The market consensus seems to be that everything will be fine. Consensus equity forecasts remain fairly bullish. Expectations for GDP growth the rest of the year hasn’t really budged. In fact, since 10y Treasury yields began moving higher in early May, 3Q growth expectations have actually ticked higher. (Q2 expectations have fallen, but appears to have been driven by yesterday’s weak retail sales figure rather than anticipated effects of higher rates)
A simple gut check, however, suggests that it is too early to signal the all clear. First, the pace of the move was substantial. On a 3 month basis, nominal yields moved over 90bps, which puts this recent episode as amongst the 6 worst periods for Treasuries over the past 20 years. (Chart below shows 10y nominal yields and the rolling 3m change in the bottom panel. Note that with the exception of 1994, all those episodes resulted in a stabilization in yields over the subsequent months)
As some of our astute readers have noted, these types of moves have historically had a significant impact on interest rate sensitive sectors such as homebuilding. The chart below highlights this, as well as the fact that this recent episode is essentially on par with the 1994 experience, albeit the pace is much faster this time. Note that we express the mortgage rate in percentage terms, since a $100 / month increase in mortgage payments is a much bigger deal if the original payments were $800 as compared to $1600.
There are, however, a number of offsetting factors that mitigates these worries. Homebuilding remains a smaller driver of US growth than in the past. The ratio of debt service payments to income are at multi decade lows. And the current mortgage rate of ~4.5%, remains BELOW the 4.74% to existing mortgages, unlike the prior instances when yields jumped.
However, TMM notes that personal expenditures growth has exceeded real income growth for some time – and TMM suspects that the refinancing activity was likely a key driver. I.e. even though real income growth has been broadly flat since 2009, (first chart below, bottom panel) consumers have been able to refinance their mortgages with a ~5% rate to ~3.5% and used to cash flow for consumption, which has grown at a fairly steady rate of 2% YoY in real terms. (Second chart below, bottom panel) If true, this tail wind is likely to weaken.
As a result, TMM thinks that a continuation of recent growth trends will require a successful growth handoff. The improving employment picture is a positive, but TMM thinks that ultimately, improvements in real wage growth will be needed. That could happen on its own as the unemployment rate continues to decline – i.e. the US economy may have already achieved ‘escape velocity,’ albeit at a slower pace than historically. However, the jury is certainly still out on this. The San Francisco Federal Reserve, for example, recently noted that the reluctance of employees to accept wage reductions meant that there may be a substantial amount of “pent up” wage reductions that are getting reduced via frozen wages that are gradually eroded away by inflation. The authors calculated that the number of people with frozen wages remains a substantial portion of the labor force:
http://www.frbsf.org/economic-research/publications/economic-letter/2013/july/wages-unemployment-rate/
On net, the balance of risks for consensus growth expectations after the recent move appears to be on the downside. This suggests US yields are likely to stabilize around current levels, at least for a while. Equity prices, however, are likely to be less affected, even if there is a slowdown. The chart below shows SPX performance in the months following historical yield spikes of comparable magnitude. All instances showed positive returns 5 months later.
As a result, equities we expect to carry on gently into outer space. (new highs)
Meanwhile something unexpected may happen to the Dollar. There is a strong belief, certainly positionally, that the USD is on a steady ride upwards too, but if we look at USD performances during the events above (BoE’s USD index used below) we see that it has actually come off:
So in the case of the dollar there is a fair chance that it may well not make it into orbit and fall down to earth.
In summary, here is a modern artistic representation of TMM’s views on US Equities, Treasury Yields, and the USD:
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