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Last week’s newsletter asked whether or not the highest interest rates of this economic cycle are behind us. At the time, this was a relatively new and bold assertion. Now, this week makes that assessment look tame by comparison.

Specifically, rates surged triumphantly lower, and at a much quicker pace.  From the recent highs, this is now the biggest, fastest drop in rates of the past 2 years.  The counterpoints are that it took the highest rates in 7 years to set us up for these gains, and that 2018’s trend of “higher lows” remains intact.

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Passing judgment on the significance of this drop in rates isn’t important though.  What everyone wants to know is whether this is just a temporary bout of volatility or the beginning of a sustained move. To answer that, we’ll need to do our best to understand why the move is happening in the first place.

Given the volatility in stocks in October and November, that’s a good place to start. Indeed, stocks did more than anything to set the tone for bonds from early October through most of November. Notice how the orange and blue lines track each other almost perfectly during that time.

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The correlation began to break down after last week’s Powell speech (which helped both stocks and bonds). Because of this, we can’t fully credit stocks for the big drop in rates. We can, however, examine how stocks are part of the equation.

There are always multiple factors underlying the ups and downs in stock prices, but there are also usually some general themes in play.  The “pesky ceiling” in the previous chart is one of those themes.  It speaks to the inability of the stock market to make a convincing move back up to September’s highs.

In the bigger picture, that pesky ceiling is reinforcing a broader deceleration in stock market gains.    The following chart shows year-over-year percent change in stock prices.  This measurement has only turned negative twice during this economic expansion: once when Europe seemed to be on the brink of a systemic crisis and once when investors worried that the Fed’s first rate hike (as well as Brexit) might hearken the end of what was already a long-lived economic cycle.

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As the chart suggests, the presidential election provided a shot in the arm for the economic cycle.  Most of this had to do with the tax bill, which was passed in early 2018 (coincides with the spikes in the “2” circle in the chart).  Momentum flagged throughout the summer, but got another boost from strong economic data in September and October (“3” circle).  That same data hurt interest rates due to fear that the Fed would need to hike its policy rate even faster.

What a change one little month makes!  Something happened in November and early December to cause a rapid reevaluation of that fear.  The gradual part of the move is easily explained with a softening of economic data in November.  Stocks, bond yields (rates), and Fed rate hike expectations were all able to lower their defenses.  This can be seen in the dotted line in the chart below.

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Clearly, things got a little crazy after that dotted line!  The sideways movement (before the Powell speech) is a fairly typical part of the Thanksgiving holiday.  After that, it’s not uncommon to see the next wave of momentum show up to set the tone heading into the end of the year.  It just needed a catalyst.  As we discussed last week, Powell’s speech served as that catalyst.

This week, however, things got more complicated.  A meeting between Trump and Xi regarding US/China trade relations boosted stocks over the weekend and pushed rates slightly higher as of Monday morning.  As additional details emerged from the meeting several days later, the weekend’s move was reversed (see the “more trade war news” caption in the chart).

But before that we have the mysterious move in Treasury yields (highlighted in red).  This one didn’t coincide with a similar move in stocks or Fed rate hike expectations.  Bonds were moving of their own accord (truly impressive considering the move began with rates already near their best levels in 2 months).

What could have motivated bonds to take off like this?  There’s a reason for the question marks.  This is one of those moves with no overt, singular motivation–even though it’s the most important move we’ve seen bonds make in a while.  One thing we do know is that it was the first day of a new month, and that the activity in bonds really began to pick up right when US traders began making their first trades of the month.

This wouldn’t be the first time that the calendar has had a noticeable impact on markets.  A certain portion of traders have to hold a certain mix of investments at the end of any given month.  The beginning of the following month allows for some more flexibility, and it’s not uncommon to see momentum shift a bit right out of the gate.  The fact that it shifted in a big, friendly way is what’s important.  It let us know that traders had a bit of an agenda coming into December.

If we had to speak for that agenda, it would go something like this:

“OK, so the economic data was surprisingly strong in Sept/Oct, and it made some sense to worry about quicker rate hikes or higher long-term rates.  But we all saw things cool down in November.  We know this economic cycle won’t last forever.  We know housing has increasingly acted as a drag.  We can see that stocks aren’t eager to undo the damage sustained a couple months ago.  We heard what Powell had to say last week about being closer to a neutral rate.  We wouldn’t be crazy to expect the upcoming jobs data and Fed announcement to be less enthusiastic than recent examples.  Considering all of the above, it may be time to start trading as if the long-term rate ceiling is behind us.  We can’t yet know how far or how quickly rates might drop, only that it’s time to start thinking about pointing the ship in that direction.”

One caveat for any discussion about a rate rally is that mortgage rates are less able to participate than Treasury yields.  This has to do with several factors, but chief among them is the fact that the Fed is now basically done buying mortgage-backed-securities as part of its reinvestment program.  The takeaway is that mortgage rates won’t usually fall as quickly as the Treasury yields they typically follow.  The silver lining is that mortgage rates have less to lose in the event Treasury yields move back up.

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Relative to the last 2 years of pain for rates, a sense of hope has emerged, seemingly overnight, as the 10yr Treasury yield (an important benchmark for longer-term rates like mortgages) broke through a key level.

3.05% had consistently blocked the advance of falling rates for more than 2 months.  The most recent bounce happened just last week.  Breaking through sets us up to challenge the big psychological barrier at 3.0%.2018-11-30 NL10

The catalyst for the late week surge was a speech by Fed Chair Jerome Powell. The Fed sets monetary policies that can have a direct impact on rates.  Those policies are largely a function of objective economic data, but there is some room for interpretation.

The Fed’s interpretation has arguably been fairly balanced over the past few years.  On the one hand, they’ve been hiking at a much slower pace compared to past cycles.  On the other hand, they’ve been hiking regularly and their outlook has clearly called for those hikes to continue well into 2019.

Powell’s speech upset the balance as far as many investors were concerned.  Back in October, Powell said rates were “a long way from neutral, probably” before adding that the Fed may even raise rates past neutral (a level that neither promotes or discourages economic growth).  He’d been sticking to that script regularly until this week when he said rates are now “just below” neutral.

Beyond the comment on rates, Powell also noted that the Fed’s rate hike outlook is no guarantee of a policy path (translation: they might not end up hiking as much as anticipated).  The determining factor in that policy path will be economic data.  On that topic, Powell said the Fed “will be paying very close attention.”

Stocks and bonds both seized on the apparent shift in tone from the Fed Chair.  In general, when the Fed is perceived as less likely to hike rates, both sides of the market rally.  That can be seen in the following chart with stocks surging and rates falling.

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Combined with the positive move in rates that began 3 weeks ago, a sense of hope seems to be returning to the bond market.  Keep in mind that at least some of that “hope” will come at the expense of stocks and the economy.  After all, rates tend to fall when the economy is weak.

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You might notice that the blue line (bonds) was more willing to move lower than the orange line (stocks) in November.  Of course we just discussed the Powell effect, but well before Powell’s speech, we can see bonds setting “lower lows” even as stocks try to hold the same defensive floor.  One potential reason is weakness in oil prices.  Oil has a bearing on inflation, and inflation has a bearing on bonds.  Falling oil prices can add downward pressure on rates.

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If these positive influences stick around, the highest rates for this economic cycle may indeed already be behind us.  That couldn’t come a moment too soon for the housing market where sales continued to slump according to two reports out this week.

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Still, it’s not necessarily safe to assume rates will keep moving lower.  Keep Powell’s comments about economic data in mind.  The Fed will be watching the data closely.  To whatever extent next week’s important economic reports disappoint, hope will remain alive for rates.  But if those reports are stronger than expected, rates could easily bounce back toward recent highs.

It wouldn’t be 2018 in the housing market if there wasn’t at least one report painting a gloomier picture.  The National Association of Homebuilders Housing Market Index (or “builder confidence” for short) did those honors this week.

Up until now, builder confidence had been holding up better than other housing metrics in 2018.  That changed abruptly this week as confidence dropped to the lowest levels in more than 2 years, and at the fastest pace in more than 4 years.

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What’s up with this sudden shift?  Builders chalked it up, in large part, to recently higher rates and home prices.  One other factor to consider is the psychological effect of sharp losses in the stock market.

Builder confidence was the only downbeat housing report of the week though!  Numbers were roughly as-expected elsewhere.  This keeps longer-term trends in decent shape, especially with respect to residential construction numbers.

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Existing Home Sales have fallen a bit more noticeably in 2018, but by bouncing here, they would be able to maintain a longer-term uptrend that began roughly 5 years ago.

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In terms of market movement this week, interest rates remained fairly flat while stocks continued lower.  Incidentally, the builder confidence numbers (which don’t tend to move markets) were shocking enough to cause a bit of a stir on Monday morning.

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Simply put, rates might have moved higher this week had it not been for the builder confidence data setting the tone  (it was the first and only economic report on Monday morning).

In general though, it doesn’t make much sense to read too much significance into Thanksgiving week market movement.  As market participants return in greater numbers for the last few full weeks of the year, we’ll be watching to see if stocks break below the key floors seen in the following chart.  If they do, that could provide the inspiration for rates to continue lower.

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