I came across an article from today’s edition of Barron’s titled, Home-Price Surge Says Inflation Is Real. The FedClings to Illusion It Isn’t, and it got me thinking about the current landscape of the financial markets. (I include a version below as the article is behind a paywall.)Home-Price Surge Says Inflation Is Real. The Fed Clings to Illusion It Isn’t. _ Barron's
But when asked about the housing market—specifically, the jump in prices and what pace of increase might induce a change in the Fed’s $40 billion monthly purchases of agency mortgage-backed securities—[Fed Chair Jerome] Powell demurred from connecting the two.
He called the double-digit annual surge in home prices a “passing phenomenon” related to the pandemic. “There’s a one-time thing happening with people who are spending all of their time in their house. And they’re thinking either I need a bigger or I need another house, and a different house. Or a second house, in some cases. So there’s a one-time shift in demand that we think will get satisfied, also that will call forth supply. And we think that those price increases are unlikely to be sustained for all of those reasons.”
Home-Price Surge Says Inflation Is Real. The FedClings to Illusion It Isn’t, Barron’s, February 5th
A chart is worth a thousand words
In a linear environment, if we were to look at the chart below and plot the differences between the 30-year conforming mortgage rate and the 10-year UST yield, I would see nothing amiss. Indeed, the Fed engineered a collapse in the 10-year UST yield during the onset of the COVID crisis, while the drop in mortgage rates were more muted. In order to narrow the differences between the two rates, the Fed embarked upon a $40bil/month MBS purchase campaign that persists to this day.
Once these initiatives were announced last March, I predicted house prices would begin to rise much higher than expected, regardless of missed rent payments and financial blood in the streets. This seems to be coming to pass. (Please note that I suspect that the Fed also knew this would be the result, and was hoping to goose house values, so that people would have an asset into which they could tap to help spending and adjust to the new normal.)
As we can see from the chart above, the yield spread between the 10-year TIPS and the regular 10-year UST (green line) is at the high-end of the 10 year range. It currently stands at 2.19%, and the direction of movement is what I find troubling.
The second most concerning aspect of the data here is simple; the yield on the regular 10-year UST (red line) is far below the TIPS spread and inflation expectations (green line). A difference this large does not persist for lengthy periods and will eventually have to return to the normal range. How that returns is something we need to contemplate.
The Fed can’t continue supporting the UST and the MBS markets with massive ongoing purchases, while letting inflation continue moving much higher with UST yields this low. The non-inflation yield of the TIPS is stuck at -1% and this simply cannot persist forever.
As the Barron’s article points out, the fed’s willful ignorance may prove costly if the Fed refuses to acknowledge that inflation is becoming a problem.
What if the Fed grows concerned about inflation?
I try to stay one step ahead of the crowd here and if the Fed starts to voice its concern that inflation is becoming a concern;
- UST yields will rise here as will the mortgage rates, regardless of Fed purchases.
- This will then cause the world to bid up the US dollar as domestic interest rate and bond yield differentials prove too tasty to pass up.
- This will in turn, cause pressure in the overnight lending markets, which will have to be addressed by the Fed. The Fed may have to shorten its timeline of zero rate policy.
- This will, of course, put tremendous pressure on stock prices, too.
- As for real estate, I can’t make a dire prediction yet. The genie is out of the bottle and inflation has a way of boosting house prices even if mortgage rates rise. Furthermore, There is still some wiggle room for the 10-year UST to rise before mortgage rates rise in lock step.
- This much is certain, The Fed needs to address inflation as the 10-year expected rate of inflation or the TIPS spread is almost as high as the 30-year mortgage rate.
The Fed cannot remain wilfully ignorant here and if it refuses to act properly, we will continue to see a run up in asset prices until it’s too late. We will then get another down cycle in asset prices like in late 2018. Anyway we slice it, the S&P 500 is close to 4,000, so a correction wouldn’t be such a bad thing. I am betting that it will be caused by Fed policy.
Of course, we may get another manufactured crisis, which will just solve the Fed’s dilemma without having to do anything about rising prices.