it will slow the velocity of money and business activity.  I don’t know what that will look like nor how ling it will last.  I study trends and see that all numbers eventually reverting to the mean.  The sooner we get into it, the quicker we’ll be out of it. 

Speaking of means, and charts and stuff. That top chart shows the prices of mortgages as they get traded every day. Green days are good and red days are bad if you like low rates.  High prices mean low rates and vice versa.  Rates have trended higher all year long until November 10th when pricing shot up almost 200 bps and drove interest rates down 1/2% in one day.  The course has been relatively flat, but pricing is trending higher since then. 

Now for the technical-geeky part.  If you look at the 20/50 day moving averages which I have also illustrated as green and red lines, you’ll see that there was a crossover on November 23, indicating that there are lower interest rates ahead.  I don’t know for certain how soon mortgage pricing will improve nor for how long it will last.  But, if the macroeconomic trends deteriorate like the FOMC is strategizing to effectuate, we’re in for lower interest rates in the future. For sure.