Morning Report: The yield curve inverts

Vital Statistics:

 LastChange
S&P futures3,833-1.55
Oil (WTI)99.580.14
10 year government bond yield 2.76%
30 year fixed rate mortgage 5.61%

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

The yield curve inverted yesterday afternoon and remains so this morning, with the 2s-10s spread at -2 basis points. An inverted yield curve is usually an early warning sign for a recession. Given the Fed’s aggressive path for rates, we are probably headed for one. The big question lies around the labor market. So far we aren’t seeing any major uptick in initial jobless claims. If that holds, then we might manage to avoid one.

As I discussed yesterday, the unofficial definition of a recession – two consecutive quarters of negative GDP growth – is not used by the government. The NBER basically has discretion to declare one is occurring. Since the labor market is so strong, they probably will avoid declaring one.

Note that the German Bund yielded 1.52% at the end of June and is now trading at 1.1%. This is a big decline in just a week as investors are fearing a recession in Europe. The Euro – dollar spot rate is almost back to parity, something we haven’t seen in over 20 years. Not all sovereign yields are down – the Japanese government bond yield is up to 25 basis points, however British Gilts are down about 30 bps over the past week. While the economies of Europe, the US and Japan are in different phases, sovereign debt markets do generally correlate. This is part of what is pushing down yields in the US.

The Fed Funds futures are becoming a touch less hawkish. Compared to a week ago, the central tendency for the end of the year has decreased by 25 basis points to a range of 3.25% – 3.5%. This is still much higher than a month ago, when the central tendency was 2.75% – 3.0%.

The current handicapping is another 75 basis points at the end of July meeting, 50 basis points in September, then 25 in November and December. That is still a lot of tightening to go, and since the Fed Funds rate tends to impact the economy with a 9 month lag or so we haven’t even begun to feel the impact of the rate hikes we have already seen.

Mortgage applications fell by 5.4% last week as purchases fell 4% and refis fell 8%. There was an adjustment for the early close on July 1, so that is probably affecting the numbers somewhat. The refi index is down 78% from a year ago, and the share of refis has fallen below 30%.

“Mortgage rates decreased for the second week in a row, as growing concerns over an economic slowdown and increased recessionary risks kept Treasury yields lower,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “Mortgage rates have increased sharply thus far in 2022 but have fallen 24 basis points over the past two weeks, with the 30-year fixed rate at 5.74 percent. Rates are still significantly higher than they were a year ago, which is why applications for home purchases and refinances remain depressed. Purchase activity is hamstrung by ongoing affordability challenges and low inventory, and homeowners still have reduced incentive to apply for a refinance.”

The service economy rose in June, according to the ISM Services Index. This reading was above expectations, but lower than May’s numbers. It looks like the prices index fell for the second straight month, which is welcome news on inflation. Here is what one retailer had to say: “Consumers are shifting purchases away from our discretionary products to essentials. Inflation is definitely taking a bite from our sales, and mall traffic is far below the norm, potentially due to inflation, a need for more disposable income on essentials and less willingness to drive to malls. E-commerce sales will be going up again.” [Retail Trade]

Another indication the economy is slowing: job openings are decreasing. Job opening fell by 427k to 11.3 million. The quits rate inched down to 2.8% from 2.9%. The quits rate tends to be a leading indicator for wage gains.

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