Long-term rates improved slightly this week, if anything, but the Fed calculus is changing fast toward rate hikes — more and sooner than markets are priced for, and perhaps closer to the Fed’s “damned dots” than any of us have thought. A hike in June has decent odds, now.
Here is the list of game-changers. Oil first. The Fed’s primary job is to prevent inflation, and since 1972 oil has been Enemy Number One. Oil is up to $50 per barrel. Most thought a rise from the January lows at $33 was reasonable, but the rise from $40 brought daily assertion that the glut would return quickly and prices fall anew. Not.
More important for the Fed, looking out a few years, the plunge in prices guarantees suppression of new exploration and investment and a price snap-back proportionate to the low. The Fed cannot maintain emergency-easy policy if oil has turned.
Second, housing. Housing is crucial to recoveries, and it has been slower to take off in this recovery than any prior. That has been good, if weird news, holding rates down.
Housing typically takes off as soon as the Fed deeply cuts rates during recessions, and the labor market trails by a couple of years. Historically, that pattern has led to delayed tightening by the Fed, which waits for the job market to repair.
In this upside-down recovery, in so many ways, we sit today close to full employment (within our ability to measure), but housing has been slow. The newest data may show housing taking off — the April numbers have been extremely strong.
The Fed now need not fear that modestly rising mortgage rates will abort housing and should be nervous that housing and full employment could feed on each other in classic late-cycle overheating.
Third, the Fed has reason to hope that the global-hysterical reaction to its first 0.25 percent hike in December will not repeat. Global markets have had five months to get used to a rising Fed and dollar cycle. In May 2013 (my, oh my, such coincidences…) Bernanke told the world the Fed would taper its bond purchases, ending quantitative easing (QE).
In four months the 10-year T-note soared from 1.65 percent to 3.00 percent , mortgages from 3.50 percent to 5.00 percent — but in just two more months markets realized their overreaction and rates began a one-year slide right back where they had been.
You can bet that the Fed blazes with candles lit in prayer that the December reaction was a transient replay of the taper-tantrum.
Fourth, the Fed distrusts today’s bond-market signals that the economy is weak. Long-term yields should rise when economies recover; not just because the Fed will tighten, but inflation risks will rise.
After the Fed hiked in December, 10-year T-notes promptly crashed from 2.25 percent to 1.65 percent, a classic warning to the Fed — but similar to “Greenspan’s Conundrum,” in which the Fed hiked from 2003 to 2006, and the 10-year rose very little in what turned out to be an all-time false signal.
The Fed suspects — accurately, I think — that foreign cash is pouring into U.S. bonds because our yields, no matter how historically low, are sky-high compared to external ones. Similar flows were at work during the Conundrum and the “savings glut” then.
Fed tightening itself creates a self-reinforcing spiral favorable to overseas investors: when the Fed hikes, the dollar rises, which raises the currency-adjusted yield on US bonds. The more they buy, the stronger the dollar, the higher U.S. bond prices go (yields down), the more the Fed tightens and the more the dollar rises, and so on. And the overseas flow is augmented by European Central Bank, Bank of Japan and People’s Bank of China easing, QE cash sloshing right out of Europe, Japan and China into U.S. securities.
Low U.S. bond yields may become — may already be — so artificial that the Fed within one year may begin to allow the bonds it bought in QE to run off its balance sheet as they mature, pushing up long-term yields. The Fed’s best indicator will be housing, and if we run at April’s pace, the Fed will want to see higher mortgage rates.
There. Happy Memorial Day at the Fed. Will it turn out this way?
Um…no. The next hike, and the next, won’t cause the panic of the first one, but the outside world is a wreck and cannot tolerate a big gap between the Fed and all other central banks. Our recovery may not abort, but the outside world does not have one.
The 10-year T-note five years back
The 10-year T-note five years back, showing the patterns in the copy above.
The 2-year T-note two years back
The 2-year T-note two years back, still in deep disbelief of Fed tightening at a significant slope.
At 600,000 annualized new homes we are still below the last recession trough
At 600,000 annualized new homes we are still below the last recession trough, no need for the Fed to intercept, but the Fed can’t stay at an emergency low if housing has ignited (graph thanks to Tim Duy).
The Atlanta Fed’s forecast adds fuel for a June hike.
The Atlanta Fed’s forecast adds fuel for a June hike.
From the NY Fed: The only significant growth in credit is in auto loans (and leases), unsustainable without Fed interception, and student loans
From the NY Fed: The only significant growth in credit is in auto loans (and leases), unsustainable without Fed interception, and student loans, which act more like a tax than an over-heater.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
