Shiller price index

Rates fall to 3-week lows. Has the corner been turned?

Rates fall to 3-week lows. Has the corner been turned?

Mortgage rates have been volatile in 2022. Most of that volatility has come in the form of higher rates. The last 2 weeks have been a notable exception.

To understand why this happens, we must first consider that higher inflation means higher rates. It was easy to forget that for most of the last decade, but impossible to escape it since early 2021, and especially since early 2022.

Several large jumps in inflation forced the Federal Reserve to tighten policy considerably. One such policy was to buy a lot of bonds, including those that specifically underpin the mortgage market. More demand to buy bonds = lower rates. As the Fed pulls back, rates are hit by the double whammy of high inflation and falling buying demand.

The resulting surge had covered enough ground by early May that it was time to consider the possibility that they had peaked indefinitely. This might have turned out to be the case had it not been for a duo of warmer-than-expected inflation reports in the EU and the US. The latter (the Consumer Price Index or CPI) was particularly troubling. This happened on June 10 and was responsible for the rapid rise of 30-year fixed rates all the way up to 6.

Fast forward 3 weeks and rates are barely back to the levels seen on June 10th. The following table includes the oft-quoted, but often misleading, weekly rate survey from Freddie Mac, in addition to actual daily averages for leading 30-year fixed rates. Volatility!

So why have rates fallen so much in recent weeks?

First, they probably rose a bit too aggressively in mid-June. Traders were nervous as they waited to see how the Fed would react to the June 10 CPI report (the Fed announcement was June 15). After that, it’s perhaps as simple as saying that a majority of economic data at home and abroad sent the signals we were hoping to see before last month’s inflation surprise.

The most anticipated example of this week was the PCE inflation data, which along with the CPI is one of the 2 major inflation indices in the United States. Although it was only slightly less cold than expected, that’s all the market needed to continue the healing process. The PCE also posted the 3rd consecutive month of decline.

20220701 nl3.png

The notion of a rate “healing” process is bittersweet because it draws its strength from the damage done to the global economy. One of the most basic ways to track general economic trends is to use Purchasing Managers Index (PMI) data. These are generally divided into manufacturing and non-manufacturing flavors. They are much more current than GDP data, so markets are more willing to react.

Most of the PMI data in Europe and the US has recently fallen with some notable milestones. One component of the Eurozone report showed the first drop in manufacturing output in over 2 years. The US version painted a similar picture via contraction in “new orders” which did indeed dip to 2-year lows, matching pre-pandemic lows dating back to the financial crisis.

20220701 nl2.png

The combination of weaker economic data, colder inflation and a seemingly overdone rate hike in June means it’s time again to tell ourselves we’ve seen the peak in rates for 2022. NOTE: this only refers to a ceiling. We wouldn’t expect rates to fall until several months of data confirm a return to historically normal inflation levels.

As for a cap, the bond market is certainly considering it. In fact, he is actively making this bet. The following chart shows market-based inflation expectations (in orange). As of this week, they have fallen back to mid-2021 lows.

20220701 nl1.png

Keep in mind that the mid-2021 lows are still higher than anything seen since 2014. Also consider that the orange line represents expectations for the next 10 years…not a forecast of an imminent price move (any positive means prices would continue to rise, but not as rapidly).

Nowhere is this concept more painfully apparent than in house prices. Home price data this week from the FHFA and Case Shiller showed price growth remained close to 20% year over year.

20220701 nl6.png

There are two caveats here. The first is that the month-on-month numbers will be increasingly important as economists look for a turning point in prices. No love here:

20220701 nl7.png

The second is that house price indexes are notoriously lagging. Both were released on Tuesday June 28 and cover the month of April. A lot has happened since! Some of the drama was captured in the form of “price cuts” on property listings.

62bb63a9937d79f2d2d95a22.png

As we discussed last week, this is best viewed as a return to sanity. The majority of the price drops are from sellers who were becoming greedy due to the staggering price trajectory of the last 2 years. Price reductions among this cohort are not only good, they are necessary! We want house price growth to be slow, steady and sustainable. This will require a sharp contraction in price growth, with some regions experiencing modest contractions, all followed by a period of very weak growth.

All of this may sound scary to those who remember 2007-2009, but we’re not talking about deep, widespread price declines – just enough of a return to normal to halt the slump in home sales.

20220701 nl5.png