A Tale of Two Opinions

A Tale of Two Opinions

Will interest rates rise or fall? The answer is “it depends.”

Will interest rates rise or fall? The answer is “it depends.” It depends on whom you ask. Opinions are divided. 

The speculators are of one opinion. Grant’s Interest Rate Observer reports that net-short positions in 10-year U.S. Treasury note futures reached a record of more than 500,000 contracts in the first week of July. These traders are betting, with conviction, that the price of the 10-year note will fall and its yield will rise. 

Recent news on consumer-price Inflation appears to support the speculators’ bet. The Consumer Price Index rose 2.9% year-over-year in June. That’s the largest annual increase in six years. Meanwhile, the New York Federal Reserve’s Underlying Inflation Gauge suggests inflation runs even hotter than CPI estimates. The UIG rose 3.27% in May. The UIG is at its highest level since 2006. 

Consumer-price inflation influences long-term interest rates more than most influencing variables. Given the latest news on consumer-price inflation, we should expect more speculators to bet that interest rates will rise. 

To bet that interest rates will rise appears the smart bet these days, but is it? Some market-participants apparently see it otherwise. 

Interest rates on the long-end haven’t been rising. The yield on the 10-year note continues to hover around 2.85%, as it has for the past three weeks. Mortgage rates, which take their cue from the 10-year note, also continue to hover within a tight range. Mortgage New Daily reports that the note rate – the rate quote that determines the payment – has held for the past two weeks (at the national level). 

Perhaps the contra-rising-rate opinion is more influenced by the shape of the yield curve than consumer-price inflation. The yield curve has flattened over 2018. It continues to flatten as we write. The spread between the two-year U.S. Treasury note and 10-year U.S. Treasury note has tightened to 27 basis points. (The 10-year note yields only 27 basis points more than the two-year note.) 

Flattening is one thing, inversion is another. We’ve noted with great frequency in recent months the implications of an inverting yield curve. When short-term yields have risen above long-term yields, a recession has followed.

An inverted yield curve has correctly predicted the past seven recessions. The last two times the yield curve inverted was 2000 and 2006. A recession followed 12-to-18 months later.  

So we have two leading opinions balanced on the opposite end of the fulcrum. This suggests to us that market-rate volatility will remain muted. We don’t see much variability in mortgage-rate quotes for the immediate future.

We also don’t see a reward commensurate with the risk of floating at origination. The conservative course is likely the prudent course. After all, low variability can give way only to higher variability. 

Another Reason to Worry?

It’s always different. No two economic eras are alike. An inverted yield has accurately predicted recent recessions. It doesn’t guarantee a future recession. Unfortunately, another influencing variable appears to support the recession narrative. 

Data mined by Calculated Risk Blog show that private fixed investment has fallen during every recession since the 1940s. Residential fixed investment is a huge component of private fixed investment. Calculated Risk Blog’s mined data show that residential investment leads nonresidential investment. As residential fixed investment goes, so usually goes other private fixed investment.  

Residential fixed investment has broken away from the uptrend in private fixed investment. Though residential fixed investment has grown monthly for most of 2018, it has grown at a gradually lower rate each successive month. Its growth rate has trended down to a point where it’s not growing at all month over month. If past is prologue (and it isn’t always prologue), the trend does not bode well for private fixed investment and for the overall economy. 

But let’s keep our perspective, let’s not exaggerate the fear. We’re not there yet. The yield curve remains positive, as does residential fixed investment.

That said, the trend in residential fixed investment is yet another reason we are so down on tariffs and trade wars. Rising building costs related to tariffs on imported lumber and steel will only hinder investment-spending growth.