Weekly Update

The Benefits of Higher Interest Rates

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Published February 24, 2023


Below are a couple of articles about markets and the economy we thought you might find interesting. First, Delta Research talks about the benefits of higher interest rates. Second, Franklin Templeton’s ClearBridge Group discusses how housing as an economic driver has evolved from the period of the Great Financial Crisis.

Part I -The good news about higher interest rates

“The 10-year treasury yield is now above 3.9%. Because of recent economic strength, the bond markets are now pricing at least two 0.25% Fed rate hikes and no rate reductions in 2023. From February 1 through this week, the market’s expectation for the terminal Fed funds rate has risen from 4.89% to 5.37%.

The last time the 10-year treasury rate was 3.9% was at the end of 2022 and in early November of last year. The S&P 500 index was roughly 3840 at the end of last year and 3749 on November 9 close. An S&P 500 near 4000 is up roughly 4% and 7%, respectively above where it was the last time the 10-year rate was 3.9%.

10-year treasuray yield and S&P 500 index

What allows the stock market to hold a higher valuation today at a 3.9% 10-year treasury rate is better economic data and the probability of a recession near-term declining from about 65% to about 30% since the October market low. Essentially, earnings may not suffer a worst-case scenario outcome.

The prevailing negative for further stock appreciation that investors periodically ignore is the consistent message from the Federal Reserve that rates are going higher and will be held higher until inflation is 2%. Although the market is higher relative to the last time the 10-year treasury was 3.9%, its capacity to continue to rise is restrained by rising rates.

Investing is all about timing and opportunity. For the first time in years, we have the opportunity to earn 4.4%+ from a money market investment. 6-month treasuries offer yields above 5%. High-yield municipal bonds (federal tax free) are offering over 6% returns. As the contest between inflation and the Federal Reserve plays out in the equity market, investors should, at a minimum, take advantage of the higher yields that are now prevalent in the bond markets.

The last time the 10-year treasury rate was roughly 3.9%, shorter duration rates were lower. For example, the 1-month treasury rate on November 9, 2022 was 3.65%. This week, it is 4.62%. The 6-month treasury is up from 4.59% to 5.08%. Relative to the last time we were here, short-term risk-free investing has become even more attractive.”

Treasury yield curves -short rates up


PART II – Housing and the economy

Below is a different look more focused on the economy and, more specifically, housing. This article from Franklin Templeton investments notes that the housing situation is substantially improved over the mess preceding the Global Financial Crisis (GFC).

“The housing market has experienced a wild ride over the past several pandemic-influenced years, with home prices rising by double-digit percentages in both 2020 and 2021 before rolling over in the middle of last year. The ClearBridge Recession Risk Dashboard focuses on Housing Permits — authorizations to build a new home — as a leading economic indicator. Permits typically move ahead of actual “shovels in the ground” metrics such as Housing Starts by several months and often fall well ahead of recessions. Permits are down nearly 30% from their peak one year ago and have dropped precipitously over the past three quarters, leading to a signal change from yellow to red.

Exhibit 1: Building Permits for New Private Housing

Building permits for new private housing

There are no other changes to the dashboard this month, although both Truck Shipments and Jobless Claims deteriorated beneath the surface and are nearing yellow territory. A worsening dashboard and economic outlook in the face of a rallying market is undoubtedly frustrating, although not entirely unexpected. In November we highlighted how countertrend rallies are not uncommon during extended bear markets, and we continue to believe a durable bottom has not yet formed.

Exhibit 2: ClearBridge Recession Risk Dashboard

ClearBridge recession risk dashboard

While the Housing Permits indicator has held up until now, the broader housing market has been at the leading edge of the current economic slowdown. This is unsurprising considering housing is typically one of the first dominoes to fall. Housing is one of the most interest-rate-sensitive areas of the economy, given most homeowners borrow to purchase homes; changes in mortgage rates have a meaningful impact on demand. Over the last 10 months through the end of January, the Federal Reserve (Fed) has raised its target rate 425 basis points to cool economic growth and tame inflation, helping push mortgage rates much higher from their late 2021 trough. The rise in mortgage rates, combined with the substantial increase in home prices, has pushed affordability metrics down to multidecade lows.

However, the threat from higher interest rates will likely be muted relative to history. In the wake of the Global Financial Crisis (GFC), borrowers shifted away from adjustable-rate mortgages (ARMs) and have largely stayed away from them since. The share of ARMs as a percentage of all mortgages (by dollar volume) has fallen back to 13.5% after peaking slightly below 25% last fall1, a stark contrast to the run-up to the GFC when around 50% of homebuyers were using this variable type of financing2. Even though higher rates may dissuade new buyers, the impact on mortgage payments for existing owners is blunted by this dynamic relative to the 2004–2006 hiking cycle.

The mortgage market also looks different than during the GFC from a quality perspective. While so-called “liar loans” — mortgages where borrowers falsified their incomes or provided no income documentation to qualify for mortgages they couldn’t afford — were common in the mid-2000s, the creditworthiness of borrowers today appears far healthier. Consumer balance sheets are still in great shape after a tough year for markets, with robust wage increases, rising home prices and accumulated savings supporting household net worth. In fact, just over 80% of mortgages originated over the past five years went to super-prime borrowers (>720 credit score), and the share of subprime borrowers (<620 credit score) was in the low single digits, a stark contrast from what the early days of the GFC when super-prime was less than 60% and subprime was over 10%.

Exhibit 3: Mortgage Origination Quality Improving

Mortgage origination quality improving

A final key difference relative to the GFC that could help limit downside in the housing market is demographics. The bulk of the millennial generation is now hitting its peak earning and child-bearing years, helping support longer-term housing demand. Many millennials have lived at home and delayed forming households longer than previous generations, although this appears to be shifting. Further, the trend toward “aging in place” means fewer retirees are moving into retirement homes, limiting housing supply in a period of increased demand. As a result, demographic trends will likely support the housing market in the coming years, which should limit how far activity and prices fall in a downturn.

While housing prices have rolled over and transaction activity has stalled, construction activity has held up. Housing completions in the fall of 2022 were at their highest level since 2007 and 2023 is likely to see the highest number of new multifamily units come to market in several decades.4 This activity is supporting strong gains in construction jobs, which steadily marched higher in the second half of 2022 despite a softening backdrop for home prices. However, as the backlog of building projects clears out this spring, the typical layoff cycle in construction is likely to commence. Although the economic pain in housing has yet to be felt, leading indicators including permits and starts suggest it will become an economic headwind in the coming quarters.

Against this challenging backdrop, there are reasons for optimism with the recent bounce in the National Association of Home Builders (NAHB) survey and weekly mortgage applications. While it’s not surprising to see homebuyers take advantage of declining interest rates, a small bounce in housing data isn’t uncommon as the Fed wraps up a tightening cycle. More concerning, however, is how the NAHB survey has historically led changes in the unemployment rate by 12 months. This survey’s massive drop in 2022 suggests more pervasive layoffs are likely in 2023.

Exhibit 4: Home Builder Sentiment vs. Unemployment

Home builder sentiment vs. unemployment

Although the economy’s trajectory is relatively clear, the timeframe and severity of a potential downturn are anything but clear. The good news is both the economy and housing market are structurally in a very different place compared to the outset of the GFC. This should limit the damage from a housing slump, creating more of a headwind than a hurricane. With the U.S. economy slow dancing toward a potential recession, we continue to believe the first half of 2023 will prove choppy for equity markets as incoming data fail to reveal a clear trend for growth and earnings.”


Market Update

Returning from a three-day weekend investors found the stock market in a sour mood. Weak earnings from Home Depot and Walmart combined with rising interest rates to send stocks to their worst day of the year. The S&P 500 slid -2%. Minutes from the most recent Fed meeting had little impact on stocks Wednesday with markets running in place awaiting the next round of inflation reports at week’s end. A +0.5% gain Thursday with earnings from semiconductor maker Nvidia sparking a modest rally in oversold tech stocks. A -1% slide Friday capped a third-straight down week for stocks after inflation data came in a bit higher than expected.

Investors have struggled to maintain January’s hot start to the year as economic reports have delivered generally stronger-than-expected news while inflation remains a bit higher than hoped for. As a result, investors have tempered their enthusiasm for a Fed shift in policy later in the year while also backing away from fears of a meaningful recession. In short, markets remain mixed and murky leaving investors unsure of how to position portfolios. That lack of conviction has taken the wind out of the bulls’ sails as the January rally fades.

The third straight week of losses for stocks found the S&P 500 (SPY) lower by -2.67%. The Nasdaq 100 (QQQ) logged a -3.09% slide. Smallcap stocks (IWM) were off -2.92%. All three indexes remain above their intermediate-term 10-week trendlines, a line which capped rallies all throughout 2022. Will that same trendline offer support in the coming days? That’s the question technical analysts are looking for an answer to. Interest rates continued marching higher this week with the 10-year note approaching 4.0% while 2-year rates have jumped above 4.65%.

Warm wishes and until next week.