Financial Market Affects September 28, 2015

Movement in the bond market this past week was characterized by choppy trading that took prices mostly in a sideways to lower direction.  After falling on Monday, bonds traded higher on Tuesday then moved sideways until a decline on Friday.

Monday, the National Association of Realtors reported Existing Home Sales declined 4.8% in August to a seasonally adjusted annual rate of 5.31 million, the lowest level since April.  The consensus forecast had been for 5.50 million annualized sales.  The August annualized sales level was lower than a downwardly revised 5.58 million in July, which was the highest in more than eight years.  This suggests the decline was likely just normal market volatility rather than a change in trend.  Tight inventory levels and rising prices were cited as reasons for the sales decline.

Tuesday, bond prices rebounded from Monday losses in response to a global equity sell-off triggered by a report from the Asian Development Bank (ADB) that lowered emerging market growth forecasts for 2015 and 2016 based upon declining economic growth prospects for China and India.  The Federal Housing Finance Agency (FHFA) reported home prices increased 0.6% month-over-month during July.  Compared with July 2014, the house price index has gained 5.8%.  The 0.2% index increase reported for June was unchanged.  The index remains 1.1% below its March 2007 peak and is approximately at the level it was seen in November 2006.

Wednesday, the Mortgage Bankers Association released their Mortgage Application Data for the week ending September 18.  Overall the Index increased 13.9%.  The Refinance Index rose 18.0% from the prior week, while the seasonally adjusted Purchase Index increased by 9.0% from a week earlier.  The adjustable-rate mortgage segment of activity increased to 6.9% of total applications from 6.8% in the prior week.

Thursday, the U.S. Census Bureau and the Department of Housing and Urban Development reported New Home Sales increased to a seasonally adjusted annual rate of 552,000 in August, the highest rate in more than seven years.  This was an increase of 5.7% from an upwardly revised July rate of 522,000 and a year-over-year increase of 21.6% compared with the August 2014 rate of 454,000.  The consensus estimate called for a rate of 515,000.  The median sales price in August increased almost $12,000 to $292,700 while the average sales price was $353,400.  The number of new homes for sale at the end of August totaled 216,000 representing a 4.7 month supply at the current sales rate.  Overall, this was a very strong New Home Sales report.

Friday, bond prices fell (yields rose) in response to a speech by Fed Chair Janet Yellen on Thursday after market close.  Yellen said the FOMC still expects to raise interest rates by the end of this year followed by a gradual pace of tightening thereafter.

For the week, the FNMA 3.5% coupon bond dropped 28.1 basis points to end at $103.81 while the 10-year Treasury yield gained 3.2 basis points to end at 2.17%.  Stocks ended the week with the NASDAQ Composite losing 140.73 points to close at 4,686.50.  The Dow Jones Industrial Average fell 70.12 points to end at 16,314.67, and the S&P 500 dropped 26.74 points to close at 1,931.34.

Year to date, and exclusive of any dividends, the NASDAQ Composite has dropped 1.06%, the Dow Jones Industrial Average has declined 9.25%, and the S&P 500 has fallen 6.60%.  The national average 30-year mortgage rate moved to 3.97% from 3.93% while the 15-year mortgage rate increased to 3.24% from 3.20%.  The 5/1 ARM mortgage rate increased to 3.03% from 2.95%.  FHA 30-year rates increased to 3.70% from 3.65% while Jumbo 30-year rates increased to 3.78% from 3.74%.

 Mortgage Rate Forecast with Chart

For the week, the FNMA 30-year 3.5% coupon bond ($103.81, -28.1 bp) traded within a 50 basis point range between a weekly intraday high of 104.20 and a weekly intraday low of $103.70 before closing at $103.81 on Friday.

The bond ended the week with a downward gap below the 25-day moving average support line located at $103.81.  This level now becomes technical resistance with support now at the 50-day moving average at $103.62.  The slow stochastic oscillator also appears to be making a turn lower from a near overbought position indicating a loss of momentum to go along with a new sell signal.

Technical signals will take a back seat to next Friday’s employment report.  If the employment data is reported better than expected, the bond market would likely sell-off resulting in slightly higher mortgage rates.  A worse than expected report would likely result in slightly lower mortgage rates.

Chart:  FNMA 30-Year 3.5% Coupon Bond

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Economic Calendar – for the Week of September 28

The economic calendar expands this week with a number of key economic reports headlined by the Employment Situation Summary for September including Nonfarm Payrolls, Nonfarm Private Payrolls, the Unemployment Rate, Hourly Earnings, and the Average Workweek.  Economic reports having the greatest potential impact on the financial markets this coming week are highlighted in bold.

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Road Signs – The Federal Reserve is losing credibility by not raising rates now

By Alex Nikolsko-Rzhevskyy, Associate Professor of Economics, Lehigh University

So the results are in: the Federal Reserve decided to keep interest rates at around zero, delaying any increase in its target for at least six more weeks.  The move did not come as a surprise to Wall Street – which was betting 3-to-1 against the hike.  But that’s not because investors didn’t think the US economy was ready for a rates “liftoff.”  Rather, it shows that markets did not believe the Fed has the will and power to raise rates for the first time since June 2006.

Unfortunately, they guessed right.  The economy is ready if not eager for a liftoff and a return to a normal rates environment.  Investors and businesses know this.  It’s time the Fed recognized this too.

Ready for liftoff

The data clearly show that the US economy hasn’t looked stronger in a very long time – a sharp improvement from earlier this year when I wrote that it wasn’t ready for an increase in interest rates.  While the labor market may not have experienced strong growth in wages yet, joblessness has plunged to 5.1%, reaching what is known as the “natural rate” of unemployment (also called “full employment”).  That’s significant because achieving maximum employment is one of the Fed’s two primary mandates, and anything below the natural rate risks fueling inflation.

And inflation, its other main policy goal, is also in range of its target of 2%.  Indexes of consumer prices, both including and excluding volatile energy prices, and personal spending are forecast to be right in that sweet spot of 1.5% to 2% next quarter.  Furthermore, the US economy grew a stronger-than-forecast 3.7% in the second quarter, much better than the previous three-month period and signaling the recovery is on a pretty sound footing.

The output gap – or difference between what an economy is producing and what it is capable of – remains negative at about 3%, and deflation is still a threat.  But regardless of what the Fed does now and in coming months, its target short-term rate will remain well below the long-term “normal” level of about 4% for years to come, so there is little risk a small increase will drag down growth.

 Why the Fed didn’t act

According to the Federal Open Market Committee statement, the main factors that persuaded the Fed to delay liftoff are the weakening global economy, “soft” net exports and subdued inflation.

Granted, developing economies, especially China and Russia, are indeed weak as are global financial markets and that could spill over into the US.  And the devaluation of the yuan in China and the recession in Canada (the US’ two largest individual trading partners) – coupled with loose monetary policy in Europe – are causing the dollar to appreciate, making US exports decline and imports rise.

It is important to understand that all of these factors except inflation are outside the Fed’s jurisdiction and its dual mandate of maintaining full employment and stable prices. If these factors matter at all to US monetary policymakers, it should only be through their effects on the US economy, in terms of inflation, labor markets and GDP.  And while an appreciating dollar and low oil prices can indeed create deflationary pressures (and reduce US GDP), the data indicate that US prices nevertheless continue to rise, if slowly.

Furthermore, a higher interest rate and stronger dollar make US assets even more attractive to global investors, thus spurring more investment, while low oil prices stimulate consumer spending.  Both of these factors boost economic activity and at least partially offset any decline due to lower net exports caused by a strong dollar.

What’s at stake

What’s more important is that the impact of a small rate hike has been with us for some time.  Capital is already fleeing developing economies, and the dollar has been strong for a while.  Hence, the direct marginal economic effects of a 0.25 percentage point increase in the target rate on the US economy would be negligible at best.  What was really at stake was repairing the Fed’s credibility in terms of successfully shaping US monetary policy and sending a powerful signal that the US economy is in strong shape.

Hoping to avoid previous bungled attempts to adjust monetary policy in recent years that led to significant market volatility, this time the Fed spent at least half of the year updating the language in its statements and gradually preparing the world for a hike. And since it did not deliver, this tells the world that the Fed is unable or unwilling to go against market expectations.

As a result, the central bank will have to either delay the liftoff until the next meeting, slowly reshaping market expectations to be consistent with a hike at that point, or risk a financial panic if it decides on an unexpected policy shift sooner.  Delaying the timing further would mean losing precious time in normalizing monetary policy, necessary so that the Fed again has the tools it needs to fight future economic downturns.  There’s also the increased risk that the economy will overheat and cause inflation to spiral out of control.

There is never a perfect time to start down this path; it is always possible to find reasons to delay.  But each postponement requires even stronger data to justify an eventual liftoff the next time.  The problem is that with the hesitant Fed sending mixed signals to the economy, that imaginary perfect day might not ever come.