Risk-On Tone Has Treasuries Under a Halloween Spell

Oct 31, 2018

Happy Halloween! May the treats be plentiful this evening and the tricks not so much.  But before the ghosts and goblins descend upon our doorsteps we do have some mundane economic results to consider. ADP’s Employment Change Report is out this morning and it found 227,000 new private sector jobs versus 187,000 expected. The series, however, has lost some luster as a predictor of the upcoming BLS report. For example, last month ADP found 230,000 private sector jobs (revised lower to 218,000) and the BLS reported only 121,000. The prior month it was reversed with ADP reporting 168,000 jobs and BLS 254,000. For the first nine months of 2018, ADP printed over BLS five times and under four times. Given that record it’s anyone’s guess what the ADP predicts for Friday. In reality, however, the most important number will be wage growth  with a move above 3.0% YoY expected, and if that occurs it will add another pillar to the Fed’s case for a December hike that is currently sitting at 72% odds. The other key driver of near-term interest rate moves will be the result of next Tuesday’s midterm elections which we discuss in more detail below. This morning a risk-on tone prevails that looks to continue the stock rally from yesterday and that has Treasuries under a spot of bother. The 10-year is off 6/32nds to yield 3.15%.


  Economic News


While the ADP Employment Change Report provides little in the way of predictive power for the Friday jobs numbers, in reality the more market-moving event is likely to be the midterm elections next Tuesday. While the jobs report is expected to reflect a labor market that is still hitting on all cylinders, the markets will be watching over the horizon for the outcome of the midterms.


Part of the equity selling this month has been attributed to the scenario that the House of Representatives flips to Democratic control while the Senate remains in Republican hands and thus divided government awaits for the remaining two years of the Trump administration. While that outcome has been the odds-on favorite for most of the year, not including a brief period when the Senate looked to also be in play, the approaching election may have sharpened equity investors’ full and undivided attention.


We think the extreme equity volatility is a reaction to a confluence of events rather than one catalyst. From a Fed seemingly intent on hiking rates well past neutral,  increasing trade tensions (see China), increasing political tensions (see Italy and the EU and Brexit) and global growth patterns that seem to be moderating (see EU, China, Japan), the domestic political uncertainty has added to the risk-off mix in our opinion.


While there are a plethora of polls to predict all manner of outcomes we have always liked the statistical bent of Nate Silver’s FiveThirtyEight website. In the latest call for the House he has the Democrats with 86.2% odds of winning a majority with an average gain of 39 seats. That would provide a modest majority of 234 seats,  16 more than the 218 needed.  With a Democratically-controlled House you can kiss goodbye to any chance Tax Cut 2.0 goes anywhere and that’s likely good for bonds, and particularly muni bonds, as additional deficit-financed supply will be kept off the governments ledger for a couple years,  at least.  And while business investment has not boomed under Tax Cut 1.0 it would seem it will remain tepid under a split government and a House probably intent on investigating Trump administration activities of the past two years rather than initiating bipartisan economic legislation. We will add, however,  that the S&P500 has finished in the green at year-end after an October low in every midterm year since 1946. In many respects just the passage of heightened event risk, like an election, is enough to shift to a risk-on tone despite the changes the election brings in the political power structure.


That track record of trading higher post-election seems to fall in the sell-the-rumor-buy-the-news reaction in regards to equity assets which implies some tough sledding for Treasuries after the election, regardless of who wins. And if stocks indeed rebound into year-end it certainly helps keep the Fed’s December rate hike firmly in place.


Meanwhile, the S&P Case-Shiller Home Price Index came in at +0.09% month-over-month in August versus +0.07% in July and year-over-year came in at 5.49% quite a bit below the 5.8% forecast. The YoY rate was the slowest since 2016 and yet another reminder that high borrowing costs and property values continue to constrain potential buyers.  The August numbers also mark the fifth straight month of decelerating YoY gains and as such the report adds to a growing list of residential real estate releases that are reflecting a slowing in sales and construction activity as higher rates and home prices constrain affordability.


Keep in mind too this report is a bit dated in that it’s August data. The more timelier series like New and Pending Home Sales (that are based on contract signings versus closings) reflect continued slowing, albeit modest, in the September numbers. One would think additional rate hikes from this point will further undermine affordability and hence activity in the housing market.  In fact, the residential real estate market has been a drag on GDP for the last three quarters and five of the last six so any additional slowdown isn’t likely to be an outsized drag on future GDP estimates but don’t look to the sector for any type of GDP boost either. Thus, the consumer will once again have to shoulder the lion-share of economic growth in 2019.




Market Update  S&P Case-Shiller Home Price Index Reflecting Higher Rates?


The graph illustrates the S&P Case-Shiller year-over-year price change for its 20-city index. Over the last 18 years annual price changes have been volatile but they had shown a steady, if slow, ascent higher since late 2014 as the economic expansion broadened. Recently, however, annual price changes have begun to decelerate with August representing the fifth straight month with sequentially lower annual gains. The deceleration in the price series is yet another housing report that appears to reflect the impact of higher rates for potential borrowers. This series along with others such as new and existing home sales, pending sales and new home construction all paint a similar picture of a sector that had been enjoying a multi-year run being suddenly buffeted by higher rates.

S&P Case-Shiller Home Price Index Reflecting Higher Rates?



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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