July 28, 2023
By Steve Blumenthal
“The Federal Reserve’s preferred inflation gauge climbed at a 4.1% annual pace in June, marking a sizable step down from May’s 4.6% annual rate and bringing price growth to its slowest pace in nearly two years..”
– Barron’s, July 28, 2023
I received a comment from a reader after last week’s OMR about Druckenmiller’s recent projections and thoughts on U.S. debt and the economy that it was a hard pill to swallow. It’s true that the future outlook is challenging for debt in general and the economy more specifically. The long-term problem is, we’ve saddled our children with IOUs that will have to be restructured in the future. Ironically, while we benefited from all the borrowing in recent decades, we’ve essentially forced our children into the position of needing to decide how much they’re going to have to reduce our social security, pension, and entitlement promises—which will affect them long after it affects us.
The bear in me is negative on overvalued cap-weighted indices and bonds yielding 4%. But that doesn’t mean there are no investment opportunities. In fact, I see many. For instance, residential real estate is one area to be bullish about. Despite the sharp rise in mortgage rates, residential real estate is doing well due to lopsided supply and demand. The supply of homes for sale is low, while the demand is high due to the large number of new buyers (individuals in their early 30s). Let’s look at that today—a big thank you to CMG’s chief economist, John Mauldin, and our good friend Barry Habib for the insights!
GDP and CORE PCE
- The GDP numbers out yesterday (July 27) showed an economy that’s still growing and consumers who are still spending—especially on services and experiences rather than material goods. So, no recession yet.
- The Federal Reserve’s preferred inflation gauge, Core PCE, which strips out food and energy, climbed at a 4.1% annual pace in June, marking a sizable step down from May’s 4.6% annual rate and bringing price growth to its slowest pace in nearly two years.
- Looking at the headline PCE, inflation for June increased by 0.2% and decreased by 0.8% to 3% year-over-year, which was in line with expectations and made it the lowest inflation rate in two years.
Yesterday, interest rates spiked higher on rumors that the Bank of Japan will increase their “yield curve control” by 0.25%. The 10-year yield breached the 4% level (again) and is likely headed higher. On this morning’s inflation news, the 10-year is slightly lower, trading at 3.99% at the time of this writing. We’ll talk about what’s going on in Japan in a future post. To be watched.
I had the pleasure of golfing with Dan Habib (Barry’s son) from MBS Highway yesterday. MBS Highway provides economic insights and financial tools for mortgage and real estate professionals with a client subscriber base of more than 40,000. The only thing besting his massive drive on the 18th hole at Stonewall is the outstanding track record of his firm’s predictions on inflation, mortgage rates, and the housing market. When I consider a real estate investment, my first call is always to Barry.
In this direction, Mauldin shared a note from MBS Highway in his Thoughts from the Frontline newsletter last week. It was excellent and worth reviewing if you missed it. Preview: The Fed’s calculation process is based on lagging data. It’s a flawed process and concerning since it is used to determine the pricing of the world’s most important interest rate, and that’s the primary reason the Fed policy stays too easy for too long (causing bubbles) and stays too tight for too long (causing things to break). These masters of the universe and their 400 PhDs should know better—and probably do—but they’re fixated on and operate with lagging data. It’s a mistake. More from the Habibs and Mauldin below.
Here are the sections in this week’s On My Radar:
- The Outlook For Inflation and Residential Real Estate
- Price to Sales – A Predictor of Coming 10-year S&P 500 Annualized Returns
- On My Radar – Podcast
- Personal Note: Some Down Time
- Trade Signals: Fed Day – Another Rate Hike
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Habib, Habib, Bajramovic, and Mauldin On the Outlook For Inflation and Real Estate
The following two sections, including the full real estate analysis and “More Fed Madness” further below, are taken directly from the latest Mauldin Economics’ Thoughts from the Frontline newsletter. Feel free to read it in its original form here.
On Home values have been exceptionally resilient. The much-anticipated housing crash never came, as home prices rose by 6% in 2022 and are expected to move higher again in 2023. At MBS Highway, we are forecasting 5.8% appreciation for the 2023 calendar year.
While home values had decreased slightly from their peak in the second half of last year, the trends have reversed in 2023. In fact, Zillow, FHFA, and Black Knight have reported that home values are currently at new all-time highs, eclipsing the peak from June of 2022. According to these reports, home values are on pace for 5% to 10% appreciation this year. How can home price appreciation be so strong with mortgage rates at 7%?
And if housing is this resilient with higher mortgage rates, what happens if and when mortgage rates decline? The main reason for housing’s resilience is a lack of inventory, matched against an abundance of qualified buyers… even with mortgage rates at 7%. So where do mortgage rates go from here? Mortgage rates are priced off Mortgage-Backed Securities (MBS), which is a long-term Bond. And like any long-term Bond, the fundamental driver of price and the corresponding yield is inflation. This is because the recipient of that Bond receives a fixed payment over a long period of time. Higher inflation means more rapid erosion of the buying power of that fixed payment. So, as inflation rises, potential investors of Bonds require a higher yield to offset the more rapid erosion of buying power. This is why long-term interest rates, like mortgage rates, typically rise when inflation rises and fall when inflation drops.
But these fundamentals have had a few hiccups of late. We have seen inflation improve, but mortgage rates have remained stubbornly high. Let’s explore why this has happened and why we believe the fundamental drivers are beginning to return.
Because the Fed has raised short-term rates dramatically higher over the past year or so, short-term safe investments, like Money Markets, are offering very attractive returns. Savvy depositors are withdrawing money held in traditional bank accounts and investing in higher earning Money Market accounts. This can be seen in the chart below.
Notice the dramatic fleeing of deposits into Money Markets, which accelerated during the failures of SVB, Signature, and First Republic. Since regional banks typically keep just a fraction of deposits on hand, capital had to be raised by liquidating their Bond holdings, including many MBS. This excess selling pressure has hurt pricing and caused yields to rise. Moreover, the assets of these failing institutions that were seized by the FDIC have been put up for sale recently, adding to the selling pressure. The debt ceiling crisis and additional new supply of Treasuries coming to the market did not help matters either. Fortunately, the trend of deposits fleeing to Money Markets is leveling off.
Mortgage rates tend to move similarly to the US 10-year Treasury. But during the past few months, mortgage rates have risen disproportionately higher when compared to 10-year Treasury yields. Some of this is due to a decrease in something called “servicing values.” 30- year fixed mortgage rates have historically traded around 1.75% to 2% above the US 10-year Treasury yield for a very long time. Look at the chart below to see how this relationship has been very consistent for the past 35 years, until recently.
For example, notice that when the 10-year yield was around 4%, 30-year fixed mortgage rates were around 6% (about 2% higher). When the 10-year yield was around 3%, 30-year fixed mortgage rates were around 5%, etc. But notice that over the past few months, the spread between the two has widened to about 3%, with the current 10-year Treasury yield near 4% and 30-year fixed mortgage rates near 7%. What’s happened here and where are we headed?
The MBS market is an amazing structure. It allows for the US housing market to have fixed rate mortgages for 30 years. This doesn’t exist nearly anywhere else, and the reason is risk… not the risk of default… it’s the risk of interest rate fluctuation. A lender holding a long-term fixed rate mortgage is exposed to the risk of a decrease in the value of their MBS holdings should interest rates rise.
Take the recent example of a mortgage that originated with a 3% rate in 2022. If marked to market today, the value would be significantly less because of more attractive 7% rates available to investors in the current market. There is a relatively simple way to estimate what the loss of value would be. If the expected duration of the life of that mortgage is 6 years, and the rate differential between 3% on the mortgage note and 7% available in the market is 4%, then you would multiply that 4% annual loss by the 6-year duration to approximate a value discount haircut of almost 25%. This is a risk too great to endure. The solution is to either only offer adjustable-rate mortgages like most other countries or offload the risk to the public via the MBS market.
Let’s look at how the MBS market works. Assume a borrower takes out a 7% rate through a mortgage originator. That mortgage originator then sells it to a servicer—we will explain their important role in a moment. The servicer then sells it to an aggregator like Fannie Mae or Freddie Mac, who then passes the hot potato by going to Wall Street, which then creates a pool of mortgages that are converted into MBS and sold to the public. Since all these players require compensation for their role, that 7% mortgage rate paid by the borrower translates to about a 5.5% yield to the investor.
With all the parties taking a fee for their role and then offloading the actual mortgage to the public, who will perform the duties of collecting the payments, answering customer questions, paying the real estate taxes as well as insurance? In other words, the mortgage needs to be “serviced.” Enter the mortgage servicer, who gets paid to perform these duties. The servicer will pay an amount up-front to gain the servicing rights to collect the monthly fee. The amount the servicer pays for these rights is called the “servicing value.” This value is highly dependent upon how long that mortgage will remain in place to evaluate the life of the revenue stream they receive. If a borrower pays off their mortgage by either selling their home or refinancing, that revenue stream stops. Therefore, the longer the anticipated duration of that mortgage, the higher the serving fee paid and greater the value the mortgage bond has, which helps to lower the yield.
Once again, for the past 35 years, 30-year fixed mortgage rates have been roughly 2% above the 10-year Treasury yield. But today the spread is closer to 3%, partially because nearly all the servicing value has evaporated, causing mortgage values to worsen, and the corresponding yield to rise. Some of the savviest market analysts are forecasting that these loans will have a very short duration. In other words, they are forecasting that a 7% mortgage will likely be refinanced over the near term due to more attractive mortgage rates on the horizon being available.
[I want to reemphasize that point. A mortgage service provider is literally the savviest market analyst I know of. They have more than just some skin in the game, they have committed a few arms and legs to the process. Judge Roy Bean at one time allegedly said that there is nothing like a hanging to focus a man’s attention. That holds true when real money is on the line as it is with a mortgage service provider.]
The shorter expected duration [due to their belief rates will come down] is causing 30-year fixed mortgage rates to trade closer to shorter duration Treasuries rather than the 10-year Treasury. And since the current market rates of shorter duration Treasuries are higher, for example around 5% for a 1-year Treasury Bill, it could explain why mortgage rates are currently trading around 1.75% to 2% above these levels.
As mortgage rates decline and servicing values return, it is likely that mortgage rates will begin to fall faster than the 10-year Treasury yield, which will narrow the spread to more normal levels.
Headline inflation has already come down significantly from 9.1% to 3% year over year as measured by the Consumer Price Index (CPI). But core inflation readings, which remove food and energy prices, have made less progress, declining from 6.7% to 4.8% on a year-over-year basis. The Fed has sent many mixed signals as to their focus. First, they told us that they were focused on the headline, because that’s what a consumer feels. Then they switched to the “super core,” which is the core reading less shelter. The “super core” has now declined to a relatively modest 2.7% year over year. But now the Fed has been fixated on core inflation and getting that number towards 2% over time. The Fed looks closely at CPI but prefers Personal Consumption Expenditures (PCE), which currently stands at 4.6%. The next PCE report will be on July 28, and we expect the core reading to decline to 4.2%. It’s making good progress, but still well above the Fed’s 2% target. The problem with the core readings is that they are heavily weighted with shelter costs. Shelter considers housing as a service, which does not contemplate home prices. Shelter costs are predominantly based upon rents and owners’ equivalent rents.
This rental data averages the previous 12 months, so there is the potential for a significant lag between the number reported within CPI and what is actually happening in real time. We have seen a dramatic decrease in year-over-year rents, which currently stands at 3.7%, but this week’s CPI report showed shelter, including rents, at 7.8% year over year due to the lag. Since shelter makes up 43.5% of core CPI, we can do a mathematical calculation to show that the difference of 7.8% shelter in CPI versus 3.7% in real time is 4.1%. If you multiply that by the weighting within CPI, the core rate of inflation is artificially higher by a whopping 1.8%. Without this lag, core CPI should currently be reported at 3% year over year… not yet at the Fed’s target, but pretty darn close and reason to give the Fed pause on further rate hikes. But the Fed doesn’t look at real-time data. Their data dependence is based upon lagging, old data.
It was this same flawed reasoning in 2021 that caused the Fed to keep rates at zero and keep quantitative easing (QE) going much longer than needed. The Fed thought inflation wasn’t a problem because it was being artificially weighed down by the lag in shelter costs. At the time, shelter was only showing an increase of 2% year over year, but in real time they were increasing by more than 7%. While these lags will catch up over time, the Fed’s fixation on the 2% target may cause them to continue to hike until something breaks—likely the labor market and/or a recession. This will almost certainly cause bond yields to decrease.
In conclusion, savvy mortgage servicing analysts agree with us that inflation will continue to decline and that the fundamental relationship between inflation and long-term rates will resume. This bodes well for investments in long-term Bonds like MBS and Treasuries, as well as the 10- year Treasury Note. Additionally, as previously mentioned, we’re already seeing home values increase in the face of roughly 7% mortgage rates. A decline in rates is likely to spark even more demand for housing and could accelerate the already impressive pace of home price appreciation we’ve seen thus far this year.
More Fed Madness
John here again. Existing home sales came in 40K less than expected last month, hitting the lowest level of sales volume since 2011. Median home prices are down -1% year over year, with almost no closed transaction level to validate a price level. Where a transaction is happening, multiple offers are still common, and 33% of closed sales took place above the asking price. It’s a soft but not collapsed market. (h/t David Bahnsen)
There’s a reason for that. Few people are willing to sell their homes. Which makes sense because… 92% of Americans have a mortgage below 6% right now, explaining the lack of incentive to sell a house only to buy a new one with a mortgage rate of around 7%. What I will add to this data point is that 23% have a mortgage below 3%, and 61% are below 4%, meaning they really, really aren’t likely to make a change. (Source: David Bahnsen)
Which is why, paradoxically, new home sales are so robust. New homes become more attractive simply because they are available. This is great for home builders. I will admit I didn’t have the combination of 7% mortgages and very positive earnings from home builders on my bingo card last year. Then again, I don’t think anyone did.
This creates a problem for Fed officials, though. If they succeed in bringing down inflation, mortgage rates will fall. Home prices will stay elevated and maybe even increase, which affects their ability to combat inflation. A true rock-and-a-hard-place situation. As we saw last week, much of the recent rollback in inflation came from energy and oil prices.
If the price of oil goes back to a mere $100—which is very possible since we aren’t drilling very much in the US—that will have a negative impact on inflation.
SB here:
I spoke with Barry this morning after the release of the PCE data. He said, “The real Core PCE number is 3.1%; if you use the current data vs. the lagging data the Fed uses.” He added, “Powell is going to make the exact same mistake he made by staying too loose for too long… He doesn’t understand the lag.” And here is his really important insight: Powell is a lawyer by training. Barry said, “Powell is not looking at the probable outcome. Like a lawyer does, he’s thinking about the worst outcome.”
Bubbles have formed. Something will break.
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Price to Sales – A Predictor of Coming 10-year S&P 500 Annualized Returns
Below is a link to a short investment discussion hosted by 3EDGE Asset Management in which 3EDGE Chief Investment Strategist Fritz Folts and CEO/CIO Steve Cucchiaro talk about the importance of valuation and address the following questions: How important is valuation when making investment decisions, and how much do valuations matter? On a historical basis, how overvalued is the S&P 500 index? How should investors think about positioning their portfolios in this environment?
Several times each year, I put out a detailed valuation / probable forward return OMR letter. (You can find the most recent post here.) What caught my eye in the 3EDGE discussion is that they have identified the Price to Sales ratio to be the most accurate determinant of coming 10-year annualized returns for the S&P 500 Index over all other valuation metrics.
Here’s the bottom line:
- The following chart shows the S&P 500 Index Average Annual Returns over subsequent 10-year periods based on the Price to Sales (“P/S”) ratio at each month’s end – data 1871 to present.
- Returns are broken down into ten deciles (think: lowest 10% of all readings to the highest 10% of all data readings).
- When P/S is low, returns are best, and when P/S is high, subsequent returns are worst.
- The S&P Price to Sales ratio on 6-30-23 was 2.5. This is higher than the average of all Decile 10 P/S readings. A good forecast is 10-year returns from the current starting point to be between 0% to 4%. That is far from the 10% annualized returns investors are expecting.
Here is a link to the full video.
Disclaimer: Please know that 3EDGE Asset Management is one of the investment managers we offer to our clients on our wealth management platform. This conflict of interest exists. Further, I’m a fan of their investment management process, team, and depth of knowledge.
Current views are subject to change. Of course, no guarantees.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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OMR Podcast
Brian Schreiner and I discuss last week’s On My Radar… and end with an emotional story. Ugh. Life. Ever forward…
Click on the picture to go to the podcast.
Personal Note: Some DownTime
Susan and I are sneaking away for a few days next week with the intention to unplug and recharge.
We made an impulsive decision to book a trip to a resort in Cancun called Nizuc. I am looking forward to a Mezcal margarita—Susan’s go-to fun drink.
It’s hard to believe August is just a few days away. And I’m sure you, too, are feeling the heat— with record-high temperatures over much of the northern hemisphere. Given the heat, I’m not sure Mexico is the right pick for an August visit, but we’ve been to Nizuc two prior times and loved it. And I guess, due to the time of year, the price is right.
Because of our trip, there will be no On My Radar next week. Hope you have some downtime planned, too.
Finally, the Woman’s World Cup is heading to the final games in the group stages. The U.S. does not look as dominant this year. Frankly, they looked unorganized in the first half of Wednesday night’s game vs. the Netherlands. The game ended 1-1. Portugal is up next. It’s a 2:30am ET game next Tuesday. A tie or a win put’s the U.S. through to the knockout round.
U.S., Spain, Germany, England, Brazil, France, and host country Australia are the favorites to win. Fun to watch.
Wishing you a great week,
Steve
Trade Signals: Fed Day – Another Rate Hike
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
I showed the following chart in this week’s Trade Signals post.
It was a good buy signal for Oil. Up approx. 5% and currently trading at $83. This should cause some additional inflation indigestion for the Fed.
Here’s a look (green arrows = buy, red arrows = sell):
I remain bullish on oil.
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