Flight to liquidity reminiscent of January and February
As the equities market sells off, it’s worth noting how much the sovereign bond market is rallying at the same time. I am seeing the 10-year US Treasury bond quoted at 3.079%, well down from a level just over 3.25% at the beginning of October. And German 10-year bunds are trading at 35.3 basis points where they were at nearly 60 basis points early in the month.
What I find interesting though is that Italian 10-year yields actually dropped in European trading this morning, with bonds now trading at 3.444%, the lowest levels this week. It speaks to a flight to safety and liquidity due to the market selloff.
Yesterday, the market rallied. I asked “Does that mean the market rout is over?” My answer was no. And we can see why today. But, as I also wrote yesterday, nothing in the real economy says we are near a recession. It’s not even clear yet whether the US economy is slowing.
What is clear, however, is that the Fed’s prior rate hikes are starting to bite. At first, it was the strong US dollar and emerging markets that felt the cold sting of Fed tightening, because as Powell’s regime shift took effect the dollar marched higher. But dollar strength receded in June before resuming again in August. The dollar index, at 96.21, is near the highest levels of the year. And there is no sign the Fed has decided to stand down.
US housing is looking weak
What I find new is the impact on US domestic credit markets, where housing is clearly slowing. You can se that in the existing home sales figures, which have declined for six months straight.
Yesterday, I got the following note from a local broker here in DC.
A Shift in the Local Real Estate Market
I hope you’re having a great fall! We are seeing a shift in the real estate market and wanted to share our thoughts. There are a few things we have noticed that indicate a change is on the horizon:
- Lower Traffic. We are seeing lower traffic numbers at open houses across price points – from entry-level condos downtown to custom new-builds in Bethesda/Chevy Chase and NW DC.
- Number of Pending/Closed Properties is Down. The most recent stats indicate that fewer homes are going under contract. In the upper brackets, we are also seeing new construction inventory start to build up as buyers have more and more choices.
- Developer Sentiment More Cautious. We just attended a panel of local developers, and normally they are some of the most optimistic parties in the room. Even they were sounding more cautious.
Why is this happening? Here are a few of the drivers we are tracking:
- Rising interest rates. As of last week, the interest rates have jumped from 4.75% to 5.1%. This has real implications for buyers, with an 80%, 30 year mortgage on $1 million now costing $4,344/month versus $4,173/month just days ago.
- Approaching mid-Term Elections. Markets dislike uncertainty, and tend to seize up before elections, especially in the DC metro area. This year is proving to be no different.
- New Construction. Developers have been putting up new condos and apartments all over the DC Metro area, and the increased inventory is finally catching up with them. Condo prices and rental rates are both softening.
- Affordability. The combination of rising rates and high prices is keeping many buyers on the side-lines. When entry level buyers can’t enter the market, move-up buyers have trouble selling their homes, and so-on. Think of it as the “trickle-up” phenomenon.
Perhaps the bigger question, though, is whether this is a short term blip or part of a longer term trend. While time will tell, we are generally optimistic that the market will pick up again in early 2019. That said, buyers will have more leverage than they’ve had for several years.
They have every incentive to be optimistic since that’s their business. But, the reality is that the market dynamics in DC and elsewhere have shifted in housing. To me, this is a sign that the Fed’s rate hikes are having an impact on credit conditions already.
So, what happens going forward?
I don’t see the present selloff as a dire end of cycle dive into recession and crisis. The macro numbers are too good at this time. However, the jitters here are a reaction to our having reached the 3.25% threshold on the 10-year bond. People are clearly concerned that the economy can’ take a lot more.
It’s key to remember that Fed policy acts with a lag. So all of the credit stress we see in housing is the result of months of prior Fed action. The actions now taking place will only start to bite mid-to-late 2019. And by then, we should see more pronounced and pervasive credit distress. That’s when we can reassess and think about end of cycle dynamics. But, it will definitely be a bumpy ride getting there.
P.S. – The market to worry about when we get to the end of cycle is US municipal bonds.