European markets couldn't match yesterday’s U.S. stock rally with an opening pop that faded through the trading day into negative territory and that has our equity futures pointing to a down open which in turn has Treasury prices trading higher. Also helping Treasuries was a rather weak housing starts release for September which was down –5.3% from a downwardly revised August print. Building permits also missed expectations falling –0.6% for the month versus an expected increase of 2.0%. The latest numbers will play to those thinking higher rates, higher prices, and limited wage gains are impacting affordability. We’ll opine that while the recent round of housing numbers don’t speak to a dramatic falloff in activity, they do paint the picture of an industry that has plateaued and that has its own implications. For now, investors turn their eyes to this afternoon’s minutes from the September FOMC meeting which we discuss in more detail below.
|Economic News||Bank Equities Move South as Yields Move North||Agency Indications|
This afternoon’s release of the minutes from the FOMC’s September rate-hiking meeting will be examined not only for indications of confidence by the members in getting a December rate hike on the books, but also for any lack of confidence in knowing and using the neutral rate to guide future policy decisions. The recent market volatility took place after the meeting so any discussion of accommodative financial conditions will have to be interpreted in light of the tightening that has come as a consequence of the recent equity selling and volatility. Given comments from several members subsequent to the meeting, confidence in the economy and inflation appear resolute enough to withstand the moderate equity selling that has occurred. That implies to us the December rate hike is still a solid go but expecting three hikes in 2019 becomes a harder sell if the equity volatility continues. Bank stocks in general have been in a funk for most of the year and usually broad-based stock advances need the financials to have any real staying power. Also, the Goldman-Sachs Financial Conditions Index has tightened to a level last seen in May 2017 and that preceded a six-month Fed pause after they had reached 1.00%. If conditions continue to tighten and equities/bank stocks continue to struggle are we due for another pause after a December hike?
As mentioned we will also be looking for hints that Fed officials are tossing out the concept of the neutral rate as a guidepost for future policy decisions now that we are approaching it. Some comments after the meeting left the impression that as the effective fed funds rate approaches estimates of the neutral rate (2.50% -3.00%), officials are starting to downplay its importance given the difficulty of accurately estimating its level. Thus, the idea that as fed funds approaches neutral it would be a natural point to pause has in some quarters been tossed. The minutes will be reviewed to see if that view is also expressed by some or several or most members.
In the meantime, despite the Fed’s confidence in the economy and post-meeting hints that no pauses are on the near-term horizon, a weaker-than-expected CPI release last week was joined by a merely ok retail sales release for September. The offset to that, however, is continued strength in the labor market with the August Job Opening and Labor Turnover release hitting a fresh high with 7.136 million jobs sitting unfilled. The thinking at the Fed is that with an unemployment rate at 3.7% as long as the labor market continues to add jobs (both filled and unfilled) wage gains will follow. Thus, the default position is to continue with rate hikes until “something breaks.”
The implication for yields is a continuing flattening of the yield curve as the short-end, while priced for two additional hikes, may need to price in another two hikes before the end of 2019. That somewhat aggressive tightening posture is likely to keep long-end rates range-bound in the face of expected moderation in GDP growth in 2019, and inflationary forces that refuse to accelerate much above 2.0%.
One possible catalyst for higher rates that has been mentioned is the increased supply of Treasury securities to fund the growing budget deficit. And grow it did as the deficit ballooned to $779 billion in 2018 per a U.S. Treasury release. Federal spending increased for the fiscal year, but, because the economy grew at a faster pace than outlays, they fell as a share of the economy, to 20.3% from 20.7%. Meanwhile, revenues rose by 0.4% from fiscal year 2017 but that was a slowdown from previous years. In fiscal year 2017 revenues rose by 1.5% and 0.5% in 2016 when economic growth was considerably slower than it had been over the last year. As a share of the economy, revenues fell to 16.5% in fiscal year 2018 compared to 17.2% the year before. The tax cut legislation led to corporate tax receipts falling to $205 billion versus $297 the prior year, while personal income tax collections rose slightly.
Offsetting some of the supply concern is the fact this is a known known, to borrow a phrase from former Defense Secretary Donald Rumsfeld. That is investors know increased supply is coming yet are buying long-duration bonds today with a decent amount of enthusiasm. And given our aging demographics, a hawkish Fed, and docile inflation outlook it’s hard to find fault with that strategy, at least to our eyes.
Bank Equities Move South as Yields Move North
We kept hoping for a reprieve for the downtrodden bank stocks this year but the recent bout of equity volatility has only brought more of the same, namely more selling. It’s been a long-held Wall Street axiom that low yields were bad for banks as they limited the profits that could be made from lending. The graph tracks the performance of the S&P 500 Financials sector against the rest of the market (white line). Higher yields have done nothing to help bank stocks since the equity market correction back in February and the latest round has only added to the misery. Why the behavior? Could it be the long-in-the-tooth expansion combined with higher rates are raising concerns that the best is behind us?
Agency Indications — FNMA / FHLMC Callable Rates