Equities have been on a tear this week and bond yields ripped higher as recession fears take a back seat to positive commentary out of the U.S. and China on trade talks. Further calming fears about the state of the U.S. economy was better than expected August retail sales report and the steepening yield curve. With the U.S. consumer comprising a majority of the economy, this report reinforces that there is no imminent recession in sight. Just last week the 10-year Treasury note was trading around 1.500% versus the current rate of 1.87%, a remarkable move in just a few days. With rates on the rise, the recent flood of applications by U.S. individual and corporate borrowers will subside, especially if rates move a bit higher from here. However, as we have opined previously, our feeling was that the U.S. economy is in pretty good shape and that a 10-year treasury under 1.500% was an alert to lock-in rates.
Across the pond, the ECB eased their monetary policy in response to their stalling economy and doubled down on negative interest rate policies. It is becoming unclear how much negative rates help economic viability, but with rates already so low and Europe teetering on recession, the ECB believes it is best to err on the side of more easing. These policies are creating havoc with respect to how to evaluate risk and are pushing investors into riskier asset classes in search of yield. The one positive for the U.S. borrower is negative rates abroad will limit how high interest rates will move back home.
The next big news event is the Federal Open Market Committee meeting next week. Odds heavily favor a rate decrease of one-quarter of one percent on the Fed Funds rate to keep pace with the easing going on in the rest of the developed world. It will be interesting to hear the commentary from the Fed Chair after the rate decision is made and how the markets respond to more easing.
The rally in bond yields has increased mortgage applications dramatically and has also served as a boon for home buyers making the cost to owning a home more affordable.
The recent rate drop caught many off-guard as most economists did not forecast 10-year Treasury yields to trade at current levels given the strength of the U.S. economy. The drop in rates can be attributed to ongoing trade tensions with China, fear of a global economic slowdown, a potential recession, poor economic readings in Europe, Brexit uncertainty, and negative bond yields in Europe and Japan. However, a recent attack by Iran on an oil tanker in the Gulf of Oman did little to move rates lower indicating we may be nearing the trough in rates.
While the flattening of the yield curve with some parts of the curve inverting suggest that Fed policy may be too tight and a rate cut is warranted, remember those assumptions have already been priced into current rates. However, with rates now back near historical lows, borrowers should take this into consideration as some prominent investment banks such as Goldman Sachs do not necessarily believe the Fed will cut rates in the near term. In fact, by just speaking about lower rates, the Fed has moved interest rates lower. A wait-and-see attitude may be the policy the Fed takes, especially with inflation in check, tight labor supply, and the recent move higher in U.S. equities.
U.S. consumer confidence remains high and retail sales are strong, illustrating the strength and resilience of the U.S. consumer. With confidence high, but some other business indicators flashing warning signs of recession, there are many cross-currents to think about. With that thought in mind, we continue to be biased toward locking-in interest rates at these attractive levels. For perspective, sub- 4% 30-year mortgages were once thought inconceivable.
Treasury yields dropped this week to a 21-month low. Multiple Fed officials spoke of the possibility of lowering short-term interest rates as ongoing trade tensions with China begin to wear on the U.S. economy. Further causes of concern include slowing manufacturing data both in the U.S. and abroad, negative interest rates in Europe and Japan, and the European Central Bank opining on the high probability of rate cuts in the Eurozone to combat its sluggish economy.
At the moment, there are several conflicting economic signals: consumer and business confidence is strong, but other key economic data are showing signs of a potential recession on the horizon. Of greatest concern is the 3-month to 10-year Treasury curve, which has inverted. A prolonged inversion supports the notion that the markets believe rates are too high, and more importantly, it is a key recession indicator.
Further pushing bond yields lower Friday was the release of the May Jobs report which came in much cooler than expected (75,000 actual versus 185,000 estimated). Some of the weakness in hires last month could be blamed on worker shortages in certain sectors such as construction. It will be interesting to see how the June jobs report plays out. A tepid June jobs report will all but guarantee a Fed rate cut. Due to the Fed Funds Rate already at a very low level relative to the length of the economic recovery which dates back almost 10 years now, the Fed has very little room to lower short-term rates and it will act sooner than later once it believes economic growth is stalling.
Speaking of rate cuts, corporate and individuals are enjoying lower borrowing costs and lenders are aggressively pricing home and commercial loans in the search for new business. With so many experts expecting lower rates to come, we continue to advise clients to be cautious as any unexpected good news (think trade deal with China) could catch markets off guard. For the moment, we are biased toward floating rates at these levels with the understanding the market is severely overbought.
The “Sell in May and Go Away” theory is on full display as stocks endure a tough week of trading to the benefit of lower bond yields. The main culprits are ongoing trade tensions with China and strong rhetoric from President Trump concerning Mexico. The U.S. will begin imposing tariffs on Mexican goods coming to the U.S. until Mexico applies stricter measures to help halt the illegal immigration crisis. This surprised the market on Thursday. Adding to the volatility is a slower growing global economy, negative interest rates on German and Japanese government debt, and fears of a potential recession. All of these factors have helped push U.S. Treasury yields to a many months low even against the backdrop of strong consumer confidence, a 3.1% GDP 1st quarter reading, and a fairly decent first-quarter earnings season. For the moment, it certainly is a tale of two stories with the “fear trade” winning.
Mortgage rates are also benefiting from lower rates and low inflation readings, but not as much as U.S. Treasuries. We continue to advise borrowers to take advantage of this very low rate environment as it would not take much to push yields higher should some positive comments come out of Washington or Beijing concerning trade talks.