On the Picket Line
Equity markets headed back to earth in recent months after rallying sharply through mid-summer. Along with the Writers Guild and United Autoworkers, stock investors appear to have gone out on strike as a number of external forces converge to threaten the soft-landing outlook that has buoyed equities this year.
Most notably, long-term interest rates have surged. Since mid-July, the 10-year Treasury yield has shot up a full percentage point, reaching 4.8% in early October. That marks a 16-year high and a return to levels not seen since prior to the Great Financial Crisis. Pundits have been scrambling to explain the catalyst for this untethering of yields.
Higher for longer
The Fed’s policies dictate short-term interest rates while inflation expectations play a significant role in shaping the longer end of the yield curve. Traditionally, higher anticipated inflation prompts bond investors to demand higher yields to compensate for the potential loss of purchasing power. However, the recent surge in long-term rates has occurred even as inflation has eased, and the Fed has signaled it is nearly done tightening. Moreover, despite increasing energy prices, inflation expectations remain well-anchored and have not jumped alongside Treasury yields.
Some observers posit that the bond market has awoken to the U.S. government’s deteriorating fiscal position. It is bidding up long-term yields in anticipation of an onslaught of new Treasury issuance. Indeed, due to persistently high annual budget deficits, federal debt has doubled over the last eight years to $26 trillion. At the same time, some large buyers of these securities — such as the Federal Reserve — have been stepping back. If the future supply of federal debt cannot be fully absorbed, yields must increase to balance the market.
Nonetheless, rising yields may simply reflect the bond market’s assessment that interest rates will be higher over the long term than previously assumed. The Federal Reserve contributed to this narrative at its September policy meeting, extending their timeline for rate cuts. And to the extent investors are more uncertain about the long-term path of inflation and interest rates, they will demand a higher “term premium”, or extra compensation (yield), for bearing interest-rate risk over the life of a bond.
Although the economy has been resilient in the face of a hawkish Fed, the hottest topic in the markets lately relates to how much pain higher long-term rates will cause. If sustained, the recent step-up will make credit even more costly for households and businesses, pressuring the growth outlook.
Many new borrowers and those with revolving debt have been getting squeezed. In early October, the 30-year fixed mortgage rate reached 7.57%, highest since 2000, according to Freddie Mac. With home prices also soaring, affordability has become a significant challenge for many buyers. The Atlanta Fed estimates that the median household would need 44% of its income to cover the monthly payment on the median-priced home. Not surprisingly, mortgage purchase applications have fallen to their lowest levels since 1995.
The double whammy of higher prices and more burdensome financing costs also characterizes the automobile market. Edmunds reported that the average monthly payment on a new vehicle amounted to $733 in the second quarter, with the typical APR rising from 5.0% to 7.1% since 2022. One in six new borrowers is now paying $1,000 or more each month. The average payment for a used vehicle amounted to $569 per month with the average financing rate increasing from 8.2% to 11.0%.
Developers and builders have also been feeling the pinch. According to the National Association of Homebuilders, the average financing rates for land acquisition, land development, and home construction all jumped from 4%-5% in early 2022 to 8%-9% in mid-2023. New construction of multi-family units has dropped 40% year-over-year.
Meanwhile, credit conditions continue to be challenging. A New York Fed survey indicated that American consumers are increasingly concerned about access to credit due to high interest rates and tighter lending standards. Sixty percent of households mentioned that it had become more difficult to obtain new financing compared to the previous year. Business surveys convey a similar message with the percentage of small firms reporting issues securing credit doubling in the last month, according to the National Federation of Independent Business.
The Federal Reserve’s quarterly surveys of senior bank loan officers continue to point toward stricter standards and lower loan demand. Overall, banks anticipate further tightening of loan requirements during the rest of the year. The most commonly cited reasons are a more uncertain economic outlook, and an expected deterioration in both collateral values and credit quality.
A few winners
Obviously, there have been some beneficiaries of the higher-rate regime. For instance, households with savings may now earn 5% or more annually on their cash. Non-financial corporations have also benefited because interest income has outpaced interest expense. Net interest payments dropped from $300 billion in the second quarter of 2022, as the Fed rate hikes began, to $212 billion in the second quarter of this year. For the S&P 500 (excluding financials), net interest expense amounted to only 8.9% of operating income in the latest reporting period, among the lowest readings since 2006.
The softening conditions unleashed by higher interest rates and tighter credit are right out of the Federal Reserve’s playbook. And so far, the economy’s downshift has occurred without a meaningful increase in unemployment. The Fed should be about done raising short-term rates although it seems in no hurry to actually lower them. Their median forecast sets the federal funds rate at 5.1% by year-end 2024, little changed from today’s 5.25-5.50% range. In other words, the monetary backdrop will be restrictive for the foreseeable future.
In addition to high interest rates, rising energy prices could contribute to a less-than-soft landing and put further pressure on stocks. OPEC+ has been aggressively cutting oil production to drive up prices. These cuts are projected to have pushed the global supply/demand balance into sharp deficit beginning with the third quarter — resulting in a shortfall of 2 to 3 million barrels per day. Brent crude prices jumped from $75 per barrel in late June to $95 per barrel in late September. And Hamas’ recent attack on Israel has the potential to destabilize the Middle East anew, leading to a wider regional conflict and perhaps even an oil shock.
Higher energy prices could trigger a resurgence of inflation, reversing some of the progress in that fight, and pushing Fed policy to become more restrictive. Rising gasoline prices will act as a tax on consumers who are already feeling a bit more pressed.
Long-term rates may be close to topping out but the evidence suggests they will remain elevated, at least compared to recent years. The 2009-21 period witnessed two rescues from financial crises, highly accommodative central bank policies, minimal inflation concerns, and ultra-low and declining interest rates. And it came on the heels of thirty years of steadily falling rates.
The positive forces that shaped the post-2008 financial landscape started shifting two years ago. Higher inflation proved not to be transitory. This tardy realization prompted sharp interest rate increases and a hostile Fed. It is difficult to imagine a recurrence of that seven-year period of 0% interest rates. Ultimately, consumers and businesses will adapt, but the enduring tailwind from a very benign rate environment has dissipated. The era of lower for longer is behind us.
A soft landing remains a plausible scenario but there is more uncertainty today as Fed tightening continues to work its way through the system. In the meantime, the corporate profits cycle appears to have hit its bottom, with growth returning in the third quarter. That’s undoubtedly good news for equities.
-Christopher J. Singleton, CFA, Managing Director
October 18, 2023