The yield on the benchmark 10-year Treasury note, which affects yields on all types of financing, rose to a four-year high this week. The rise in yields was stoked by ongoing inflation concerns which were further supported by higher inflation data at both the consumer level and wholesale level. Stronger inflation may cause the Fed to raise short-term interest rates more than forecasted this coming year which would not be friendly to bonds. However, after two weeks of selling in both the stock market and bond market, equities shined higher this week, even with the 10-year Treasury note touching 2.95%. At what point Treasury yields “take the shine out of equities” is anyone’s guess, but this author’s feeling is that rates moving above 3.000% will put pressure on equities and hard assets.
The big question that remains is whether inflation will continue to rise and eventually meet or exceed Fed inflation target rates. A faster pick-up inflation could result in another vicious bond and equity sell-off.
While interest rates are higher, rates are still attractive from a historical perspective. It also should be noted that rising inflation is not “all bad” as recent increases in both wage and consumer inflation are being supported by a strong global economic expansion and a high level of business confidence in the U.S. The low level of housing inventory, will continue to keep home demand high with lenders increasing loan product offerings in the face of rising prices and an ultra-competitive purchase market.
With the big move in rates, we remain cautiously biased toward floating interest rates due to the quick move higher in all yields the past couple of weeks. We reiterate this position with extreme caution as the bond market has not been friendly to those borrowers floating interest rates as of late.
After several months of tranquility, volatility has definitely returned to both the bond and equity markets. All major U.S. indices traded down near or above 2% on Friday after a choppy week of trading. The 10 Year U.S. Treasury broke through key technical indicators and closed above 2.84%. Some of the factors propelling Friday’s negative market include fears of inflation, mixed earning from big tech companies this past week, as well as rumors about global central bankers looking to reduce quantitative easing, and an unease with the rapidity of the market’s rise over the last few months.
In economic news, the January jobs report was solid with 200,000 jobs created. Unemployment remained at 4.100%. The big news (of which we have been warning our readers) is that there was an uptick in wage inflation. Bonds responded as expected and traded higher in response to the threat of increased inflation. Why is higher wage inflation scary, when one would think higher incomes are good for the economy? The answer is that for a long time, assets have been priced against ultra-low or negative interest rates. Rising inflation also affects bondholders as rising rates hurts bond portfolios. With the government debt yields moving higher, risky assets may become less appealing. All of this was at work this week.
In defense of interest rates, rates are still low from a historical perspective. However, we must keep in perspective that the reason interest rates are rising is that the economy is doing well. With the 10 Year Treasury hitting 2.85%, we remain cautious and biased toward locking-in interest rates unless you have the stomach to weather continued volatility.
Stocks rose and bond yields worsened Friday despite slower than expected U.S. economic output. The miss in 4th Quarter GDP, which rose 2.600% below the 2.900% expected, was largely a result of U.S trade imbalances. However, within the report, consumer spending grew at the fastest clip in two years. Business spending also surged and December Durable Orders grew by 2.9%, well above the 0.9% expected.
The rise in the stock market Friday has more to do with Mr. Market looking ahead at 1st quarter GDP readings and how the added business tax cuts from this past year’s tax reform will affect future growth. Bonds also appear to be adjusting higher in anticipation of consumer and wage inflation. Inflation is the archenemy of low interest rates. With the 10 Year Treasury Note breaking through the 2.62% ceiling of resistance, this now becomes our new support level and it will take significant negative news to push yields below 2.62%
With the rip-roaring equity rally that we are witnessing, we are biased toward higher interest rates and continue to advise clients to lock in interest rates. It is important to note that lenders are still offering adjustable rate mortgages (ARM’s) in the low to mid 3 percent range and 30-year mortgages are still in the low 4 percent range. By historical standards, interest rates remain very attractive and the move higher in rates should not adversely affect home buying decisions.
Even with the chance of a government shutdown looming, government bond yields continue to rise. The 10-year Treasury note broke through a key resistance band this week of 2.62%, a level not seen since the summer of 2014. While the U.S. stock market roars higher, the rise in interest rates has been the most notable development of the year. The reason for the rise in yields may be attributed to several factors including:
- A nascent global synchronized economic recovery.
- Inflation is beginning to simmer as CPI data suggests inflation is picking up.
- The economies of Europe and Japan are improving, which may allow the central banks of these countries to step back on quantitative easing.
- China’s economy continues to grow beyond projections.
The aforementioned positive factors have pushed interest rates domestically and higher abroad. The 10-year German Bund recently pushing above .50%.
With the increased confidence in the economy, higher wages, and the 2018 tax cuts now in place, slightly higher interest rates should not adversely affect the housing markets. However, given the move above 2.62% on the 10-year Treasury, we remain biased toward locking-in interest rates at current levels. Even with the recent move higher in interest rates, interest rates are still at historically attractive levels with many economists believing the 10-year Treasury note to trade no higher than 3.000% this year. A rise above 3.000% may be problematic, but for now, current interest rates continue to be a boon for real estate, equities, and commercial and residential real estate.
Opinions, beliefs, and viewpoints expressed by the author are his own.
Interest rates remain under pressure due to ongoing positive economic data and signs of potential inflation. Those pressures were fueled earlier in the week by a misleading report that China may slow or halt purchases of U.S. government securities which pushed yields higher on Wednesday before retreating when the accuracy of the report was called into question. Chalk it up to “saber rattling” by China as the U.S. continues to try to negotiate better trade deals with the Middle Kingdom. While bonds did wind up rallying after the report was confirmed to be inaccurate, one must be reminded how delicate the balance is between our trading partners. China owns over $1.2 trillion of our outstanding $6.3T in treasuries which represents 19% of the pot. Why does China buy our bonds? China buys our bonds so that the U.S. keeps buying inexpensive manufactured goods from China. It is a situation where both countries have mutually benefited for a long time and disrupting this relationship could have severe consequences.
The key economic reports this week were the Producer Price Index (PPI) and Core Consumer Price Index (CPI) readings. While the PPI reading was tame, the CPI readings, which strips out volatile food and energy, saw its largest increase in 11 months with year-over-year CPI increasing from 1.7% to 1.8%. With the pro-growth policies in place, the threat of inflation is real and if inflation rises unexpectedly it will negatively affect bond yields and interest rates. Couple the threat of inflation (actual confirmation that inflation is rising has not been verified) along with record property and equity markets leaves the Fed confronting some difficult decisions in the coming months with respect to how to raise interest rates gingerly while still protecting the economy from a potential bubble(s). It will be interesting to see how the new Fed chairman responds to these potential challenges.
While at the time of this writing the all important line in the sand of 2.62% on the 10 Year Treasury Note remains intact, we are mindful of the fact that the probability is that interest rates go higher rather than lower. Therefore, we continue to remain biased toward locking in interest rates which are still very attractive historically at current levels.
With the first week of trading in the books, the Dow, Nasdaq, and S&P 500 all closed at record highs. Short-term and long-term yields continue to compress with the so-called 2-year to 10-year gapping by only 50 basis points. A flattening yield curve normally suggests the economy is moving into the later part of the economic cycle and that less risk should be taken. However, animal spirits remain alive and well.
On the jobs front, there was some concern after Thursday’s ADP report blew past expectations that the December Jobs Report would come in “extremely hot” much to the demise of bond yields. The top-line report data fell short of expectations with 148,000 jobs created versus 188,000 expected. The unemployment rate came in at 4.1%. However, the November jobs numbers were revised higher and the body of the report showed some positives such as average hourly earnings rising 0.3% from November’s 0.2% and increasing 2.5% year over year, above the 2.4% annually in November. Should wage earnings move higher, rates will continue to move higher as well.
There are varying opinions on where the US is in the economic cycle. Certainly the massive central bank stimulus over the last decade has distorted asset prices and has kept yields artificially low. True price discovery has become difficult to quantify. The pro-growth argument is supported by synchronized global economic growth, pro-business tax reform, and low global interest rates. For those less bullish, there is concern about the flattening of the yield curve, the Fed’s determination to tighten rates, and the expansion of the price earning ratios on stocks, as well as low-cap rates in real estate and increasing consumer debt.
With unemployment at 4.10% juxtaposed against low wage and consumer inflation readings, the Federal Open Market Committee (FOMC) made good on its promise to raise rates in 2017 with its second rate hike. The overnight lending rate, known as the federal funds rate, increased to 1.25% -1.500%, and was increased by .25%. Government expectations are for a growing economy in 2018 which may be amplified with the Republican Tax Reform Plan which is just about finalized. The conundrum remains that while inflations is beginning to show signs of increasing here and in Europe, it still remains persistently below the Fed’s 2% target. Soft inflation data has been a boon for bonds. As we have written previously, should inflation data heat up, you should be prepared for a quick rise in interest rates both domestically and internationally.
Bonds traded well this week even in the face of a roaring stock market, pro-business tax cuts, and an increase in lending rates. One reason was the benign comments out of the FOMC and Federal Reserve Chair Yellen on the path to normalizing interest rates – slowly and carefully.
With the 10-year trading in the 2.300% to 2.400% range in light of the many positive factors including tax reform, strong corporate earnings and global synchronized economic growth, we remain biased toward locking in interest rates at current levels.
Treasury yields and stocks rose Friday in response to a better than expected jobs report. The U.S. added 228,000 new jobs in November which beat economists’ forecasts of 195,000 jobs. Unemployment remained at 4.15%, while average hourly earnings rose .2%, lower than the expected .3%. Wage growth has remained elusive during this nine-year long economic expansion, and the lack of wage inflation has been a main factor in keeping interest rates lower for longer.
The Fed will speak next week with a nearly certain probability of announcing a rate increase in the overnight lending rate. The market will be closely watching how long term interest rates react to this rates increase as concerns of a flattening yield have been receiving some attention as of late.
We continue to remain biased toward higher rates and are advising clients to lock-in interest rates at these current levels.
This week saw another powerful equities market rally as the prospects of a U.S. tax cut, synchronized global growth, and low-inflation boosted equities higher. Bonds suffered a bit as interest yields for mortgage rates and government debt rose. While there are signals that inflation may be brewing, the Federal Reserve’s preferred measure of inflation, personal consumption expenditures price index (PCE), continues to run below its 2% target, and is a main reason that yields have not jolted higher.
The big news this week was the tax overhaul which is likely to pass before Christmas. The proposed tax reform will benefit corporations and earnings, and is one of the main reasons our stock market is roaring higher. The added fuel of these tax cuts on top of an improving economy should pressure bonds to rise at some point. There are simply too many positive economic factors at work, including unemployment at 4.00%, tighter employment pool of skilled workers, high real estate and equity valuations, and finally, strong signals from the Federal Reserve that it is now time to attempt to normalize interest rates. However, higher mortgage interest rates can be supported in a growing and robust economy combined with overall lower tax rates.
With the 10-year U.S. Treasury near 2.400%, we remain biased toward locking in interest rates given the many positive economic readings that we are seeing.
Mortgage bonds and long-term Treasuries ended the week unchanged after a volatile week of trading. Thursday saw a strong rise in equities with the House passing its tax reform bill. The next step is the Senate where it will meet some resistance from Republicans based on the current iteration of the tax reform bill. However, for the moment, Mr. Market likes what it sees.
Inflation remains muted but small signs of an increase in inflation data are emerging. If inflation does rise, bond rates are likely to rise as well. As long as inflation remains soft, mortgage and bond rates will continue to benefit from these benign readings.
We also continue to monitor both short-term and long-term interest rates. The so-called flattening of the yield curve continues to weigh on investors’ minds, as well as hurt bank profitability. Compression of the yield curve is often a sign of a slowing economy. With mortgage rates near support levels, we continue to be cautious on interest rates and believe locking-in interest rates is the right call.