Our latest US housing outlook is available here, and the bottom line is that despite rising mortgage rates, demand for housing remains strong. Combined with record-low supply the housing market is expected to continue to do well over the coming quarters. A soft landing remains the most likely scenario.
The Fed is raising rates to cool down inflation, but daily indicators for consumer spending, airline travel, hotel reservations, and restaurant bookings show no signs of the economy slowing down, see charts below.
Combined with the strong March employment report, the conclusion is that despite higher rates and heightened geopolitical uncertainty, the incoming data is still strong and the Fed will continue to be hawkish until the economy starts to show signs of slowing down.
Our latest credit market outlook is available here. Turbulence is likely to continue driven by inflation uncertainty, rising rates, and emerging fears of a hard landing.
The market is currently pricing that the Fed funds rate will peak at 3.25% in mid-2023. On average, the Fed began cutting rates six months after the Fed funds rate peaks. And 10s typically peak around the time of the last Fed hike see chart below.
The consensus forecast is that inflation will soon peak.
With inflation soon peaking, the question in rates markets is when the Fed will turn more dovish because there is less need for the Fed to be as hawkish once inflation begins to trend lower.
If the Fed starts to sound more dovish because of inflation trending lower, then long rates will likely peak and begin to move down in anticipation of fewer Fed hikes and slower growth coming.
With this asymmetric setup, the pain trade in markets this week is if we get an inflation print lower than the expected 8.4%. In that case, rates are likely to move lower across the curve quickly.
The latest wage data from the Atlanta Fed is out, and it shows the highest growth in wages on record. Job switchers are seeing particularly strong increases in compensation, see charts below.
The Fed will look at these trends and conclude that the labor market is overheating and financial conditions have to be tightened immediately. Either via higher rates, wider credit spreads, lower equities, or some combination. The goal now is demand destruction to get inflation under control, and the market should not underestimate the Fed’s commitment to make this happen.
Rising stock prices and rising discount rates have increased the funding ratio of private and public pension funds, see charts below.
For the first time in 15 years, private pension funds have assets and expected cash flows matching future liabilities.
With the funding ratio reaching 100%, pension funds are de-risking and locking in gains in stock prices and buying rates and also high-grade credit to lock in yields.
The bottom line is that rising funding rates are creating significant demand for fixed income as yields move higher.
A different way to look at it is that as the Fed stops doing QE, another buyer, namely pensions, is stepping in to buy fixed income.
And such significant structural buying makes it harder for the Fed to achieve the desired tightening in financial conditions.
The Fed is going to shrink its holdings of Treasuries by $60bn a month and using the estimates in this Fed working paper, quantifying the stock effect shows that this decline in the Fed’s balance sheet is expected to increase the level of 10-year rates by 50bps by the end of this year. The rule of thumb from the Fed’s work is that for every $100bn in QT 10-year rates will rise by 10bps. The bottom line is that QE pushed rates down and markets should expect QT to push rates higher.
In New York City, subway use is at 60% of pre-pandemic levels office use is only 37% of pre-pandemic levels and restaurant bookings are more than 30% below pre-pandemic levels; see charts below.
