Morning Report: Hong Kong extradition bill withdrawn

Vital Statistics:

 

Last Change
S&P futures 2932 23.5
Oil (WTI) 55.12 1.74
10 year government bond yield 1.49%
30 year fixed rate mortgage 3.78%

 

Stocks are higher after the Hong Kong government backed down on its extradition bill that drew massive protests in the Chinese-controlled city. Bonds and MBS are flat.

 

Mortgage applications fell 3.1% last week as purchases increased 4% and refis fell 7%. This was despite the lowest rates since late 2016. MBA Associate Vice President of Economic and Industry Forecasting Joel Kan said “Despite lower borrowing costs, refinances were down from its recent peak two weeks ago, but still remained over 150 percent higher than last August, when rates were almost a percentage point higher.”

 

The trade deficit decreased in July, however the deficit with China increased. Exports rose slightly, while imports were down.

 

The Fed’s balance sheet could be set to increase in size by the end of the year. The NY Fed is forecasting the balance sheet could swell to $4.7 trillion by the end of 2025. They had been edging towards normalcy, however they halted the run off in July when they cut rates by 25 basis points. Note the ECB is probably going to start QE as well, adding fuel to the global sovereign debt bubble.

 

Ray Dalio of Bridgewater lays out his theory about the political and economic landscape and compares it to the Great Depression era.

 

The most important forces that now exist are:

1) The End of the Long-Term Debt Cycle (When Central Banks Are No Longer Effective)

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2) The Large Wealth Gap and Political Polarity

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3) A Rising Work Power Challenging an Existing World Power

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The Bond Blow-Off, Rising Gold Prices, and the Late 1930s Analogue

In other words now 1) central banks have limited ability to stimulate, 2) there is large wealth and political polarity and 3) there is a conflict between China as a rising power and the U.S. as an existing world power. If/when there is an economic downturn, that will produce serious problems in ways that are analogous to the ways that the confluence of those three influences produced serious problems in the late 1930s.

 

It is an interesting read, and certainly standard gold-bug fodder. I suspect going from an edge-of-deflation environment to hyperinflation is going to take a long time, as in decades. But it is interesting to play through scenarios in this unprecedented government bond bubble.

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Morning Report: High frequency traders and mortgage rates

Vital Statistics:

 

Last Change
S&P futures 2907 -16.5
Oil (WTI) 53.33 -1.74
10 year government bond yield 1.50%
30 year fixed rate mortgage 3.78%

 

Stocks are lower this morning on trade issues. Bonds and MBS are flat.

 

The holiday-shortened week ahead looks to be relatively quiet, with the exception of a spate of Fed-speak on Wednesday and the jobs report on Friday. The September Fed Funds futures are pricing in a 100% chance of another 25 basis point cut, and the Fed seems to be in market-following mode, so the data should take a backseat.

 

Manufacturing activity slipped in August, according to the ISM Manufacturing Survey, which came in at 49.1, well below expectations. This was the first contraction in the manufacturing sector since mid-2016. The level for the ISM typically corresponds with 1.8% GDP growth.

 

Separately, construction spending rose 0.1%, which was lower as well, however the previous month’s drop was revised upward from -1.3% to -.7%.

 

Home prices rose .5% MOM / 3.6% YOY in July, according to CoreLogic. Home price appreciation slowed in 2018 as rates rose. That effect will reverse over the next year, and Corelogic expects annual home price appreciation rates to settle in around 5%. Tight supply, especially amongst starter homes will support prices, as well as a robust labor market and a move out of urban areas to the suburbs. About 37% of the US housing stock in the top 100 MSAs is overvalued. This metric is based on wage growth and housing supply.

 

Hurricane Dorian is expected to miss direct landfall, however it is slow-moving and dumping a lot of rain. Coastal areas will be at risk of flooding as the storm parallels the Eastern Seaboard this week.

 

The WSJ has an interesting article this morning about thinning liquidity in the markets. Late summer is often characterized by thinning liquidity, which means fewer active investors are trading, which causes exaggerated market movements when a big buyer or seller wants to execute an order. They mention what has been going on in the Treasury market:

Some analysts point to high-frequency traders. They have dominated the government-bond market, making up a big chunk of trading activity compared with slower counterparts, according to JPMorgan analysts. These traders withdrew last month, the firm said, suggesting that they amplified turbulence. Investors said liquidity worries are even more pronounced in riskier corporate bonds.

“As you go further down the credit spectrum, it starts to get a bit more volatile,” said Gautam Khanna, a fixed-income portfolio manager at Insight Investment. “Liquidity is definitely thinner in this market than it has been.”

This might help explain why mortgage rates have lagged the move in Treasuries. In essence, high frequency traders help establish a liquid market, where it is easier for large investors such as banks, sovereign wealth funds, pension funds, etc to trade large positions. When these high frequency traders withdraw, bid / ask spreads widen, and volatility increases. Here is the issue: MBS investors hate volatility because it makes their portfolios hard to hedge, and adds uncertainty about prepayment speeds. This causes them to be more conservative with respect to the prices they are willing to pay for mortgage backed securities, which flows through to mortgage rates falling less than the move in Treasuries would predict. Below is a chart of 10 year Treasury futures volatility. You can see the spike in the index beginning in August, which corresponds with the dramatic drop in rates, and the exit of high frequency traders from the market.

 

treasury futures volatility

 

 

Morning Report: Adjustable rate mortgages becoming less attractive

Vital Statistics:

 

Last Change
S&P futures 2875 19.5
Oil (WTI) 55.05 0.84
10 year government bond yield 1.53%
30 year fixed rate mortgage 3.84%

 

Stocks are higher after Trump toned down the rhetoric with China at the G7. Bonds and MBS are flat.

 

Both the US and China made statements intended to de-escalate the trade war, which is adding a spring in the step of the S&P futures. China supposedly wants to get back to “calm” negotiations, while Trump has mused over canceling the recent new tariffs. On Friday, Trump ordered US companies to start looking for alternatives to China, which he doesn’t really have the power to do. S&P futures sold off on Friday afternoon, and bond yields fell. That said, the market do seem to be adjusting to Trump thinking aloud on Twitter.

Durable Goods orders increased 2.1% in July, which was way more than expectations. Nondefense capital spending ex aircraft (which is a proxy for corporate capital expenditures) rose 0.4%, much higher than the decrease the Street was looking for. For all the handwringing in the business press over the state of the economy and trade, it isn’t showing up in the numbers, at least not yet.

 

The upcoming week looks to be relatively non-eventful, with only some meaningful data late in the week – the second revision to Q2 GDP on Thursday, and personal income / spending data on Friday. Another rate cut seems baked into the cake for September, so a strong number probably won’t have that big of an impact on markets.

 

The spread between adjustable-rate mortgages and fixed rate mortgages has been contracting as the yield curve has flattened. This is because the difference in long term rates and short term rates has fallen. Currently the difference between a 30 year fixed and a 5/1 ARM is about 55 basis points, whereas it was closer to 100 basis points during the post-bubble era. If you only plan on living in your home for 5 years or so, ARMs generally make sense, however if you can lock in your rate for 30 years at a similar rate to an ARM, it doesn’t make sense to go adjustable.

 

adjustable vs fixed.

 

Regulators are thinking about raising the threshold where homes require an appraisal, from 250,000 to 400,000. This would be the first increase in the threshold since 1994. About a year ago, the FDIC, OCC and Fed released a proposal which would make the change, and the FDIC just published the final rule.

 

SUMMARY: The OCC, Board, and FDIC (collectively, the agencies) are adopting a final rule to amend the agencies’ regulations requiring appraisals of real estate for certain transactions. The final rule increases the threshold level at or below which appraisals are not required for residential real estate transactions from $250,000 to $400,000. The final rule defines a residential real estate transaction as a real estate-related financial transaction that is secured by a single 1-to-4 family residential property. For residential real estate transactions exempted from the appraisal requirement as a result of the revised threshold, regulated institutions must obtain an evaluation of the real property collateral that is consistent with safe and sound banking practices.

 

 

Morning Report: New home sales fall.

Vital Statistics:

 

Last Change
S&P futures 2907 -14.5
Oil (WTI) 53.79 -1.64
10 year government bond yield 1.61%
30 year fixed rate mortgage 3.86%

 

Stocks are lower as we await Jerome Powell’s speech in Jackson Hole. Bonds and MBS are flat.

 

Jerome Powell speaks at 10:00 am, while the markets are looking to see if the Fed trims its sails to what the Fed Funds futures are saying. Some at the Fed have been throwing cold water on the idea that we have entered an easing cycle, but in an era of negative sovereign yields worldwide the die is probably cast for lower rates regardless of what the Fed does.

 

New Home Sales fell to 635,000 from an upwardly-revised 728,000 in June. They are up over 4% from a year ago.

 

new home sales

 

The Conference Board Index of Leading Economic Indicators improved last month. “The US LEI increased in July, following back-to-back modest declines. Housing permits, unemployment insurance claims, stock prices and the Leading Credit Index were the major drivers of the improvement,” said Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board. “However, the manufacturing sector continues exhibiting signs of weakness and the yield spread was negative for a second consecutive month. While the LEI suggests the US economy will continue to expand in the second half of 2019, it is likely to do so at a moderate pace.”

 

Note that China imposed additional tariffs on $75 billion of US goods overnight. The tariffs would apply to soybeans, small aircraft, and crude oil.

Morning Report: Trump calls for 100 basis points and more QE

Vital Statistics:

 

Last Change
S&P futures 2922 0.5
Oil (WTI) 56.11 0.44
10 year government bond yield 1.55%
30 year fixed rate mortgage 3.78%

 

Stocks are flat this morning on no real news. Bonds and MBS are up.

 

No economic data this morning, and we wait for Jackson Hole comments later this week.

 

Trump called on the Fed to cut rates by 100 basis points and should re-embark on quantitative easing. “Our Economy is very strong, despite the horrendous lack of vision by Jay Powell and the Fed, but the Democrats are trying to ‘will’ the Economy to be bad for purposes of the 2020 Election,” Trump tweeted. “Very Selfish! Our dollar is so strong that it is sadly hurting other parts of the world. [Interest Rates] over a fairly short period of time, should be reduced by at least 100 basis points, with perhaps some quantitative easing as well….If that happened, our Economy would be even better, and the World Economy would be greatly and quickly enhanced-good for everyone!”

 

The Home Despot reported better than expected earnings this morning. Falling lumber prices caused them to take down their sales estimates, and they are worried about how tariffs will impact sales. “We are encouraged by the momentum we are seeing from our strategic investments and believe that the current health of the U.S. consumer and a stable housing environment continue to support our business,” CEO Craig Menear said in a prepared statement. “That being said, lumber prices have declined significantly compared to last year, which impacts our sales growth. As a result, today we are updating our sales guidance to account primarily for continued lumber price deflation, as well as potential impacts to the U.S. consumer arising from recently announced tariffs.”

 

Ballard Spahr weighs in on the new disparate impact rule. Disparate Impact is a concept that was intended to put the burden of proof on the defendant, not the plaintiff. If a lender’s customer base doesn’t reflect the demographics of the relevant market, then it is assumed the lender is guilty of discrimination. While a Texas court upheld the concept, it did institute some guardrails to prevent abuse. HUD’s new guidance was intended to reflect that decision.

 

The relief for lenders turns on the use of algorithms to make lending decisions. Since most lenders use DU or LP automated underwriting systems, the big question is whether this insulates them from discrimination charges. Ballard Spahr believes it does. “However, if the use of the model is an “industry standard,” the defendant is relieved from liability if it uses the model “as intended by the third party” that created it.  It appears that the second defense could apply in a variety of situations, including when a mortgage lender uses the automated underwriting systems of Fannie Mae or Freddie Mac.”

 

The Business Roundtable officially ended the era of shareholder value yesterday and declared that it would focus on “all stakeholders.” Though this document is largely symbolic, it is an attempt by business to play along with the new populism emerging in the Democratic Party. “The American dream is alive, but fraying,” said Jamie Dimon, Chairman and CEO of JPMorgan Chase & Co. and Chairman of Business Roundtable. “Major employers are investing in their workers and communities because they know it is the only way to be successful over the long term. These modernized principles reflect the business community’s unwavering commitment to continue to push for an economy that serves all Americans.

 

To me, this document is indicative of several trends: first the emerging populism in both political parties, second a tight labor market, and third the emergence of indexing as the primary long-term investing vehicle. We are seeing the left become more comfortable in their historic role of being a check on big business, while the right is talking about antitrust and Big Tech. Neither party seems particularly hospitable and the “third way” Democrats are battling an increasingly mobilized left. The tight labor market is also playing a part, as companies need to attract employees and this might be the second-to-last resort to try and attract them. Of course the last resort is to raise wages and hire the long-term unemployed, and that may be on the horizon.

 

The indexing angle is probably the most significant. When most of the largest shareholders in the S&P 500 are index funds and ETFs, you have take into account they don’t have the motivations that money managers had a couple decades ago. 20 years ago, money managers were paid to beat the market and pick good stocks. Those that did so were rewarded with inflows and their managers were paid big bonuses. That was the Peter Lynch model. Today, the biggest money managers aren’t interested in beating the market. They aren’t paid to do that. They are paid for minimizing tracking error and fees, which means they aren’t paid much since the skill set is completely different. They couldn’t care less if XYZ Inc’s CEO is a bum who makes bad decisions – as long as their fund holds the requisite 2.49856% of net asset value in XYZ, they have done their job. Indexers largely vote the way Institutional Shareholder Services (ISS) recommends, and ISS has its own set of priorities. Punch line: companies can get away with this because their largest shareholders don’t have any skin in the game.

Morning Report: Why we aren’t headed for a recession

Vital Statistics:

 

Last Change
S&P futures 2874 24.5
Oil (WTI) 54.62 -0.14
10 year government bond yield 1.55%
30 year fixed rate mortgage 3.78%

 

Stocks are higher on no real news this morning. There is a risk-on feel to the tape after a tumultuous week. Bonds and MBS are down.

 

Housing starts disappointed (again!) coming in at 1.19 million, lower than the 1.26MM street estimate. This is down 4% on a MOM basis, and up about 0.6% on a YOY basis. On the bright side, building permits surprised to the upside, coming in at 1.34 million versus the 1.27 million street estimate. Still, new home construction remains depressed due to labor shortages and lack of buildable lots.

 

Despite these issues, homebuilders remain optimistic. The NAHB / Wells Fargo Builder Sentiment Index rose in August to 66. Current sales conditions improved, while expectations for the next six months moderated. “While 30-year mortgage rates have dropped from 4.1 percent down to 3.6 percent during the past four months, we have not seen an equivalent higher pace of building activity because the rate declines occurred due to economic uncertainty stemming largely from growing trade concerns,” said NAHB Chief Economist Robert Dietz. “Although affordability headwinds remain a challenge, demand is good and growing at lower price points and for smaller homes.” Interesting about the tariff issue – building materials prices are down quite substantially. If tariffs were really that big of a deal, you would expect to see shortages and increases. We aren’t.

 

Given all the chatter about the yield curve and a possible recession, it is worthwhile to step back and take a look at the facts on the ground. The business press is awash with stories about the yield curve and how it is possibly signalling a recession. Quick explanation: the yield curve shows interest rates along the spread of maturities, and short term rates are usually lower than long term rates. However, we are flirting with a situation where long term rates are lower than short term rates. That is a yield curve inversion, and historically a yield curve inversion has been a decent (but not perfect) predictor of an imminent recession. The reason for this is that it implies that businesses are taking less risk, which means they must see something wrong in the economy.

 

The problem with the inverted yield curve model is that it gives off a lot of false positives – an old market saw is that an inverted yield curve has predicted “15 of the last 10 recessions.” Many times an inverted yield curve is the result of technical issues in the bond markets, which are temporary and don’t really spill through to the overall economy. This current period is probably one of those cases, and the technical issue is central bank behavior. The Fed, ECB, Bank of Japan have been pushing down long term rates in order to stimulate the economy for years, and now we have negative interest rates in much of the world. Negative interest rates in Germany and Japan (two huge bond markets) are pulling down US bond yields as overseas investors sell government debt that pays less than nothing (German Bunds and Japanese Government bonds) to buy government debt that does pay something (US Treasuries).

 

The business press is emphasizing the Trump / tariff / recession angle here because (1) it is a much simpler story to tell, (2) the partisans get to blame it on Trump, and (3) many strategists reluctant to stick their necks out and discuss the implications of negative rates worldwide – this is a completely new phenomenon and quite simply people don’t know.  We have a bubble in sovereign debt that has been engineered by global central banks – and unlike stock and real estate bubbles, we don’t have any historically similar periods to review. We know that bubbles end eventually, but when and how this resolves is anyone’s guess.

 

That said, what is the current economic state of play? Europe is doing its same-old Euro-sclerosis thing, which it has been doing for decades. Germany had a slightly negative GDP quarter and most of the Eurozone is slowing down in sympathy. Japan has been in the throes of a sclerotic economy since the New Kids on the Block ruled the charts. China is also tempering its growth. On the other side of the coin, the US has the lowest unemployment rate in 50 years, initial jobless claims are the lowest since we had a military draft, wages are rising, inflation is under control, and the consumer is increasing spending. This simply is not a recipe for a recession. And to take this a step further, tariff income has been about $60 billion since they have been implemented. In the context of a $21 trillion economy, this is insignificant – about 1/3 of 1%. It is a humorous state of affairs with partisan talking heads accusing Trump of destroying the economy over small-beer tariffs, while Trump accuses partisan journalists of sabotaging the economy with negative stories – as if the press had the power to do that.

 

Here is the big picture: The US economy has been strong enough to withstand a tightening cycle from the Fed, and has had 2.6% GDP growth in the immediate aftermath of a tightening cycle. Inflation is low, and is probably going to go lower as Europe and China begin exporting deflation to the US. Oh, and by the way the Fed is now cutting interest rates, which is the equivalent of giving a can of Red Bull to your kid at 9:00 pm on Halloween night. Don’t buy the recession narrative. None of the required pieces are in place.

Morning Report: Trump tries to talk down the dollar

Vital Statistics:

 

Last Change
S&P futures 2905 -14.5
Oil (WTI) 54.68 0.64
10 year government bond yield 1.69%
30 year fixed rate mortgage 3.86%

 

Stocks are lower after a bunch of non-US political headlines over the weekend. Bonds and MBS are up.

 

Overseas, currencies and bond yields are focusing on elections in Italy and Argentina, as well as protests in Hong Kong. Protestors shut down the Hong Kong airport over the weekend.

 

The week ahead will have a few important data points, but nothing likely to be market-moving. We will get inflation at the consumer level tomorrow, retail sales / productivity / industrial production on Thursday, and housing starts on Friday. There doesn’t appear to be any Fed-speak this week, so things should be quiet absent overseas political developments. Congress is on vacation until Labor Day, so things should be quiet in DC as well.

 

Building materials prices rose 0.7% (NSA) in July, but are down overall year-over-year. Despite tariffs, softwood lumber prices are down 20% over the past year, while other products like gypsum are down less. Roofing materials (tar / asphalt) were flattish-to-down as well. Rising home costs are due more to labor, land, and regulatory costs than they are due to sticks and bricks.

 

After rising for a decade, average new home sizes are falling as builders pivot away from luxury buyers to first time homebuyers. In 2018, the average size of a single family dwelling was 2,588 square feet, down from 2,631 the year before. Builders had largely decided to relegate the first time homebuyer to the resale market and focused on McMansions and luxury urban apartments during the immediate aftermath of the housing crash. Townhomes are also increasing in popularity, with 69,000 sales last year, the most since 2007. This is the sector growing the fastest.

 

Prepay speeds were released on Friday, and we saw some eye-popping CPRs on the government side: 2018 FHA had a CPR of 30.7%, while VA was almost 50%. People who loaded up the boat on MSRs in 2017 and 2018 have been killed.

 

The Fed is looking at the idea of a countercyclical capital buffer as a way to mitigate the credit cycle. The idea would be to have the banks hold more capital (i.e. lend less) when the economy shows signs of overheating and then allow them to hold less (i.e. lend more) when the economy goes into a down cycle. This would only apply to the Citis and JP Morgans of the world – banks with more than 250 billion in assets. “The idea of putting it in place so you can cut it, that’s something some other jurisdictions have done, and it’s worth considering,” Fed Chairman Jerome Powell said at a late July press conference. It is an interesting idea, although reserves are typically sovereign debt, and this sounds a bit like adding buying pressure to a market that certainly does not need it.

 

Trump tweeted about the dollar, arguing that it should be weaker. Note this is a yuge departure from the strong dollar policy that every other president has supported. “As your President, one would think that I would be thrilled with our very strong dollar,” he tweeted. “I am not! The Fed’s high interest rate level, in comparison to other countries, is keeping the dollar high, making it more difficult for our great manufacturers like Caterpillar, Boeing, John Deere, our car companies, & others, to compete on a level playing field. With substantial Fed Cuts (there is no inflation) and no quantitative tightening, the dollar will make it possible for our companies to win against any competition. We have the greatest companies in the world, there is nobody even close, but unfortunately the same cannot be said about our Federal Reserve. They have called it wrong at every step of the way, and we are still winning. Can you imagine what would happen if they actually called it right?”

 

The strength in the dollar is more due to the relative strength of the US economy versus its trading partners, along with various carry trades. A carry trade is where you borrow money in a low yielding currency like the Japanese yen and invest the proceeds in a high-yielding government bond like the US Treasury. The net effect of a strong dollar is to make our exports more expensive to foreign buyers, make imports cheaper for US consumers and to lower interest rates in the US. The problem is that the ones who benefit from a weaker dollar (exporters) are loud and visible, while the beneficiaries (everyone else) aren’t even aware they are benefiting from it. Note that as the US has pivoted from a manufacturing-based economy to a service / IP based economy, the currency has a smaller and smaller impact on things.

 

Chart US dollar index (1989 – Present):

 

dollar