Is the Economy Throwing Us a Curveball?

Are we getting thrown an economic curveball ... in the right direction? Inflation is surging and talk of a recession is growing, but we're now actually seeing some signs of optimism in financial markets. You see, less than three weeks ago, the U.S. Treasury curve inverted, which is where the 2-year Treasury trades at a yield higher than the 10-year Treasury. A curve inversion is a classic recession warning, but since April 1, the curve has rapidly reversed course, with the gap between those two Treasuries jumping from -8 basis points to 30 basis points. This is far too short a period of time to make any sweeping judgements, but this normalization of the Treasury curve is just one of a few signs that maybe the economy still has room to expand. Here's my take. Yield Curve Steepens First let's look at the un-inversion of the yield curve. The curve is said to be inverted whenever some shorter-term Treasury bond yields more than some longer-term bond. The most closely watched pair is the 2-year and the 10-year. Those two points have inverted before every recession in the last 50 years. So when the 2-year yield rose above the 10-year yield earlier in April, it caused quite a stir. We have two ways the curve can become un-inverted: Either the 2-year yield can fall or the 10-year yield can rise. If it is the 2-year yield falling, that would indicate markets expect fewer Federal Reserve rate hikes. That isn't what has happened in recent weeks. Instead the 10-year part of the curve has been rising. Rising long-term yields tend to be a sign that economic growth and/or inflation expectations are going higher. In other words, when the curve steepens because 2-year yields fall, it is a sign that the Fed sees weakness ahead and won't be hiking as aggressively. When it is because the 10-year rises, it is because markets see economic conditions improving. That we are seeing the later so far in April is definitely a positive sign. Specifically, real rates are what is rising The story gets better when you dig deeper. The so-called real yield is the yield of a Treasury bond after accounting for inflation expectations. We can see what this yield is in real-time by looking at Treasury Inflation-Protected Security, or TIPS, which automatically pay investors for whatever actual inflation occurs. So far in April, it has been real yields that are rising, while inflation expectations have remained about unchanged. Longer-term real yields are a function of long-term growth expectations. Hence this is the good kind of rising yields, in that it is a sign that the expansion may continue. 'Neutral' Policy Rate Rising Another way of looking at the same concept is to think about how high the Fed might be able to hike before causing economic damage. If the economy's fundamentals are very strong, the Fed may be able to hike quite high without hurting growth, and vice versa. This threshold is called the neutral policy rate, which is the rate where Fed policy is neither tight nor easy. We can't know what the neutral rate actually is at any given moment, only guess at it. What we can do is see what the market thinks the neutral rate is by observing longer-term Fed rate expectations. If we rewind to April 1, futures market pricing suggested the Fed would hike to around 3% by 2023, but then cut by three-quarters of a percentage point over the course of 2024 and 2025 to end up around 2.25%. Generally it is a good assumption that this end up around number is the market's guess at the neutral rate. Now the market is projecting a higher peak rate and a higher neutral rate. The market sees the Fed getting to around 3.25% in 2023 and then cutting to around 2.75% by 2025. Again, this is a sign of confidence. The markets think that the economy is fundamentally stronger than it assumed a few weeks ago, and therefore has revised how high it thinks the Fed can hike without causing a recession. Watch the Housing Market Interest rates have a massive impact on the whole economy, but one of the most direct effects is on the housing market. Virtually all homes are bought with a mortgage, so obviously higher rates make buying a home less affordable. As I'm sure readers have heard (or experienced), the housing market has been white hot. We hear stories of houses selling sight unseen in a matter of hours and at a price well above asking. It wouldn't be a bad thing for housing market to calm a bit, as this is not what a healthy market looks like. But we don't want to see home prices actually fall materially, nor would we want to see the pace of home building slow in a big way. Either of those would damage the economy, and likely be signs that the Fed had hiked too much. Mortgage rates have been moving higher -- so rapidly that it is hard to tell what impact it is having. The kinds of data we usually rely upon just isn't released frequently enough. Here's what we do know. Mortgage applications are tracked every week, so that's our most real-time read on activity. The bad news is that applications to buy a new home are down a decent bit. For the week ending April 15, purchase applications were down 9.7% vs. the 2021 average. The good news is that purchase applications have been in a similar range since March. In addition, the average application pace of March-April 2022 is almost exactly equal to the average from 2019. This could be a sign that home buying is slowing from 2021's breakneck pace, but it settling in at pre-Covid norms. Data on home building and sale activity is only reported monthly, so the most recent data we have is from March. For what it's worth, new home construction hit an all-time high in March, so far so good there. Existing home sales were released Wednesday, and showed a mild slowing to 5.8 million annualized pace of sales, down from 6.1 million average over the last year. Pre-Covid existing home sales generally hovered around 5.5 million, so March's figure is still quite healthy. My take is that it would be good for housing activity to slow down a bit. It was never sustainable for the housing market to remain as hot as it was in 2021. To me, the ideal scenario is that higher mortgage rates cause most prospective home buyers to change what kind of home they shop for, not drop out of the new home market entirely. That would fit what we know about demographics and home buying. Most of the time people choose to buy a new home because of their personal circumstances: getting married or having another kid. And then they figure how much they can afford and shop for houses that fit that budget. If higher yields have simply shifted while they are shopping, that would be a perfectly healthy outcome. What About Stocks? Of course I'm talking about all this optimism, but kind of ignoring the elephant in the room: It is still the case that stocks have fallen on net during this period, with the S&P 500 falling a bit more than 1% since the 2-10 curve first inverted on April 1. Since that's the financial market where readers are probably focused the most, so my points might ring a little hollow. But even here we have signs of optimism for the broader economy. Growth stocks, which due to unusually high valuations have been more interest-rate sensitive than usual, have been leading the downturn. But the more cyclically sensitive Russell 1000 Value is up about 1.5% during this period. That's been wiped out by the growth component of the index, which is down more than 5%. Ultimately stock performance is going to be about maintaining earnings growth. It may be that growth companies need to find the right valuation for a higher interest rate environment, but if the broad economy can manage to keep growing, it is very likely those more cyclical stocks continuing to advance. Cautious Optimism When people like me want to express no definitive option, declaring they are cautiously optimistic is a common go-to. It's vague enough that you can claim you were right almost, no matter what happens. And yet, I think it best describes how I feel. We know the Fed won't get inflation under control until aggregate demand weakens a bit, and therein lies a significant risk. It isn't easy to weaken the economy just enough to slow inflation, but not so much that we have a recession. And yet what little evidence we see so far isn't so bad. Housing is slowing a little but not falling off a cliff. Goods inflation declined a little last month, but overall consumer spending remains robust. And the labor market remains quite hot, which should keep household incomes pretty strong. These are the things I'll be watching most closely in the coming months: housing activity, wage growth, employment, goods inflation, and consumption. If we can see those items find a happy medium, this expansion just might keep going.

Is the Economy Throwing Us a Curveball?

Amid chatter of inflation and recession, something strange is happening with the yield curve. Let's see what it could be telling us and what other signs (hint: housing) to watch.

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