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What you Missed: Long-term interest rates rose and equities reversed sharp early-week losses, as markets looked past the spread of the Delta variant of the coronavirus and focused on strong corporate earnings. Treasury yields were volatile, with the yield on the 10-year note dipping as low as 1.16% on Monday before rebounding to 1.30% by the end of the week. Short-term rates, like 1-month LIBOR and SOFR, remained stuck near record lows. Oil was skittish through the week, as the price of West Texas Intermediate crude fell below $66 before rebounding to end the week about where it began, at $71.60. Elsewhere, the US Dollar and Gold both weakened. After a rollercoaster week, Treasury yield volatility, a key driver of the cost of rate caps and other option-based derivatives, ended lower on the week.
Yields say that US growth is set to slow. Equities say otherwise. Who’s right? With stock markets implying blistering economic growth for the foreseeable future and Treasury yields implying just the opposite, the markets’ topsy-turvy nature this past week defied facile explanation. Nominal GDP growth, the next measure of which is released this week, could come in near 17% yoy, while the 1-year Treasury yield hovers just above 1%. That gap is probably a record, and one that will be filled over the coming months as economic growth slows, and we see a gradual rise – over many months – in interest rates.
Our take: The message we’re getting from markets over recent days is that uncertainty and volatility are on the rise, and being driven by the red-hot inflation debate, lofty stock valuations, an increasingly gloomy public health trend, and growing questions about whether any meaningful fiscal infrastructure measures will make it through Congress. On top of all that, the Congressional Budget Office is forecasting that America’s output gap – the distance between the economy’s actual and potential production – will be eliminated by the end of this year. It’s a signal that peak, post-pandemic growth is likely upon us, and that it will likely moderate near year’s end, squashing broad inflation fears with it. If this scenario comes to fruition, the Fed, by opting to keep the stimulus pedal to the metal and claiming that current inflation is transitory, will look like a genius move.
US home prices continue advance. US existing home sales rose 22.9% from a year earlier in June. The median price of homes sold rose 23.4% over the same period last year, to $363,300. Sales of homes worth over $1 million more than doubled last month compared with the year earlier. Inventories of unsold homes edged up in June but remain below typical levels. However, sentiment among builders of new homes fell to an 11-month low in June, due to elevated building materials costs and supply shortages.
What to Watch: The Fed’s monetary policy meeting on Wednesday takes the spotlight this week. No one expects the Fed to adjust either of its policy levers (by hiking the short-term rate or changing the pace of their asset purchases) at this meeting. Instead, given the growing signals that America’s post-pandemic recovery will be a turbulent one, we expect Fed officials to focus on beginning to determine how they’ll mechanically activate a taper when they deem the time is right for one, likely in early 2022 in our view.
What the heck do we mean by “mechanically activate”? Well, the key question the Fed must answer for itself soon is if it should reduce its purchases of mortgage-backed securities first, or more rapidly than other types of bonds it’s buying. The answer to that question and the method the Fed ultimately employs could have big effects on the housing market.
It works like this: The Fed, despite the lowest mortgage interest rates in history, continues to buy mortgage-backed securities to keep mortgage rates low. One result of ultra-low mortgage rates is record demand to purchase homes, which then, has resulted in the rapid rise in home prices. These high prices are now forming a negative feedback loop, where high prices are starting to scare potential home buyers off, slowing the housing market down. If the Fed decides to begin tapering mortgage-backed securities purchases first, or at a more rapid pace than other bonds it’s buying, the slowdown in the housing market will likely accelerate. It’s going to be fascinating to see how the Fed threads this needle in the coming months.
On the data front, the full calendar in the coming week will produce updated gauges on the economy’s momentum at midyear. The advance estimate of Q2 GDP (Thursday) is set to post the high-water mark for the year; monthly consumer spending data for June (Friday) will lay down a base for Q3 GDP tracking estimates (Friday); June durable goods orders (Tuesday) will show business and consumer’ appetites for big purchases in a time of higher prices and flat wages. Finally, July consumer confidence (Tuesday) and the final July Michigan sentiment measure (Friday) will offer insight into whether consumers are becoming more uncertain amid eye-watering price jumps and if their view is taking some shine off reopening optimism.
Big Picture: In terms of economic recovery from the pandemic, America is now in a completely different place from the rest of the developed world. No other leading economy had a shorter COVID-driven recession, and none is on course to eliminate its output gap this year. Only one other country – Canada – will come close to those stats, but they won’t achieve them until late next year.
That type of economic progress implies that the Fed should be tapping the stimulus brakes much earlier than any other country, and that the dollar should strengthen. That would put a floor under Treasury yields, take some steam out of equity markets, and help to douse inflation. Recent bond and equity market volatility are evidence that markets are starting to come to terms with such a scenario and are struggling to figure out where to settle.
The unknown factor in all of this is COVID’s Delta variant. While it’s making headlines, we suspect we won’t see any real economic impact until a large share of the population is affected by rising cases and local government leaders respond by tightening restrictions and re-imposing lockdowns. Since California, Texas and New York combined make up a third of the economy, we’d focus on those states specifically when figuring out the economic impact of any Delta infection surge. Regardless of your political leanings, red states (Texas) aren’t likely to re-impose lockdowns, and California and New York both have more than half of their adult population fully vaccinated, hence, a Delta surge likely won’t be as impactful economically as many fear.
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