Everything Says Up, But Rates Go Down

Minutes from the latest meeting of Federal Reserve officials show officials are more confident of sustained economic growth. They raised their estimate for gross domestic product (GDP) growth to 2.7% from…

By Brian Barker

The yield on the 10-year U.S. Treasury note drifted lower. The yield hovers around 2.8%. Mortgage rates dipped to their lowest level in two months. This all occurred last week.

It shouldn’t have occurred. The headline news points to Treasury yields and mortgage rates moving to higher ground.

Minutes from the latest meeting of Federal Reserve officials show officials are more confident of sustained economic growth. They raised their estimate for gross domestic product (GDP) growth to 2.7% from 2.5% for 2018. The same officials are also confident that consumer-price inflation will adhere to their 2%-annual- increase target.

As for consumer-price inflation, Fed officials have had their confidence fortified. The Consumer Price Index (CPI) for March showed a 2.4% year-over-year increase in the total component.

The “core” CPI, which excludes food and energy, increased 2.1% year over year. This is the highest reading for both measures in the past 12 months.

Market watchers responded to the news by pricing a greater likelihood that the Fed will increase the federal funds rate (a key overnight lending rate) four times by the end of the year.

Traders in fed-funds-rate future contracts still offer the best odds on three increases, but the odds for four are on the rise.

News on the budget deficit would also suggest interest rates should be higher. The U.S. budget deficit will surpass $1 trillion by 2020, two years sooner than previously estimated, according to the Congressional Budget Office.

Higher budget deficits require more Treasury securities. High yields would appear to be on offer to entice investors to buy the increased supply.

The uptick in GDP growth expectations and measured inflation, coupled with a deteriorating fiscal outlook, all portend a higher interest-rate regime. For now, though, the regime continues to maintain the status quo. We have mitigating factors.

Treasury securities are still desired havens. Geopolitical risk is on the rise due to the heightened risk of a trade war with China and the heightened risk of a real war with Russia regarding Syria.

As for the fiscal deficit, the profusion of Treasury securities required to fund the deficit has been historically benign to interest rates.

Analysis by financial historian Paul Schmelzing, a history professor at Harvard, finds that deficits have little influence in setting bond yields. The data in Schmelzing’s analysis date to the 13th century.

The fact that interest rates in general and mortgage rates in particular, have held their ground when confronted with a slew of pro-rising-rate news points to mortgage rates holding the immediate ground.

If the time-frame is short, it might be worthwhile to float on a mortgage. Over a longer term, though, not so much. The impetus is still for rates to rise over time.

Do You Know the Way to (or Out of) San Jose?

“Otherworldly” is the best descriptor: Zillow reports that the typical home in San Jose and nearby burgs gains $50 in equity every day. Similar appreciation rates can be found in Seattle and nearby Vancouver.

How long can it last?

Mark Perry, finance and economics professor at the University of Michigan, has unearthed some enlightening data. Perry examined U-Haul rental rates. He found that a 26-foot U-Haul truck costs $132 to rent for a move from Las Vegas to San Jose. A rental on the same truck in the other direction costs $1,990.

U-Haul prices were similar for moves to and from San Jose and Phoenix. Perry found similar prices for moves to and from other bay-area cities and other Southwest desert cities.

The implication is that more people are leaving the bay area of California than arriving. Given home prices appreciating 50 bucks a day, it’s easy enough to understand the trend. We also infer that most of the U-Haul renters headed to the desert are aged 30 and under.

We could be wrong and home prices in the hottest regions could continue to compound at an annual price comparable to that of a well-apportioned Kia Soul. We are talking about many homes with starting with prices denoted in millions of dollars, after all.

But if we’ve learned anything over past 10 years, the hottest markets can leave the deepest burns. Deep burns occur most frequently when market participants are oblivious to the risks of otherworldly price trends.

Brian Barker, Contributor
BBVA Compass