The Rise in Rates is Real: October U.S. Rates Update

Monthly Commentary

November 08, 2018

October has a long history of being unkind to equities. This year, the Dow Jones Industrial Average and S&P 500 finished the month down 5.1% and 6.9%, respectively, the worst October since 2008. Unfortunately for investors there was no place to hide. Treasuries traditionally play the role of safe harbor during turbulent times, but this month they posted negative returns as Treasury rates rose to cycle highs. The noteworthy aspect of this selloff is that the Treasury yield curve is steepening despite inflation expectations falling. The sell-off was led by a rise in real rates as the market reprices term premium higher and inflation premium lower. More uncertainty translates into higher price volatility which means repricing of term premium, or risk premium as one moves out the yield curve. The market is not short of things to worry about as the effects of the U.S. election results are contemplated, the trade war with China continues, and higher rates begin impacting the economy. The rise in real yields helped push the Dollar Index (DXY) to its highest level in 16 months, and EM continued to struggle as the U.S. market repriced the FOMC’s rate.

The sharp selloff was sparked by Fed Chairman Jerome Powell’s comments on October 3 at an event in Washington hosted by The Atlantic magazine and the Aspen Institute. “Interest rates are still accommodative, but we’re gradually moving to a place where they’ll be neutral – not that they’ll be restraining the economy,” he said. “We may go past neutral. But we’re a long way from neutral at this point, probably” (our emphasis added). Whether Powell intended to make those comments or if it was a rookie mistake, as others have espoused, the market interpreted this as a hawkish turn as the long bond had its worst one day selloff since President Trump’s election. Recent FOMC speeches have put the neutral rate anywhere from 2.50% to 3.0% and given the Fed Funds target is at 2.25%, the market rightly had a hard time circling the square of being a “long way” from neutral. Looking at the FOMC projections the market is still unable to price to the Fed’s dot plot despite the sell-off. The market is currently pricing in a 3% Fed Funds target by the end of 2019 vs. the Fed’s 3.25% projected rate.

Interest rates can be broken down into a sum of inflation expectations, real rates (growth expectations), and term premium. For the better part of the last decade the term premium has been near zero as the central banks have been the price insensitive buyer in the market place. These asset purchases suppressed volatility and in turn reduced investors preferences to move further out the curve for additional yield. Uncertainty and volatility are returning to the markets as the central banks are finally stepping away from their extraordinary monetary measures. The FOMC is in the final stage of reducing its balance sheet, allowing up to $50 billion in assets roll off each month. The ECB has intimated that QE will end at the end of this year, and the Bank of Japan has made it clear it plans to buy less bonds as well. Powell’s comments, intended or not, served as a wake-up call to the markets. Powell has distanced himself from the academic and model-driven Fed of Yellen and Bernanke and embraced a Greenspanesque approach to policy. The market might be looking for a “Powell Put” but his comments reveal a Fed willing to stay on its gradual tightening path and look through the uncertainty in the market place.

The term premium manifested itself in a steeper curve and higher real rates. Rising risk-free real rates have not traditionally been good for risk assets in this cycle. The extreme case was the Taper Tantrum in 2013, when 30 yr real yields rose 120 bps in three months. The current rise in 30 yr real rates has been a more modest 40 bps in the last two months and 25 bps of that came in October. Inflation expectations actually fell at the same time as 30 yr inflation break-evens contracted over 10 bps last month. Oil’s 10% slide to $65 a barrel certainly had an impact, but more broadly, it is hard to price in higher inflation risk when realized inflation remains tame and the Fed is on course to tighten policy further. October’s CPI release came in below expectations. It showed little impact from the tariffs and some weakening in home prices. Other inflation indicators such as import prices and the prices paid component showed little inflation pressure building as well. Treasury Inflation-Protected Securities (TIPS) underperformed, matching some their lowest break-even levels of the year, as inflation expectations fell on the month.

30 Year Real Yields the Highest Since 2015

Source: Bloomberg

The economic releases for the month continue to show a strong labor market. The non-farm payroll report was weaker than expected but was dismissed due to impacts of Hurricane Michael. However, the most reliable real time job indicator, jobless claims, remained near historic lows throughout the month. The JOLTS job openings report showed the number of openings at 7.136 mm. That is more than the 5.9 mm people unemployed in the U.S. and a record mismatch. The inflation picture wasn’t as robust as CPI came in below expectations with the core rate rising only +0.1% and the year-over-year number falling to 2.3%. Housing has an outsized impact on CPI with a weighting of nearly 33%. The month-over-month increase in shelter prices decelerated from +0.3% to +0.16%. It might be too soon to call for a turn in housing, but the housing data in October continued to paint a painful picture as housing starts fell -5%, and existing home sales fell -3.4%, the sixth straight monthly drop. Existing home sales are now at their slowest pace in nearly three years. One has to look no further than the rise in mortgage rates to explain the slowdown in housing and housing prices as the 30 yr mortgage rate has risen nearly 100 bps this year.

The steady rise in real rates on the back of strong economic growth and Fed rhetoric created wobbles in risk assets in October. The easy part of the hiking cycle is past us. Financial conditions have tightened considerably on the month. Real rates and even money markets now offer an attractive investment alternative. The era of chasing returns because central banks were forcing you out the risk spectrum is coming to an end. This should lead to greater volatility but ultimately to greater investment opportunities down the line. Until then, higher real rates should pressure risk assets lower, all other things equal. Ironically, as higher long-term rates from elevated term premiums front run further Fed hikes, the need for the Fed to go beyond neutral will ebb, and the focus on the potential or actual fall in both financial and real assets will circle back to the Fed and remind it that free markets play an important role in optimal asset allocation for economic growth. Now that’s something we haven’t seen in over ten years.

 

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