Week ended Sept 29, 2023 (end of 3Q)
Dismal quarter ends: housing prices, UST yields, US govt shutdown
The final week of September locked in the rather dismal performance of stocks and bonds for the third quarter, with long duration bonds getting hit particularly hard. It’s hard to find anything constructive to say about what has traditionally been a difficult month except that “I’m glad it’s over”. Below is a quick review of the performance of some key financial indices and assets in the 3rd quarter and YtD:
There are more detailed charts for these indices and assets in the section “The Tables” below.
WHAT MATTERED THIS WEEK?
US government shutdown (likely / pending as this goes to press)
“Same old, same old”, with a totally dysfunctional US government – especially Congress – unable to reach any sort of agreement on a new budget for the world’s largest and most prosperous country. What a shame. Rather than pontificate on this, I will simply borrow Moody’s Investor Services’ words from a report they published this week, which sums up the situation perfectly:
“In particular, following the debt limit brinkmanship episode that concluded in passage of the Fiscal Responsibility Act (FRA) in June of this year, a government shutdown would demonstrate the significant constraints that intensifying political polarization continue to put on US fiscal policymaking during a period of declining fiscal strength, driven by persistent fiscal deficits and deteriorating debt affordability. …. After having negotiated a contentious bipartisan debt limit deal in June, US Congress is yet again renewing internal party disagreements that threaten a government shutdown and clearly reflect the political hurdles to US fiscal policymaking. In particular, aligning political support around a comprehensive, credible multi-year plan to arrest and reverse widening fiscal deficits through measures to increase government revenue or reform entitlement spending, appears extremely difficult in the current highly polarized political environment.” – Potential Credit Implications of a Government Shutdown, 25 Sept 2023, #Moody’s Investor Services
It would be difficult to argue with a decision by Moody’s if they strip the US of its last remaining Aaa rating, as they have effectively set the stage and the US government has earned it. The effect on asset markets of a shutdown (and a potential downgrade) is not expected to be material so long as the shutdown does not last long.
US real estate, mortgage rates and inflation
There has been a fair amount of discussion about the shelter component of core inflation, which is proving to be particularly sticky. Shelter accounts for just over one-third of US CPI, so the direction of travel of housing costs is especially important as far as influencing headline and core inflation figures. Not only is it the largest component of CPI, but shelter accounted for the second largest increase in August CPI (behind gasoline prices), illustrating the relevancy of housing prices and rents.
Why is housing proving to be so resistant even though the Fed has been putting the screws on monetary policy for well over a year now, causing mortgage rates to more than double? The combination of a strong US jobs market and resilient economy, coupled with very (artificially) low historical mortgage rates, has caused the transaction volume of existing home sales to plummet without any meaningful effect on prices.
This, in turn, is related to the structure and characteristics of the US mortgage market, which is largely a long-term (generally 30 years), fixed rate market. (In addition, unlike in the UK, mortgages in the US are not portable, meaning the existing mortgage cannot be transferred to a new home.) As such, US homeowners with existing (lower cost) mortgages do not feel the pain of higher mortgage rates unless they move or re-mortgage, the latter unlikely for obvious reasons. In essence, homeowners with low-rate legacy mortgages are effectively trapped in their home, unable or unwilling to move because they cannot afford to pay a significantly higher amount for a mortgage. For example, a 30-year $300,000 mortgage at 3.0% would require monthly payments of $1,265, while a similar mortgage with a 7.0% rate would require monthly payments of $1,996, a 58% increase. The effect of sharply higher mortgage rates on the volume of existing home sales is obviously negative. However, the effect on prices is more muted, almost negligible in fact, because few people are trading into new homes if they have to obtain a higher-rate mortgage, and the jobs market has been sufficiently strong that there are few distressed sales. According to the National Association of Realtors (here):
The average sales price of an existing home has risen 3.7% YoY, and
Transaction volumes have plummeted by 15.3% over the same period, and have decreased every month since February.
The situation we are in today, characterised by legacy mortgages at artificially low rates, is a derivative effect of unconventionally loose monetary policy during the period between the GFC and the beginning of monetary policy tightening in March 2021 (post-pandemic). During this period, the Federal Reserve
kept rates at both the short-end of the curve (i.e. kept the Federal Funds at effectively zero) and – very influential for the mortgage market – at the long-end of the curve through several rounds of QE and limited QT. You can see in the table below the general level of US 30-year mortgage rates in decades since 1971. Focus especially on the decades prior to the GFC, to the decade+ since the GFC, and to the March 2021 to present period, during which the Fed has consistently tightened monetary policy.
The average rate on the 30-year US mortgage rate has more than doubled from around 3.07% post-pandemic and prior to the Federal Reserve starting its interest rate increases, to over 7% today, according to Freddie Mac. This perfectly illustrates the dilemma – homeowners that borrowed in the decade since the GFC (and prior to the beginning of the Fed’s tighter monetary policy tilt) have super-attractive mortgage deals (3%-4%) compared to what is available today, driving down sales of existing homes and keeping prices firm. Unless homeowners are forced to sell, they simply have little incentive to do so given how mortgage rates have skyrocketed. Needless to say, this also contributes to the lag effect of tighter monetary policy. This could change as consumer savings dwindle and should the jobs market get more challenging in the months ahead.
US Treasury yields continued to increase this week, arguably also dragging yields higher in the U.K. and the Eurozone government bond markets. 10-year government bond yields in the UK, Eurozone and US, respectively, are 4.46%, 2.85% and 4.58%, all hovering at or near record highs.
In spite of the movement higher in UST yields, I believe that these levels could be near their highs. This is a contrarian view and is based on there being a sufficient list of diverse issues that represent headwinds for the US economy, which is gradually starting to feel some pain that is likely to accelerate in the months ahead. For this reason, I think long duration bonds are set to rally.
There are of course idiosyncratic risks in the large, diverse and liquid $25 trillion US Treasury bond market that could derail this premise, including:
Growing US Treasury funding needs driven by record deficits and higher interest costs on the existing stock of US debt (as it rolls over),
Selling of USTs by China and Japan in order to defend their weakening currencies,
Ongoing QT which is removing circa $60 billion of demand for maturing USTs each month ($95 billion if MBS is included), and
The real unknown risk which involves the price arbitrage being undertaken by macro hedge funds which exploit the difference between bond prices and bond futures. I don’t pretend to understand this well, but for FT subscribers, there is an excellent article on this risk here.
MARKETS THIS WEEK
As mentioned earlier, indices and asset prices were generally under pressure all week, and ended September and the third quarter lower. The UST curve “twisted” as short-term yields fell (as August PCE was slightly better than expected), and intermediate and long-term yields rose, apparently because the “higher for longer” Fed message is finally resonating with investors. The US Dollar continued to strengthen. The EUR-USD FX rates is below the level at which it started the year, with the GBP-USD FX rate just keeping its head above its starting level for 2023 but fading fast. I had thought both European currencies should weaken, and I see this continuing as the relative outlooks for the economies of the US, Eurozone and UK diverge. Oil was also a touch higher, but backed off its mid-week gains. Gold got hammered this week, and the Yen – not surprisingly – continued to hover just below the ¥149/US$1.00 level, with the ¥150 level most likely stoking Bank of Japan intervention. September is over, and hopefully some of the stress points that affected asset prices will go away too, although there is plenty to keep an eye on in the weeks ahead.
As a final note, it is ironic that Street analysts rushed to revise their year-end forecasts for the S&P 500 higher just a few weeks ago, and stocks have fallen ever since. I just had to say this!
WHAT'S COMING UP THAT MATTERS?
Things to watch:
UAW strike in the US: volatile situation / ongoing
US government shutdown / 2023-24 budget discussions frozen
Student loans are out of forbearance with payments starting again in October
Carryover themes: Higher oil prices, stronger US Dollar, China growth (signs property sector is worsening)
Corporate earnings for 3Q23 to start mid-month with the major US banks up first
Economic data this coming week:
US: ISM manufacturing and services data for Sept, JOLTS data and the September employment report (Friday); plenty of Fed-speak too from the Fed talking heads
Europe: Employment report, PPI, retail sales (all for August)
Upcoming central bank meetings:
ECB: Oct 26 and Dec 14
Federal Reserve (FOMC): Oct 31/Nov 1; Dec 12-13
Bank of Japan: Oct 30-31 and Dec 18-19
Bank of England: Nov 2 and Dec 14
The tables below provide detail across various global and US equity indices, the US Treasury market, corporate bonds and various other asset classes.
Corporate bonds (credit)
Safe haven and other assets