The guest commentary below was written by Mike O'Rourke of JonesTrading.
“I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same. This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times.”
-Federal Reserve Chairman Jay Powell, October 2, 2018
Hearing Fed Chair Jay Powell speak those words Tuesday should have made the investment community cringe.
Investing is not for today’s environment, but instead investing is based upon what you expect the future to bring. Thus, hearing that the current environment is “extraordinary” or “too good to be true” implies that the continuation of such an atypical environment, which is unlikely.
The other alarming comment was that although the Fed Chair noted the historically high asset prices, he does not see financial stability risks to the economy. As much as we respect Chair Powell, that is every Central Banker’s fatal flaw. They never see the risk that knocks the economy off course. Once such a risk is exposed, it is too late to contain the damage.
Chair Powell did note at Jackson Hole that the last two recessions emanated from financial stability risks. He is well aware of the risks that asset price dislocations can cause. In short, a great economy with high asset prices would imply there is not sufficient upside in a perfect environment from which a great deal can go wrong.
The “extraordinary times” environment carried though to today’s economic data. The September ADP Payrolls report handily exceeded expectations. The real star was the ISM Services report, which posted its second highest reading in its history, and its highest reading in 30 years. The Employment component posted its highest reading ever.
The Institute for Supply Management’s summary of the report noted,
“The past relationship between the NMI® and the overall economy indicates that the NMI® for September (61.6 percent) corresponds to a 4.6-percent increase in real gross domestic product (GDP) on an annualized basis.”
The strong economic data combined with a very slight constructive pivot by Italy’s coalition government on its budget debate sparked a bond market sell off. The combination of the haven bid dissipating and economic data accelerating prompted the 30Yr Treasury yield to break out to new 4 year highs (chart below). The 30Yr Treasury’s 3.34% yield is the highest reading of the Post QE era. Shortly, after the 30Yr breakout, the 10Yr Treasury yield broke out as well (chart below). The shorter dated Treasuries have been hitting new decade highs in yields throughout the year, as rates have risen (chart below).
When risk free assets begin re-pricing, it reverberates throughout the economy. It is no secret that the homebuilders have been under pressure due to the rising rate environment. The national average for a 30Yr fixed rate mortgage has begun closing in on 5%, a level last seen briefly in 2011. Lennar talked about the environment conference call today stating,
“Generally speaking, the increases in new and existing sales prices, home sale prices over the past years together with the general migration of interest rates upward, have caused a pause in the progression of the housing recovery. Additionally, labor shortages, trade-driven material price increases and limited approved land availability have both limited production and, therefore, limited supply and muted sentiment around the housing market's strength and margin sustainability. This has led many to believe that the housing recovery is over or stalled. We do not agree. Instead, we believe the market has taken a natural pause.”
That comment had a little of everything. It describes a couple of factors mentioned earlier, rising rates, high assets prices, labor shortages as well as materials inflation. Just remember the housing recovery is “pausing” after a decade of low interest rates and in an economy that the Fed Chair describes as “extraordinary times.”
This is a Hedgeye Guest Contributor research note written by Mike O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.