One of the questions I'm most commonly asked is what is the biggest threat right now to the markets. It's obviously a very difficult question to answer succinctly, but I will address it in two ways in this column and the next. Today, I'll address the biggest economic concern I have and tomorrow I'll address the biggest immediate market concern.
On the economic side, the biggest threat is that borrowers, especially individuals, do not respond well to a Fed rate hike.
Since the last FOMC statement, the bond and gold markets have begun to reflect concerns and expectations that the Fed will raise rates in December or soon after.
The CME 30-day Fed fund future prices have steadily reflected increased expectations of a Fed rate hike in December, with the probability now at 54%.
The 10-year Treasury yield has increased from about 2.05% before the last FOMC statement was released to 2.22% now.
Spot gold prices have moved from about $1,180 per ounce to $1,107.
These moves are all reflective of the fact that an increase in the Fed funds target rate pits upward pressure on the U.S. dollar and thus downward pressure on bonds and commodities, especially gold.
The increasing expectation for a Fed rate hike in December and the increase in long-end Treasury yields have also caused 30-year fixed mortgage rates to rise by a corresponding percentage.
Every year at this time, I discuss the importance of stability of mortgage rates, as I did last November in the column, "A Solid Foundation Is Key."
In short, consumer demand for home purchases in the spring season begins during the year-end holiday season of the previous year. If mortgage rates move greatly in either direction between that season and the spring housing market, demand is caused to remain as potential rather than being actualized.
The most important part of that, however, is not the probable volatility of mortgage rates caused by a Fed move in December, it's in determining the degree of demand.
Demand is not desire. Demand is a measure of the level of consumer financial capacity to act on the desire to become a homeowner by way of taking on debt to do so; typically referred to as pent-up demand.
Demand cannot be caused to increase by moving rates. Moving rates up or down can only provide an incentive or disincentive for existing demand to be actualized.
The rapid increase in household formations over the last two years also cannot cause demand to increase.
However, it is typically an indicator of rising consumer confidence and as such an indicator of willingness to take on debt.
That willingness has already been expressed in the form of an increase in auto sales over the past several years, with much of that demand being met by the availability of subprime auto loans.
But as I discussed in the June column "The Changing American Dream: From House to Car," increasing auto sales, which are most commonly debt financed, preclude the demand for housing to increase because the potential homebuyers have already allocated their available credit into a car, which provides a much lower multiplier effect on economic activity than does the purchase of a home.
Even more worrisome from an economic perspective, though, is that although auto sales have reached cyclical peaks, the rate of increase in sales is declining, which I addressed in the September column "Slowing Auto and Housing Markets Will Force the Fed to Reverse Course."
If we normalize auto sales to adjust for the increased availability of subprime loans and the extension of loan terms allowing for lower monthly payments, the result is that over the past two or three years sales that would have occurred in the future have been pulled forward into the present.
This not only precludes an increase in demand for housing now, but probably ensures that not only will vehicle sales decline over the next five years, but that housing demand over that period will also be handicapped by the residual payments on auto vehicle loans being taken on currently.
All of these issues are also immediate cyclical issues that occur with broader secular and structural issues that will prevent house sales from returning to the levels that predated the last housing crisis.
I'll address those issues in Thursday's column.
In the immediate, though, the primary economic concern is that a Fed rate hike in December will cause bond yields and mortgage rates to become very unstable and cause demand for house purchases to decrease, rather than increase.
This is a part of the unintended and undesired consequences I wrote about in the column, "This Is Where the Fed's Problem Lies."