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But wait… How can we be talking about rates near all-time lows while stocks are near all-time highs? Doesn’t conventional wisdom dictate that rates and stock prices typically move in the same direction?
Yes and no. It is true that economic strength generally puts upward pressure on both stocks and rates (and vice versa), but that’s far from the only factor. Inflation has historically been a fairly critical factor for rates and it really threw the long-term relationship with stocks out of whack in the early 80’s. Hyper-inflation set the highest bar we’re ever likely to see for rates, and most of the past 40 years has simply been a return to earth. Meanwhile, stocks have done what stocks generally do.
While there will always be “down times” for stocks, in the long run, they’ll continue to grow as long as the economy grows. Rates, on the other hand, are designed to oscillate inside a range (even though the 80’s make it seem otherwise) regardless of the size of the economy.
Unless the economy is actively moving into or out of a recession, our best chance to actually see correlation between stocks and bonds is to look at much shorter time-frames. Odds improve when the overall market is in the middle of reacting to some temporary, unexpected shock. The Fed complicates things as accommodative Fed policy generally acts to push stocks and bond yields in opposite directions.
Right now, we do indeed have a friendly Fed and we’re definitely not actively moving into or out of a recession. In other words, there’s very little to inform stock/bond correlation apart from unexpected market shocks like coronavirus. As the following chart shows, coronavirus took a clear toll on both stocks and bonds in late January. The improved outlook in early February prompted a rebound, but bonds haven’t been as quick to move back up.
Even without coronavirus, the general trend over the past year has been toward higher stocks and lower rates. Correlations certainly emerged when the trade war hit (that’s one of those “unexpected shocks”), then again when trade prospects improved, and most recently amid the coronavirus volatility. But in the bigger picture, we’re still left with bonds resisting a move higher despite stocks surging to all-time highs.
To reiterate, the Fed is a big piece of that puzzle. They’ve been able to offer the market accommodation in a few ways recently. The most significant way is simply their guidance about what it would take for them to hike rates. Strong economic data would normally cause concern for Fed rate hikes, but that won’t do it this time around. They’d have to see a big uptick in inflation, and that’s proven to be elusive time and again in recent years (so much so that policy officials openly express confusion as to why it hasn’t shown up). Additionally, the Fed repeatedly says the next economic downturn will see a reprisal of the same sort of bond buying programs that juiced financial markets during the great recovery (2011-2015).
All that to say, bonds/rates have some reasons to avoid a quick return to recent highs, even as the stock market can justify it. Coronavirus adds to the discrepancy because bonds are accounting for the economic impact likely to be seen in the near future while stocks are fresh off a strong earnings season and generally riding the wave of ongoing US economic expansion. Bonds are also a global safe haven in times of uncertainty. The US economy is decent for now, so US stocks are forgiven for being as high as they are. But the Chinese economy will undoubtedly take a bigger hit from coronavirus–so much so that investors haven’t been nearly as quick to fuel a rebound in Chinese stocks.
Bottom lines on stock/bond discrepancy:
- A friendly Fed serves as a backdrop for generally lower rates and higher stock prices
- Coronavirus hurts the Chinese and global economies more than the US economy
- Global investors use the US bond market as a safe haven (which puts downward pressure on rates)
- The US bond market always does more to price in economic expectations for the future than the stock market
There was a far better case to be made for the risk of rising rates in the new year. This had to do with their recent, extended stay at long term lows–largely due to trade war uncertainty–coupled with the fact that trade war uncertainty was beginning to clear up.
While there was a bit of upward pressure on rates surrounding the phase 1 US/China trade deal, those concerns quickly took a back seat to January’s unexpected events. The threat of a US/Iran war briefly sent shockwaves through the market earlier in the month, but ever since then, the coronavirus outbreak has been the dominant consideration for the bond market (which, of course, dictates interest rates).
In short, the coronavirus effect abruptly put an end to the trend of rising rates that had been in place ever since the trade war ushered in long-term lows last summer. This can be seen in the following chart of 10yr Treasury yields, which serve as an important benchmark for longer-term interest rates like mortgages.
Looked at another way, we could simply say that rates were favoring the higher end of their post-trade-war range, marked by 10yr yields of 1.70% through 1.95% and that coronavirus brought them back into the lower half of the post-trade-war range.
Mortgage rates have been moving in a similar direction to Treasuries during this time, but not always in lock-step. This first became readily apparent as rates plummeted in August. Mortgages were lower, yes, but not nearly as quickly as Treasury yields. That ultimately proved useful, however.
As Treasury yields began to rise, investors started worrying about a big bounce in rates, but mortgages were able to remain more calm by comparison. This improved the flow of business both for purchases and refinances. It also allowed time for the mortgage market to adjust to the new rate range and position itself to take better advantage of the next move. That’s exactly what’s happened over the past 3 weeks as the average 30yr fixed mortgage rate managed to drop at a much more comparable pace to Treasury yields.
All of the above adds up to a fairly intense level of activity in the mortgage market. Purchase apps may have lost a small amount of ground this week, but overall (and in annual terms), they continue to push post-crisis records.
Refi apps may never make it back to the post-crisis records seen during the golden age of low, stable rates in 2012, but they just hit the next most impressive milestone by breaking 2016’s weekly application record. That qualified as a “refi boom” then, and it qualifies now.
How long can this last and how low could rates go? Accurately answering that question requires clarity on the coronavirus outbreak. Granted, this isn’t the only consideration for rates, but it’s definitely still the biggest one. The bottom of the recent move in rates coincided perfectly with the peak level of uncertainty in mainland China’s financial markets (which were closed for the new year holiday at the end of January).
As soon as US markets could get a clear read on China’s market response, fear was replaced with hope, momentum turned on a dime, and rates began to head higher. (NOTE: in the chart below, Hong Kong’s stock exchange is used in order to show more market activity, and it reopened several days before mainland China’s Shanghai index).
If you’d asked the average market analyst on Wednesday, they would have been more likely to tell you the coronavirus move was over and markets were beginning to correct back in the other direction. But then this happened:
In other words, the drama has yet to play out. The first 3 days of the week represented more of an ‘opening of floodgates’ that allowed traders to get a better read on China’s market response. They were prepared for the worst and found that they were just a bit over-prepared. The past 2 days suggest that “fear” has yet to be permanently replaced by “hope” with respect to coronavirus.
When that happens (and it will), traders will still be asking themselves what the lasting economic impact will be. As always, if the global economy is weaker than expected, upward pressure on rates will be limited. That said, some measure of upward pressure is still the baseline assumption. So at the very least, those who don’t want to miss out on this refi boom should probably get their ducks in a row sooner than later.
That may come as a surprise to those who believe the Fed controls mortgage rates. The Fed concluded one of its 8 annual meetings on Wednesday and released a policy announcement without changing rates. Moreover, they reiterated that rates weren’t likely to change without a big shift in the economy or inflation.
It’s true that the Fed Funds Rate is quite a bit higher than it was in 2016, and that it remained unchanged this week, but the Fed’s rate only applies to overnight loans between big banks. Mortgage rates are based on bonds that last a lot longer, and investors expect different rates of return for longer lasting loans. The following chart shows the Fed Funds Rates along with 10yr Treasury Yields and the average 30yr fixed mortgage rate.
Longer-term rates fell significantly in 2019 for a variety of reasons. Global growth concerns, the US/China trade war, low inflation, and geopolitical tensions all played a part. After rates hit long-term lows in September, they held a narrow range into the new year. With the phase 1 US/China trade deal signed in mid-January and a US/Iran war averted, investors were rightfully concerned that the next big move in rates would be to the upside. But literally less than 24 hours after the major de-escalation of the US/Iran tensions, the new strain of coronavirus was announced in China.
Back then (Jan 9), coronavirus wasn’t in the headlines much and it didn’t seem like a huge deal to the market. Even so, the bond market was beginning to hedge its bets based on the last time something similar happened (i.e. SARS in 2002-2003). It wasn’t until January 24th that stocks finally started to panic about coronavirus implications, moving quickly lower and bringing bond yields along for the ride. That move gave way to plenty of additional volatility this week.
There is some confusion out there as to why a viral epidemic is such a big concern for financial markets. Simply put, it is already having a major effect on commerce and that could be true for several more weeks or even months. The broad notion of “commerce” is what turns the crank of the global economy. A slower economy is less capable of sustaining high stock prices and interest rates. Moreover, if investors are merely uncertain about the implications, they commonly move money into safe havens like US Treasuries. As demand for Treasuries increases, rates fall.
Mortgage rates are not directly tied to US Treasury yields, but they are almost always moving in the same direction. The average lender was already fairly close to the lowest levels since 2016 earlier this week. So even though mortgage rates haven’t fallen nearly as fast as Treasury yields, they only ever needed to fall moderately to get back to long-term lows. The following chart overlays mortgages and 10yr Treasuries on a separate y-axis to better visualize relative performance over time.
With coronavirus being credited for so much of the drop in rates, it’s more than fair to wonder if we’ll see a big bounce when the disease is contained. To some extent, the economic damage has already been done, but bonds/rates are also certainly accounting for bad news yet to come. As such, if the containment of coronavirus happens sooner/better than expected, rates would likely face upward pressure. Even then, there would be bigger, more important questions.
Before coronavirus, rates were already resisting a move back up to the levels seen before the trade war flared-up in mid-2019. For reference, 1.95% would be the best line in the sand as far as 10yr Treasury yields are concerned. Before coronavirus headlines began pushing rates lower more rapidly, 10yr yields were already down to 1.80%. That gives us two important ceilings to watch in the event of rising rates.
If those ceilings are easily broken, it would suggest additional upward momentum in rates (above 1.95%). Conversely, if the economy begins to contract and stocks look like they might enter a correction, rates have a better chance of remaining in the current lower territory. Either way, broad economic momentum is at the heart of the question. With that in mind, next week brings several of the most important economic reports.