All Things in Moderation

Vital Statistics:

Stocks are higher this morning after the Fed announced its tapering policy yesterday. Bonds and MBS are flat.

As expected, the Fed announced that it will start reducing its MBS and Treasury purchases as it unwinds its COVID support. It will reduce its Treasury purchases by $10 billion per month and MBS purchases by $5 billion per month and should complete this process by summer next year.

The reaction in the bond market was muted. Rates ticked up 3 or 4 basis points and we are back to pre-meeting levels this morning.

The Fed Funds futures became slightly more dovish, with investors trimming their bets on the extreme rate hike scenarios. The consensus seems to be that we will see two rate hikes next year.

Initial Jobless Claims feel to 269,000 last week. It appears that we are getting closer to pre-COVID numbers, but we still need about a 22% reduction to get back to pre-COVID normalcy. Separately, companies announced 22k job cuts last month, according to Challenger, Gray and Christmas.

Productivity fell by 5% in the third quarter, as output increased 1.7% and unit labor costs rose 8.3%. This is an awful report. There is no way to sugar-coat it. Output (i.e. GDP growth) is tepid, while costs are rising. This translates into inflationary non-growth, aka stagflation. The Fed has a tough line to walk here.

The Fed is betting that the supply chain issues are in fact temporary, and it needs that to be the case in order to stick the landing. If the supply chain issues translate into persistent inflation, then we are pretty much in a replay of the late 1970s. Inflation picks up -> Fed tightens -> Economy goes into recession -> Fed eases to boost economy -> Inflation rises faster. Inflation spirals higher while the economy vacillates between mild recessions and mild recoveries.

This set of affairs ended up causing what was then known as the “misery index” which was the sum of inflation, unemployment and interest rates. They only thing that will break that cycle is that the supply chain issues work themselves out and inflation returns to its normal 2% level. If so, then the Fed can take its time raising rates. Otherwise we could be in for a bumpy ride over the next year.

In the 1960s, it was hip amongst macro-economists to try and “fine tune” the economy. The hope was that fiscal and monetary policy could engineer out the business cycle and create a permanent prosperity. Guys like Paul Krugman were raised on that mindset. From the mid 1960s through the late 1970s, left-Econ ran the show. Fiscal policy through “guns and butter” and new entitlements was exceptionally loose. The government closed the gold window, which ended any discipline with interest rates. Rates rose and nearly killed the banking system as depositors fled the banks, which were limited by law to cap deposit rates at 5%. Eventually the whole thing devolved into stagflation, and Econ in general began to realize there are limits to economic engineering.

Fast forward to today: we are in a very similar position. Left Econ has run the show since 2008. Government spending has soared, and the Fed has been running an unprecedented experiment in the financial markets, trying to manage the economy by purchasing trillions of Treasuries and mortgage backed securities. While it is possible that government (fiscal and monetary) policy can extricate itself from the economy, it looks like the powers-that-be might have engineered the same result as the 1970s.

The parallels are there.

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Vital Statistics:

Stocks are lower as we await the decision out of the Fed. Bonds and MBS are flat.

The Fed decision is set for 2:00 PM EST. While no one expects the Fed to raise rates, the consensus seems to be that the Fed will begin to reduce its purchases of Treasuries and mortgage backed securities.

The economy added 517,000 jobs in October, according to the ADP Employment Survey. Leisure / hospitality and transportation had the biggest gains. The Street is looking for 400,000 payrolls in Friday’s jobs report.

“The labor market showed renewed momentum last month, with a jump from the third quarter average of 385,000 monthly jobs added, marking nearly 5 million job gains this year,” said Nela Richardson, chief economist, ADP. “Service sector providers led the increase and the goods sector gains were broad based, reporting the strongest reading of the year. Large companies fueled the stronger recovery in October, marking the second straight month of impressive growth.”

Mortgage applications decreased 3.3% last week as purchases fell 2% and refis fell 4%. “Mortgage rates decreased for the first time since August, as concerns about supply-chain bottlenecks, waning consumer confidence, weaker economic growth and rising inflation pushed Treasury yields lower,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “Most of the decline in rates came later in the week, which is likely why refinance applications declined to the lowest level since January 2020, and the overall share of activity fell to the lowest since July 2021. Government refinance applications fell for the sixth straight week, as it becomes evident that an increasing number of borrowers have already refinanced.”

Zillow was down 16% yesterday after reporting disappointing Q3 results and announced that it will wind down its iBuying Homes segment. The company’s third quarter results included a $304 million writedown for homes bought in the third quarter that are worth less than current selling prices. The company expects another $265 million in writedowns in the fourth quarter. It will also lay off a quarter of the workforce in the iBuying segment.

Zillow was able to convert only about 10% of its bids into actual sales. Zillow kept its fee a secret, but it was more or less around 7.5%. Since the typical home seller is mainly responsible for the two realtor’s commissions of 3%, many must have considered the extra 1.5% to not be worth the hassle of letting Zillow handle the staging and final maintenance.

Given the rapid home price appreciation over the last year, it is hard to see how they lost money on buying homes, unless they really missed the seasonality aspect of home prices. Regardless, this is the first data point that indicates that home price appreciation is slowing.

New York State has extended CRA requirements to non-banks. I do wonder if redlining is really a thing in this age of “push button, get mortgage.”

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Vital Statistics:

Stocks are flattish this morning as the Fed begins its 2-day FOMC meeting. Bonds and MBS are up small.

Manufacturing decelerated in October, according to the ISM Manufacturing Survey. We saw a big decline in the index for new orders, while the Prices Index rose substantially. “Business Survey Committee panelists reported that their companies and suppliers continue to deal with an unprecedented number of hurdles to meet increasing demand. All segments of the manufacturing economy are impacted by record-long raw materials lead times, continued shortages of critical materials, rising commodities prices and difficulties in transporting products. Global pandemic-related issues — worker absenteeism, short-term shutdowns due to parts shortages, difficulties in filling open positions and overseas supply chain problems — continue to limit manufacturing growth potential. However, panel sentiment remains strongly optimistic, with four positive growth comments for every cautious comment. Panelists are fully focused on supply chain issues in order to respond to the ongoing high levels of demand.”

The biggest complaint has been the inability to get products out of China. Rolling blackouts are exacerbating the problems. The report has some individual responses from companies in different industries. Many see the shortages continuing through 2022.

Home prices rose 18% in September, according to CoreLogic. CoreLogic sees the home price appreciation slowing to 2% over the next year, however. “The pandemic led prospective buyers to seek detached homes in communities with lower population density, such as suburbs and exurbs. As we head into 2022, we expect some moderation in the current pattern of flight away from urban cores as the pandemic wanes.”

Construction spending fell 0.7% MOM in September, according to the Census Bureau. Residential construction fell 0.4% MOM and rose 7.8% YOY.

The number of loans in forbearance fell again last week to 2.15%, according to the MBA. “For the first time since March 2020, the share of Fannie Mae and Freddie Mac loans in forbearance dropped below 1 percent,” said Mike Fratantoni, MBA Senior Vice President and Chief Economist. “A small decline for this investor category was matched by similarly small declines for Ginnie Mae and portfolio/PLS loans. Forbearance exits slowed at the end of October to the slowest pace since late August. With so many borrowers having reached the end of their 18-month forbearance term, we expect a steady pace of exits in November.”

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Vital Statistics:

Stocks are higher this morning ahead of a big week for data and earnings. Bonds and MBS are down.

In terms of economic data, we will get the ISM numbers this week, along with productivity and the jobs report on Friday. The Street is looking for 400k jobs, unemployment to fall to 4.7%, and a 4.8% increase in average hourly earnings.

The Federal Open Market Committee meets on Tuesday and Wednesday. No changes are expected to the Fed Funds rate, however the consensus seems to be that the Fed will announce its first reduction in the pace of Treasury and MBS purchases.

MBS spreads are still pretty tight compared to history, and especially compared to the 2013 taper tantrum. I think the difference today is certainty; in 2013 the menu of options for the Fed was much wider. In other words, the markets in 2013 thought the Fed could actually sell their portfolio of Treasuries and MBS into the market. We now know that they probably won’t even let it run off naturally. The Fed will probably reduce its purchases by $10 billion a month and will go into maintenance mode – in other words re-investing maturing principal payments back into the market – by summer.

Speaking of MBS spreads, mortgage REITs Annaly and AGNC Investment reported increases in book value for the third quarter. This is a far cry from 2013, where book values were cut in half and the mortgage REITs cut their dividends big time.

Troubled Chinese property developer Evergrande made another interest payment on Friday, which prevented a default. Another troubled Chinese developer (Yango Group) has asked international bond holders to swap its dollar bonds into a new bond. Yango bonds are trading around 20 cents on the dollar, and the cascade of Chinese real estate companies heading into troubled waters signals we might be witnessing the start of an epic real estate bust.

IMO, this will send another deflationary wave around the globe. It is worthwhile to distinguish between deflation and inflation. Inflation is “too much money chasing too few goods.” It is a monetary and supply issue. It describes the current setup in the US right now.

Deflation is a credit issue, and it happens when asset prices are falling. This makes anyone who borrowed a lot of money insolvent. This is what China is experiencing. Entire cities were built “on spec” and it looks like they will never get filled. Whoever lent money for those projects will probably get nothing on that investment. This means banks will have to start writing down assets and liquidating what they can. The Chinese government will try and manage the crisis, but this one will be epic.

The playbook for countries in this sort of spiral is to devalue the currency. The first thing FDR did (after confiscating everyone’s gold) was to change the gold / dollar exchange rate. We saw the same thing in the Asian Tiger crisis in the late 90s. China manages the exchange rate, and since it has capital controls, it can pretty much set it wherever it wants.

That means Chinese investors are going to pile into Treasuries since they will immediately reap a huge gain on that investment when the yuan devalues. It will also cut the prices of Chinese goods entering the US which could help the inflation issue.

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Vital Statistics:

Stocks are lower this morning after Apple and Amazon both missed earnings expectations. Bonds and MBS are down.

Personal incomes fell 1% in September, according to the Bureau of Economic Analysis. The drop in government assistance as extended unemployment benefits expired was the big driver. Wages and salaries rose by $80 billion while unemployment benefits fell by $255 billion. Consumer spending rose by 0.6%.

The Personal Consumption Expenditures index (PCE) rose by 0.3% MOM and 4.4% YOY. Ex-food and energy, it rose 0.2% MOM and 3.6% YOY. This is higher than the Fed’s preferred level, however the central bank (and Treasury) still consider the current spate of inflation to be temporary.

The Employment Cost Index rose 3.7% YOY as companies are raising wages in order to attract employees. One thing to keep in mind is productivity and wages. We saw 3Q GDP come in at 2%, while employment costs are rising much faster. This would imply falling productivity (output increasing slower than wage growth). Increasing productivity is the key to higher living standards, and when productivity is low, you generally see inflation and stagnation. Which is kind of where we are now.

To that point, Treasury Secretary Janet Yellen is peddling the idea that the Administration’s big spending package will be anti-inflationary because it will include subsidies for healthcare and childcare.

Pending Home Sales fell 2.3% last month, according to NAR. “Contract transactions slowed a bit in September and are showing signs of a calmer home price trend, as the market is running comfortably ahead of pre-pandemic activity,” said Lawrence Yun, NAR’s chief economist. “It’s worth noting that there will be less inventory until the end of the year compared to the summer months, which happens nearly every year.”

The hottest markets were Jacksonville, Tampa, Nashville and Denver. Pending Home sales dropped almost 19% YOY in the Northeast, while they declined mid-to-high single digits everywhere else.

Despite some of the disappointing economic data, the Fed Funds futures are increasing bets that interest rates rise next year. The December 22 Fed Funds Futures seem to be coalescing around 2-3 rate hikes next year. This is a huge jump from a month ago.

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Vital Statistics:

Stocks are flattish this morning despite a disappointing GDP print. Bonds and MBS are up.

Economic growth slowed to 2% in the third quarter, according to the Bureau of Economic Analysis. This was well below expectations, and seems to confirm that the economy is slowing down. The Chicago Fed National Activity Index earlier this week confirmed that the economy is growing below trend.

Initial Jobless Claims fell to 281,000. This is close to getting back to normalcy, however we are still elevated compared to pre-COVID.

New Home Sales fell 18% YOY to a seasonally-adjusted annual rate of 800,000. At the end of September, there were 379,000 units in inventory, which represents a 5.7 month supply. The median sales price rose 19% YOY to $408,800.

Durable Goods orders fell 0.4% in September. Ex-transportation, they rose 0.4%. Core Capital Goods (a proxy for capital expenditures) rose 0.8%. I wonder if the labor shortages are encouraging businesses to invest more in productivity-enhancing technology.

Mortgage applications rose 0.2% as purchases rose 4% and refis fell 2%. “Mortgage rates increased again last week, as the 30-year fixed rate reached 3.30 percent and the 15-year fixed rate rose to 2.59 percent – the highest for both in eight months. The increase in rates triggered the fifth straight decrease in refinance activity to the slowest weekly pace since January 2020. Higher rates continue to reduce borrowers’ incentive to refinance,” said Joel Kan, MBA’s Associate Vice President of Economic and Industry Forecasting. “Purchase applications picked up slightly, and the average loan size rose to its highest level in three weeks, as growth in the higher price segments continues to dominate purchase activity. Both new and existing-home sales last month were at their strongest sales pace since early 2021, but first-time home buyers are accounting for a declining share of activity. Home prices are still growing at a rapid clip, even if monthly growth rates are showing signs of moderation, and this is constraining sales in many markets, and particularly for first-timers.”

Zillow is pausing its iBuying program. The problem is that it has a backlog of inventory has swollen its balance sheet. Zillow’s program basically allowed homeowners to sell their property to the company, which then would make any repairs, stage and sell the home. This was popular in many communities where bidding competition was fierce, and a non-contingent offer could help carry the day. Zillow would charge a fee of something like 7.5% for this service.

Shortages of labor and materials are making it harder for the company to flip and sell their homes, and debt has been building up to finance the activity.

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Stocks are higher this morning as earnings continue to come in. Bonds and MBS are flat.

Home Prices rose 18.5% YOY, according to the latest FHFA House Price Index. “Annual house price gains remained extremely high in August but the pace of month-over-month gains continues to decelerate,” said Dr. Lynn Fisher, FHFA’s Deputy Director of the Division of Research and Statistics. “This does not mean house prices are at risk of declining—far from it, they continue to climb at a double-digit pace in all regions—but it does suggest we may have seen the peak in annual gains for the time being.”

Based on that home price appreciation gain, we should see 2022 conforming loan limits around $650k. Of course the FHFA might not increase it by that much. Next month’s report will be the one FHFA uses to set the new limit.

The share of loans in forbearance fell to 2.28% last week, according to the MBA. “Following two weeks of rapid declines, the share of loans in forbearance dropped again, but at a reduced rate. As reported in the past, many servicers process forbearance exits at the beginning of the month, therefore it is not surprising to see the pace of exits slow again mid-month,” said Mike Fratantoni, MBA’s Senior Vice President and Chief Economist. “The composition of loans in forbearance is evolving. More than 25% of loans in forbearance are now made up of new forbearance requests and re-entries, while many other homeowners who have reached the end of 18-month terms are successfully exiting into deferrals or modifications.”

Separately, Treasury distributed about $2.8 billion worth of rental aid in September. While the eviction moratoriums issued by the Center for Disease Control have expired, many states still prohibit foreclosures and evictions.

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Vital Statistics:

Stocks are higher this morning as earnings continue to come in. Bonds and MBS are down.

The upcoming week has a lot of important economic data. We will get new home sales and the FHFA House Price index on Tuesday, the advance estimate of third quarter GDP on Thursday, and personal incomes / outlays on Friday.

The FHFA House Price Index will cover August, and the new FHFA limits will be based on the third quarter numbers. We are seeing a lot of lenders start to accept loans based on the expected new limits. Given the pace of home price increases, the new limit will be around $650k or so.

The Street is looking for GDP growth to come in around 2.7%. This is a deceleration from the first half of the year, and it definitely looks like shortages are beginning to show up in the numbers. The Chicago Fed National Activity went negative last month, which indicates the US economy is grew below trend in September. This index is a meta-index of about 85 indicators, so it is a pretty broad based look at the economy.

Jerome Powell pretty much confirmed that tapering will begin this year: “I do think it is time to taper,” Mr. Powell said Friday. “I don’t think it is time to raise rates.” He went on further to discuss the economy: “We think we can be patient and allow the labor market to heal,” he said. But at the same time, “no one should doubt that we will use our tools to guide inflation back down to 2%” if it looked like more persistent inflationary pressures were taking root, Mr. Powell added.

Despite the repeal of limits on non-owner occupied properties, the private label market is still going strong. IMO, this was the ultimate rationale for the limits in the first place. The private label market disappeared in the aftermath of the 2008 financial crisis, which meant that something like 90% of all mortgage production was backed by the taxpayer. Mick Mulvaney ended up forcing the issue by creating a need for it.

One thing to keep in mind: while there is probably a contingent of the far left that likes the fact that the taxpayer backs the vast majority of mortgages, most housing professionals are uncomfortable with it. What happens if the the government says “yes, the FHFA House Price Index is up 20% YOY, but we don’t want to be subsidizing every loan below $650k.” If the limits get raised by something below 14%, then a lot of these wholesalers who are betting on the FHFA price index might find themselves caught short.

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Vital Statistics:

Stocks are higher this morning after troubled Chinese property developer Evergrande made an interest payment last night ahead of the default deadline. Bonds and MBS are up.

Globally, we are seeing improved sentiment based on the Evergrande situation, however manufacturing activity in Europe is down to an 8 month low as shortages are clogging up the system. European manufacturers are able to pass along price increases relatively easily, so you have falling GDP and rising inflation. The German Bund yield is trading at a 2.5 year high of negative 9 basis points, which is part of a global move higher in yields.

Existing home sales rebounded 7% MOM in September, according to NAR. This was still down a couple of percent on a YOY basis however. “Some improvement in supply during prior months helped nudge up sales in September,” said Lawrence Yun, NAR’s chief economist. “Housing demand remains strong as buyers likely want to secure a home before mortgage rates increase even further next year.”

Depleted inventory remains the biggest issue for the housing market and is largely responsible for the upward pressure in prices. Inventory fell 13% YOY to 1.27 million units, which represents a 2.4 month supply at the current sales pace. A balanced market is generally considered to be around 6 month’s worth. The average home sold in just 17 days.

The median home price rose 13% to $352,800, and all-cash sales accounted for 23% of transactions. First time homebuyers are being squeezed by professional investors and institutional money which is flooding into the residential rental space. With cap rates around the mid single-digits and double digit home price appreciation, the returns in this strategy dwarf every other asset out there.

Yesterday’s Treasury Inflation Protected Securities (TIPS) auction was strong, and is useful as a market-driven look at inflationary expectations. The way these work is the face value of the bond increases by the Consumer Price Index during the life of the bond. You can therefore compare it to a corresponding Treasury and calculate the expectations for inflation going forward. This is called the “breakeven” inflation rate, which means if inflation rises above the breakeven rate, you are better off in the TIPS bond. If it doesn’t you are better off in the Treasury.

If you take a look at yesterday’s auction, the breakeven inflation rate rose to 2.94% for the next 5 years. This is pretty much an all-time record. Note TIPS are a relatively new security and weren’t around during the high inflation 70s and 80s.

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Vital Statistics:

Stocks are lower this morning on no real news. Bonds and MBS are down again.

Initial Jobless Claims fell to 290k last week, which was lower than expected. We are still well above pre-COVID levels however.

The economy grew at a “modest to moderate” rate in September, according to the Federal Reserve Beige Book, which is a report by all of the regional Fed banks on the economy. The overall punch line is that growth is slowing and supply chain issues and a lack of labor are pushing up prices.

On the overall economy, they said: “Economic activity grew at a modest to moderate rate, according to the majority of Federal Reserve Districts. Several Districts noted, however, that the pace of growth slowed this period, constrained by supply chain disruptions, labor shortages, and uncertainty around the Delta variant of COVID-19.”

On the labor market, they observed: “Employment increased at a modest to moderate rate in recent weeks, as demand for workers was high, but labor growth was dampened by a low supply of workers….Firms reported high turnover, as workers left for other jobs or retired….The majority of Districts reported robust wage growth. Firms reported increasing starting wages to attract talent and increasing wages for existing workers to retain them. Many also offered signing and retention bonuses, flexible work schedules, or increased vacation time to incentivize workers to remain in their positions.”

And on inflation: “Most Districts reported significantly elevated prices, fueled by rising demand for goods and raw materials. Reports of input cost increases were widespread across industry sectors, driven by product scarcity resulting from supply chain bottlenecks. Price pressures also arose from increased transportation and labor constraints as well as commodity shortages. Prices of steel, electronic components, and freight costs rose markedly this period. Many firms raised selling prices indicating a greater ability to pass along cost increases to customers amid strong demand. Expectations for future price growth varied with some expecting price to remain high or increase further while others expected prices to moderate over the next 12 months.”

What does all of this mean? For the Fed, the issue of inflationary expectations is critical. Once the population expects higher prices in the future, it tends to create a self-reinforcing cycle. Consumers accelerate purchases in order to avoid paying more in the future. This exacerbates supply shortages. Workers demand bigger cost-of-living wage increases which bumps up labor costs. Economists call this the wage-price spiral and this was a big component to the 1970s inflationary period.

There are many similarities between the 1970s and today: commodity price increases, shortages, profligate government spending and extremely easy monetary policy. As long as the economy is strong, people grudgingly accept it. The problems begin when the economy slows, because fiscal / monetary policy have reached the point of diminishing returns. Economists call this “pushing on a string” which means that further stimulus doesn’t create growth – it just creates inflation.

Jimmy Carter referred to it as “malaise.” Economists called it stagflation. Regardless of what you call it, I suspect it will be the template going forward. The government spent a crap-ton of money stimulating the economy over the past year and a half, the Fed has cut interest rates to 0% and has been buying MBS and Treasuries to support the economy. In return, economic growth is “modest to moderate,” which is Fed-speak for “meh.”

The Fed and the government have been conducting a stealth experiment in modern monetary theory over the past year and a half. Investors should ignore any gaslighting out of the media that offers MMT as a potential solution, as if we aren’t already there. We are. And we should get the verdict on that experiment soon.

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