Divided Fed
Tim Duy's latest "Fed Watch" post argues that the Fed is deeply divided and that Bernanke is essentially pulling the strings. Half are for and half are against tapering, but Bernanke had to be the deciding force to lay out the plan for eventual tapering as the cost of continuing QE are too high. In doing so, the 7% unemployment target and inflation pickup to 2% (economists predict somewhere around 1.4% by Q3 2013) should also be met. We assume that the FOMC is on board with this, but Bullard stated that these thresholds were not voted or approved by the board, so it's just a reasonable outlook to help guide future policy decisions. This makes the overall message confusing to those wanting a definite answer, but there are many factors to consider before a decision is made to taper.
Inflation data looks promising with producer prices at 2.5% y/y for June, and CPI inflation rate at 1.4% in May (June figure posted on 7/16/2013). Consumer inflation expectations are at 3.3% over the next 12 months, up from the June projection of 3% according to the U.Michigan Consumer Sentiment Survey. However, the growth side faces some hurdles after the IMF issued a lower outlook on global growth that could hit home.
US growth expectations are at a 2.3% pace for Q3, to 2.6% for Q4. With China and Europe posting slower growth, will the US rise above or coincide with global pressure? UPS lowered its forward looking guidance and expects a slowdown in the US industrial economy. Nevertheless, economists are still positive on the second half of 2013, but a lot still rests on the Fed.
The market needs greater clarity, and if the message is not clear, then perhaps the board is a bit uncertain about timing. The scare factor will remain present in the market as investors price in the fact that tapering will eventually occur. The recent USD sell-off after Bernanke's "dovish comments" - which was just a jolt back to reality - is another sign of over-reaction. Better data are supporting yields, but the real question is whether or not the economy is ready perform on its own feet. The first real test will be how well the housing market performs as rates rise.
Higher rates sparking fear in housing?
As the 30yr fixed mortgage rate climbed to 4.51% this week - currently at a two year high - the total number of mortgage applications fell 23% from the prior week, according to data from the Mortgage Banker's Association. The refinance index slipped 4% as higher rates are becoming less appealing, but are still historically low! This is still a lax environment that will keep the housing market afloat. We could see activity picking up to lock in these historically low rates.
Refinance applications still represent about 64% of existing mortgages, with about 35% coming from the HAMP program. Generally, foreclosures are way below 2009 peak levels, and there is a noticeable lag between judicial and non-judicial states - factoring in the process of going through state courts to finalize a foreclosure. The extra steps involved in foreclosures could spur auction activity. Remember that cash buyers are out there and investors are fueling the housing recovery. People who have accumulated wealth and saved up during the down times, are returning on the backs of an improving economy. On the basic level, the picture is still not structurally sound. Employment figures are still stuck near that 3 month average, and first time homeowners are lagging in the lost generation facing increasing debt; resulting from the student loan crisis which will create a greater economic strain down the line. The market is ripe for the come-back household and market investors. Housing activity is directly tied to the local level where states are slowly entering recovery mode.
Rate impact on the local level
The 10yr yield continued to rise near 2 year highs when yields topped near 2.74% in 2011. Improving economic data and the bond sell-off on fears of Fed tapering contributed to the recent 10yr performance. Yields have since declined off the 2.70% level to around 2.60% after Bernanke's dovish comments. It's interesting to see the impact of rising yields on the local level.
General Conditions --
States are working to close budget gaps and many have improving outlooks. Problems still remain with pension obligations and other liability short-falls, but the regional recovery is starting to shape the US economy. Many opportunities that can easily get lost in the macro fray are occurring locally, and the trend is moving inward. The Shale Boom pushed North Dakota out of 38th place in real GDP terms in 2011 to #1 in growth from 2011-2012, with 10.84% in per capita real GDP according to the US Bureau of Economic Analysis. However, a Pew Stateline article stated that other states are not faring too well. Alaska's production is significantly lower, and Wyoming's tax revenue is down almost 17% from its pre-recession peak. With supply exiting Cushing to refineries on the Gulf coast, many are starting to question whether expanding railroad infrastructure instead of pipeline growth will keep up with the Shale Boom. Generally, we are seeing more public/private partnerships in transportation and infrastructure funding, and overall visible supply in the muni market is still low for the summer.
Capturing Yield --
With economic opportunity present, and some problems still needing a fix, investors are keeping a close eye on yields. Much of the focus is on protection; Morgan Stanley's Municipal Bond Monthly report put it best: "yield pickup on the longer end remains relatively flat...are investors adequately compensated for additional interest rate risk?" We could expect investors to either limit duration in muni portfolios or demand greater yield on the long end.
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