The Insane Market Moves of the Past Week: CPI, Bond Markets, and Mortgage Rates

Your eyes aren't playing tricks on you: the chart above really does show that the average 30 year mortgage rate dropped 60 basis points in one day.

This is the type of mortgage rate move that normally takes months; seeing it happen in a single day is crazy.

So what exactly happened last week, how did we get such a massive mortgage rate move, and what's next for real estate and the broader economy?

CPI Deep Dive

I already wrote a short post about my high level thoughts on the CPI print soon after it happened. However, now that I've had time to digest the report and take in some broader market data, I have some additional thoughts that I can share.

To recap, both headline and core CPI came in below expectations (7.7% and 6.3% year-over-year growth respectively).

Let's take a look at the breakdown of the CPI report:

It's interesting to see that we finally have some categories below 0. It looks like the drop in car prices has finally started to work its way into CPI. Additionally, the inventory glut that many have been discussing appears to have worked its way into apparel prices as well.

As for the positive categories, it looks like shelter still makes up a significant portion. It's commonly understood that shelter CPI actually lags behind real world data; rents have rolled over slightly in some markets and house prices are seasonally down as well, but shelter inflation still makes up 0.3% of the monthly inflation. If the current trends continue, I could see a world in which shelter inflation starts to steadily retreat as well.

There's some more good news for inflation going forward. According to the NY Fed Global Supply Chain Pressure Index, we're currently only 1 standard deviation over the historical average (compared to around a 3 standard deviation peak during the pandemic):

In addition, China has indicated that they're going to start relaxing their zero Covid policies. If we see less restriction in China, this could further relieve supply chain pressures.

Based on the evidence, I'm cautiously optimistic.

Bear Market Rally or Market Bottom?

Based on what I've seen, I think it's likely that the market moves we saw last week were the result of a short squeeze.

Without getting too into the weeds, basically everyone was betting that stocks and bond prices would fall because everyone thought we'd get a bad CPI print. Betting that prices will fall involves selling the asset with the goal of buying it back at a lower price later and profiting the difference. When CPI turned out to be much lower than everyone expected, traders had to buy stocks and bonds to close out their negative bet, putting upward pressure on prices and causing a huge move in stocks and bonds.

Therefore, I don't think that we've hit an inflection point in markets. This could be a short term relief, but there are still a lot of long term factors putting downward pressure on markets.

The most important thing to remember is the biggest takeaway from my previous Linkedin post: Jerome Powell would much rather tighten too much and turn the money printer back on if he breaks something than tighten too slowly.

We're definitely not out of the woods yet.

The Potential Impact on Real Estate

As I mentioned at the start of the article, we saw a massive drop in mortgage rates on the CPI news.

This was mostly due to the drop in the 10 year treasury rate. However, there's another way that mortgage rates can continue to drop. Historically, mortgage rates are larger than the 10 year treasury yields by a certain margin. The historical spread is somewhere around 1.5%, but since the Fed started hiking, the spread has gone up to almost 3%.

Lenders are adding an extra buffer between the treasury and 10 year to make up for uncertainty about future rates; in addition, the Fed pulled out of the MBS market after they started tightening, which removed some downward pressure on mortgage rates.

If, for example, the Fed came out and stated that they're hiking to a terminal rate of 5%, or they come out and say that they will reenter the MBS market, the spread will drop down. For example, if the spread drops to 1.7%, then the average mortgage rate at today's 10 year treasury rate would be 5.58%.

While this clearly won't return the real estate market to the fervor of the past two years, I think rates in the 5% range will stabilize the real estate markets.

This is just a hypothetical though; I don't think the Fed will do either of these things, so in the short term, we're stuck with higher rates.

So What Should We Do With This Information?

Probably nothing. As I've said, I think it's too early to tell where things are trending. We had a surprise gain in CPI last month when everyone thought we had established a downtrend, which caused markets to tank.

While I see a lot of evidence that supply chain constraints are easing, and people are starting to deleverage, commodity prices just had their biggest weekly gain since the 1960s. In addition, wage growth is still extremely elevated (6.4% YoY in October) which definitely puts a positive pressure on inflation.

To conclude, while things are looking better, don't assume that inflation has been beaten. The Fed still has plenty of work to do.