Nominal Rates & the Fed
Last week, all economic measures came in better than expected and reinforced the idea that our economy is quite strong and healthy. When we think about the future direction of the Fed in this context, we can conclude that rate cuts are not currently on the table. Even if inflation recedes, there’s no reason to cut rates when the economy is demonstrating that it can thrive under the current conditions.
For the first time in a long time, all rates increased in money markets and capital markets across the board. Total money market funds decreased by $2.89 billion: while retail was up $5.81 billion, institutional assets decreased by $8.71 billion. Last week, we mentioned news headlines who are misunderstanding where money is moving within the money market sector; they believed money was leaving the money market area and moving over the equities, but that was incorrect. In fact, we’ve seen equity markets down almost $14 billion, commodities down $409 million, combined mutual funds and ETFs are down $6.28 billion, but bond funds are up $9.41 billion. Bond funds are part of the capital market, so it would appear money is beginning to flow out of money market funds and heading into capital market funds.
In looking at the historical data released by the Investment Company Institute, the last month has shown money flowing steadily out of equity markets. But the bond market reported its last outflow at the end of May and has since reported inflows week after week.
The next FOMC meeting is about three weeks away, and the Jobs report for both the US and Canada releases at the end of the week. The current likelihood for a 25 basis point (bps) rate increase is at 86%, but that should come as no surprise if you’ve been monitoring the Fed’s track record. Projecting ahead to December’s meeting shows another varied likelihood in where we’ll be, rate-wise, at the end of the year. As we mentioned last week, the 6% range finally emerged as a possible target and represents 3 rate hikes on top of our current range. The Fed is expecting to institute at least two more rate hikes, but the possibility of a third rate hike could delay the resurgence in equities.
And don’t forget about lags! We seem focused primarily on rate hikes and the outcomes of the FOMC meetings because they are significant decisions to follow. But their real effects aren’t felt immediately. The trailing effects of the rate hikes take months, sometimes even more than a year, for the full effect to be felt. So while we track and predict the Fed’s moves on a regular basis, we also need to track the effects of their decisions in the coming months.
Real Rates, Federal Funds Rate, and TLT
A bit of excitement among real yields, with the 5-year, 7-year, and 10-year reaching cycle highs.
Federal fund futures (FFF) are still flattening out and projected future earnings suggest at least one more rate hike before the end of the year. But as we’ve mentioned earlier, we’re probably in store for more than just one rate hike.
TLT, the major long-term bond ETF index, fell just 37 bps in the last week.
Housing & OAS
The Primary Mortgage Market Survey shows 30-yr. Fixed Rate Mortgages (FRM) are at 6.71% (up 4 bps from last week) and 15-yr. FRM are at 6.06% (up just 3 bps from last week).
- Mortgage applications are up 3%
- Refinances are up 3.32%
- Purchases are up 2.83%
- New home sales (May) are up 12.2%
Home developers reported another week of gains, but much smaller gains than prior weeks. Even with this slowing, home developers are still way way up on a year-to-date basis. When home developers report these kinds of gains, we might assume that interest rates are low… but they’re not! So we might assume housing prices have taken a dive… but they’re haven’t! They’re only down 1.7% year-over-year. Then what can we conclude about how housing will look in the coming months, or even at the same time next year? With borrowing power down and housing prices essentially flat, new home buyers are in a tough environment. Existing homes are held tight by current owners, so the only option is new homes, which explains why new home developers are reporting gains as if they’re printing money from a press!
Grains, Lumber, & Timber
Wheat, corn, and soybeans all performed differently last week in drastic ways: soybeans had a killer Friday, wheat took a beating, and corn suffered a big loss. Quarterly inventories for all these commodities came in below their forecasts. The USDA reports highlighted where soybeans are planted across the US and these reports show a collective 5% drop in “acreage under seed,” which refers to the usable soil that will yield a crop. This accounts for the price increase on soybeans. Corn, on the other hand, reported a 6% increase in acreage under seed, so even though corn stocks came in lower than expectation, production numbers running at 6% should put a downward pressure on price.
Lumber futures were up almost 13% in June. We’re just entering the beginning of forest fire season and already Canada is on fire! Forest fires have already swept across several regions of Canada, obstructing air quality and driving the price of lumber up with supply literally burning up as we speak.
“End of an Era” Study
A study was released by the Fed, authored by Michael Smolyansky, entitled “End of an era: The coming long-run slowdown in corporate profit growth and stock returns.” Smolyansky concludes that, over the past 30 years, the decline in interest rates and corporate tax rates have accounted for the majority of many companies’ exceptional stock market performance. However, he reasons that this pattern is unlikely to continue in the future. Many companies, even before the 2023 burst of AI hype, have been doing everything they can to increase their earnings and give shareholders what they want. But does this result in the deterioration of the quality of earnings? Smolyansky would say “Of course it does!” Meldrum comments that another way to track this deterioration is to look at the earnings quality over the past four decades and see what the index was trading at in terms of its PE (price-to-earnings ratio). He suggests we’d find a negative (or opposite) correlation between PE and earnings quality: Meldrum believes the higher the PE, the lower the earnings quality. He questions whether these company earnings are the result of sophisticated engineering by accountants, “accounting shenanigans” as he calls them, or even potential fraud on small and large scales.
Overall, it seems that the economy is strong and thriving, but we shouldn’t get drawn into a false sense of safety. There are still plenty of places for things to break down and we still have to grapple with the ripple effects of the Fed’s rate hikes. As Warren Buffet says of recessionary times, “Only when the tide goes out do you learn who’s been swimming naked.” Be sure to stay vigilant and not be caught without your swimsuit!
This newsletter is a synopsis of a continual series of updates by a market analyst Mark Meldrum. Mark Meldrum is a CFA that provides weekly updates on the market, but they tend to be an hour long. Here is a synopsis of his video found here.
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