The Week that Shook the Bond Markets

Over the past year, we’ve seen multiple moves in the 10-year treasury yield that you would expect to see once every 5 years.

Just this past week, the 10-year yield basically fell from 5% to 4.5% in 3 days, which is an insane move by historical standards.

Let’s take a look at why this happened, what this means for mortgage rates, and therefore what’s going to happen to real estate prices.

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The Treasury Refunding Announcement and Why it Matters

Last Wednesday, the US Treasury released its quarterly announcement of how much debt it was issuing and at what term.

This quarter, they announced that they plan to issue $112 billion in securities in order to fund government expenses.

Great, the government is spending money like crazy, what part of this is supposed to be new exactly?

The part of the announcement that really moved markets was the fact that the Treasury decreased the amount of 10-year and 30-year bonds that it will issue in favor of shorter-term treasuries.

I’ve covered bond pricing dynamics many times before (refer to the Bond Pricing section of this newsletter if you need a refresher: The SVB Fallout and the Future of the Economy | LinkedIn), so I won’t go into the details again. I’m going to assume that you understand that bond prices and bond yields are inversely correlated.

Let's consider the Treasury’s effect on the bond market until now. Previously, they were issuing 10-year bonds in greater quantities. Since they were flooding the market with new bonds, that was causing the prices of those 10-year bonds to fall, causing interest rates to rise.

Now, they’ve announced that they plan to issue less 10-year bonds, which means that there will be less supply of those bonds in the future. Investors then priced in this scarcity immediately, causing the prices of these bonds to go up, and therefore causing yields to fall.

This is a critical driver of the massive move in yields that we saw this week.

The Fed Pause

By now, we've all seen that the Fed paused their rate hikes for a second meeting in a row, and the market consensus is that they're done hiking for good.

This definitely bond yields drop; less rate hikes mean a lower average interest rate in the future, which allows bond yields to drop.

I just wanted to highlight a few interesting things that Jerome Powell mentioned during the press conference.

The statement that really stood out to me was the following: "We're getting reports from housing that the effects of [higher interest rates] could be quite significant."

It would be really interesting to get more insight into that statement; is he talking about preliminary reports that haven't been published yet? And if so, it would be interesting to see what significant effects he's talking about.

If it's a further collapse in transactions, that wouldn't be too surprising. But if it's something more insidious, that could be a problem. This is something I'll continue to follow up on and monitor.

Besides that, Powell also mentioned a few things that I liked to hear.

First, he said that inflation moderated over the summer, but it still has a long way to go to get to 2%.

It was nice to hear him acknowledge that inflation was coming down; I think he had to add in the "long way from 2%" to not seem too dovish.

He also said long term inflation expectations from a variety of surveys remained anchored. This is also pretty good news. Inflation is a self-fulfilling prophecy in a way: if people believe high inflation will become the norm, they know that the things they want will be more expensive in the future. Therefore, they're more likely to buy that stuff now when it's cheaper. But, if everyone thinks like that, this pulls demand from the future into the present, which makes everyone bid up prices and ends up causing inflation.

Therefore, having anchored long term inflation expectations is great because it prevents that self-fulfilling prophecy from happening.

He also mentioned that, although the labor markets remain tight, the supply/demand conditions are coming into balance. This was also great to hear: he's acknowledging that labor is slowly returning to equilibrium, and it actually sounds like he's no longer aiming for a job loss recession.

The final thing I wanted to cover was something that really made me step back and think. Jerome Powell was asked a question about why the economy has remained resilient even though inflation has come down.

Powell responded by saying that there were two main drivers of inflation reduction. One is the unwinding of the supply/demand distortions from pandemic. The second is the tighter monetary policy that they've instituted. The former can bring down inflation without lower growth and higher unemployment.

That sounds pretty reasonable.

But it got me thinking: if the economy is still this strong despite inflation dropping so much, doesn't that mean that most of the inflation reduction we've had so far came from pandemic distortions unwinding and not from monetary policy? And therefore, we have yet to see a lot of the effects of monetary policy?

Hopefully I'm not overthinking this, because if we haven't felt the bulk of the effects of the rate hikes yet, I think the economy is in for some trouble.

The Loosening Labor Market

Unemployment hit 3.9%, 50 bps above bottom of 3.4%.?

This is "good" in the sense that it indicates that the labor market is loosening a bit.

But in reality, the number isn't what it seems. The United Auto Workers strike decreased the manufacturing payrolls data by about 33k jobs.

More interestingly, jobs added in August and September were actually revised down by 101k, indicating that the labor market was as tight as it seemed.

Finally, wage growth also came down to 4.1% YoY, which is the lowest it's been since June 2021.

As I've discussed many times in the past, wage growth is important to monitor because it directly feeds into inflation. When workers have more disposable income, they're able to spend more on goods and services, and therefore bidding up the prices.

Wage growth is something the Fed tracks closely, so it's good to see that wage growth is moderating as well.

Conclusion

This was a crazy week for the markets.

As of Friday, the 10-year treasury closed at 4.589%, and the average 30-year mortgage ended at 7.38%. This nets out to a spread of roughly 279 bps, which is really significant given that the spread has persistently been around 300 bps.

I've been saying for a while now that I think the mortgage rate spread can start to come down once we hit the terminal Fed funds rate.

I think the second Fed pause in a row, along with all the other relatively soft economic data we saw last week, might have started to convince the markets and mortgage lenders that we're at the peak Fed funds rate.

If we see the mortgage rate spread revert to the historical average of around 180 bps, we could see mortgage rates in the mid 6s even if the 10-year doesn't drop any more.

I think the smartest thing to do from here is to closely monitor the spread between the 10 year and mortgages. If we see the spread continue to compress, it might be a good sign for the single-family real estate market. I have a suspicion that we'll see activity roar back if we return to mortgage rates in the low 6s.

That's all for this week!