The FOMC meeting this week will go down as one of the most memorable in recent history.  Yes the Fed raised the benchmark rate 25 basis points into a range between 1.00% and 1.25%, which was widely accepted.  Where the Fed surprised markets is announcing a plan to wind down the balance sheet (and 8 years of stimulus with it).   The Fed plans to reduce their $4.5 trillion balance sheet through two mechanisms.  They will start by reducing the balance sheet by $6 billion a month in Treasuries and $4 billion a month in mortgage-backed securities.  This amount will increase over time until they reduce the balance sheet at a pace of $50 billion per month (or $600 billion a year).   Once the balance sheet is reduced to approximately $2 trillion then the wind down should stop.

The Fed also updated its forecasts for interest rates and inflation.  The projection for inflation for 2017 was reduced to 1.6% from 1.9% and the Fed still anticipates one more rate increase this year but three next year.  If the Fed follows through with those increases then the FOMC’s benchmark overnight rate would be 2.13%.  Currently the 10yr Treasury is trading at 2.13%.  Let that sink it.  The overnight borrowing rate will be 2.13% in a year and half but an investment earning 2.13% annually would require an investor to tie up their funds in Treasuries for 10 years!  Why buy a 10yr Treasury?

Or to put it another way, the FOMC raised rates 25bps this week and long term rates dropped.  The yield curve continues to flatten (see graph below) while the Fed is forcing their narrative on the market.  They want to remove accommodation, build support for future rate changes in case of economic retraction and simultaneously not spook markets or liquidity.  One would expect with this announcement that the markets would price longer term Treasuries at a higher yield and mortgage rates would follow.  Recall that Ben Bernanke during 2013 mentioned the possibility of unwinding some stimulus and that sent rates up 100bps.  With this meeting the market had already priced in the rate increase but did not expect the balance sheet announcement.  Rates didn’t move higher because the long term Treasury market is not very concerned about inflation of any form and likely believes the Fed will have to lower rates sometime in the future.

This is a very dangerous game being played and the flattening of the yield curve should be taken seriously.  How the Fed unwinds the balance sheet (with or without rate increases) could profoundly affect rates.  I’m sure they will clarify if the unwinding is in lieu of the increase or in addition to.   Either way be cautious of rate volatility.  If the Fed is right, longer term rates are moving much higher.  If the market is right, the Fed will have to lower short term rates.

Side note: this isn’t the only threat to interest rates.  Tax reform, GSE reform and regulatory reform are all under review and reconsideration.  Any changes there could drastically affect interest rates and the housing market.  Please get involved and let your voices be heard.  We are at a pivotal point and our legislators are listening.  The new administration needs feedback and support before anything is written into law.  See link below on joining the Mortgage Action Alliance to support our industry and homeowners. http://apps.mba.org/Advocacy/MortgageActionAlliance/MAASignup.htm

Watch the video here! https://youtu.be/tg-4U1qhLwQ

Market Update

Date: March 28, 2017

Reflation is different than inflation.

• Inflation is widely considered “bad”, which are price increases beyond the long-term trend line of what’s considered price stability.
• Reflation on the other hand is a recovery of prices when they’ve fallen below the long-term trend line.  

The “Reflation Trade” began right after Election Day and has been a “Great Rotation” from bonds into other asset classes, especially stocks. Stocks have climbed about 15% since the election while bond yields (along with mortgage yields) were up 75bps.  Remember prior to the move 2 weeks ago, the Fed only raised rates 25bps since the election but bond yields moved up 75bps.

The Federal Reserve had prognosticated three rate increases for 2017 and three increases for 2018 leading into the FOMC meeting. Going into the meeting was this notion that reflation is about to turn into inflation. The 2% target by the Fed would likely be exceeded thanks to tax reform and infrastructure spending. The “Animal Spirits” were awakened and suddenly the market was pricing in 100% chance of a raise at the March meeting with many pricing in four moves by the Fed in 2017 and 2018.  The 10-year was at 2.60% going into the FOMC meeting last week and once they raised the benchmark rate, Treasury yields and mortgage rates dropped.

Wait what?!

If you thought mortgage rates were going to rise then you were with the 95% majority that thought the same thing. The market got ahead of itself with the Fed and the Fed told the market the exact same thing it said in December and February. They expect to raise rates three times in 2017 and three times in 2018.  The market wanted either four times in 2017 or four times in 2018. The market got caught shorting Treasuries into the Fed meeting and were forced to cover (buy them back), sending Treasury yields and mortgage yields back toward the lower end of this 2.30-2.60% range. Today, the 10-year is at 2.42% and if this range sounds familiar, it’s because we are coming up on almost 4 months of trading here.  When will we break out of this range?

I would call it a 60% chance of breaking the range to the upside versus 40% to the downside.  The market wants higher returns and wants rates to move higher; they want the reflation trade.  The Fed would love to raise rates to put more dry powder in their gun.  However, for rates to move higher, plain and simple there needs to be more inflation. Year over year Core PCE at 1.74% isn’t exactly a level that should send bond yields racing higher. The FOMC did say they still plan to raise rates three times in 2016 and three times in 2017. That’s not something to be taken likely, especially with business and consumer confidence higher. And that’s why I say 60%, out of respect for the power the Fed has, but the 40% also has a solid argument.

For rates to drop a few things would need to happen but the big two are inflation and jobs.  If Core PCE year over year drops or job gains start to erode and the unemployment rate rises there could be a massive reversal and bond yields could break down below 2.30%. If they break through the lower side, they could drop all the way to 1.80%. The chance of that happening in 2017 is relatively low as there would likely be some warning signs now.  Also take note of the Dot Plot, the Fed’s prediction of future rate changes:  two particular members don’t believe the Fed should raise any more in 2017 and one doesn’t think they should raise in 2018 as well.  How is that possible?  The doves (lower rate members) believe the Fed can wait longer because this isn’t an environment for fast moving inflation whatsoever and it’s a viewpoint I agree with.  Unemployment is holding steady but isn’t dropping even with rates this low, commodity prices are coming down, the stock market is very frothy, there is still a debt ceiling battle, tax reform battle, infrastructure battle and health care overhaul battle upcoming with no clear signs on direction.  Last but not least the economic environment in Europe is uncertain as the actual Brexit is scheduled to begin and there is talk of Frexit (French exit from the EU). Nationalist movements will limit economic activity and bring rates down.  With the amount of debt being incurred across the globe and the inability to balance budgets, governments may decide a more nationalist approach is the lesser of two evils.  That is speculation but the point remains there are serious unknown risks out there.

Watch the video here on this market update!

https://youtu.be/64VcBf5CY1s

It is without a doubt that if you were an investor in March of 2009, you should have bought stocks when uncertainty around the economic future, thanks to the Financial Crisis, was at its peak. March 9^th marked the 8-year anniversary of the "bottom".

• S&P 500 traded at 676 on March 9^th, 2009 and has since risen to 2,370 today.
• The economy is in much better shape today than it was 8 years ago, thanks to low interest rates, economic stimulus, and quantitative easing (QE) programs.
• Prospects for the future are near a peak not seen in a decade with optimism around tax cuts, infrastructure spending, and the release of untapped potential via regulation changes.
• Price to earnings (PE) ratios on the S&P 500 have increased steadily since 2009 from the low 11's to almost 22 today. That means investors are willing to spend twice as much today as they did in 2009 for the same earnings stream.

What’s the difference?

The environment.

In 2009 earnings were expected to go down versus today they are expected to keep rising. So…are stocks overpriced?

Investors must choose between a whole variety of investments and generally cash is not a good option. Whether it be stocks, government bonds, corporate bonds, or commodities, it really depends on one's appetite for risk and desired return, plus potential statutory obligations.

For simplicity sake let's assume an investor today must decide between stocks and bonds. Would you rather own a potentially overpriced stock but potential upside with legislative changes or a bond with a low yield and potential inflation on the horizon? 

If one purchases a 10-year treasury at a yield of 2.55% and inflation is 2%, then the real yield is only 0.55%. Bonds seem much more unattractive if you believe the growth story that buzzes around the market. The stock market and bond market are not in agreement. Stocks are trading at all-time highs and the 10-year is still trading under this resistance level of 2.60%. Not to mention both the non-farm payroll report and FOMC meeting are right around the corner. Is someone in for a surprise or will this divergence of opinion continue?

The market has completely priced in a 25bps increase to the Fed Funds Rate this week. With a strong payroll report there are a lot of whispers of four potential increases this year instead of the three predicted by the Fed. Remember the Fed must meet its dual statutory mandate of full employment (5% or less) and stable inflation (around 2%). It's safe to say that they have met the employment mandate with the unemployment rate around 4.7-4.8%. Inflation has long been the challenge and core PCE (the Fed's preferred measurement) was released last week showing a year over year change of 1.7%. The Fed will raise when it feels that inflation will move to 2% or higher.

To illustrate the dual mandates, see graph below. I 've circled the current inflation measurement and it's not exactly screaming "raise rates!". That's where the Fed must turn to leading indicators of inflation and that makes the rate decision tricky.

On the inflationary side, consumer spending is up, as are wages with the possibility of tax cuts and infrastructure spending on the horizon. It's even argued that the expectation of inflation ultimately causes inflation.

On the deflationary side, oil and gold are down, higher interest rates strengthen the dollar and that hurts exports, not to mention considering how low unemployment has been, wage inflation should have already accelerated. Not to forget a potential global trade war coming and an administration that has openly stated the dollar is overvalued. 

Short term rates might move higher with the Fed but long term rates might remain at these levels. If the yield curve flattens (short term rates and long term rates are at the same level) then the market is telling the world that recessionary risks are material. That is still down the road but something to keep an eye on.

Watch a short video about inflation and wage rates. Watch and find out!

Economic Calendar:

March 10^th Unemployment rate and non-farm payrolls
March 14^th PPI
March 15^th CPI, Retail Sales and FOMC Meeting 
March 17^th Leading Index