With the media-manufactured “systemic banking crisis” apparently behind us, the bond market has returned its focus to inflation data. As a result, yields have returned to near March levels, and the inversion in the curve has reached its steepest point this cycle. Housing is in full decline, and while recent data for some markets has shown very slight gains, it is too soon to call a rebound. Other signs point to emerging economic weakness, as the economy faces significant headwinds.
Yield Curve and Monetary Policy:
The two-year Treasury yield rose by 81bp in the second quarter to 4.87%, testing the high-water mark for the year, as resumed concerns over further rate hikes supplanted fears of a banking crisis. The ten-year yield increased by 48bp to 3.81% to end the quarter. The current inversion in the yield curve is the steepest during this rate cycle at more than 105bp, a clear signal of anticipated future recessionary conditions. The Fed funds target range has increased 500bp since March 2022.
Fed funds futures have priced in more than a 90% probability of another 25bp rate hike in July, with consensus expectations for no further tightening, but that the Fed will move to an accommodative posture by mid-2024 due to emerging economic weakness. The consensus of the FOMC’s own dot plot also foresees modest accommodation commencing next year.
Housing Market Trends:
The widespread housing bubble that persisted in the U.S. for 20 months has ended, cut off by sharply rising mortgage rates and higher prices that impeded affordability for many buyers. The average 30-year fixed mortgage rate is hovering near 7%. All 20 markets in the S&P/Case-Shiller Composite Index have declined on a year-over-year basis for several months, and eleven of the markets in the composite index are down year-over-year.
Several markets have posted recent month-over-month gains on a seasonally-adjusted basis, but those gains were very modest, and in some cases only resulted from the seasonal adjustments. Given the possibility of further rate hikes driving mortgage rates still higher, and emerging economic weakness, it’s too early to call an end to the housing market decline.
Auto Sales:
Auto sales remain somewhat muted relative to pre-pandemic levels. Sales in May were an annualized 15.1 million units, roughly the same as they’ve been for the last several months. Used car demand has tapered off somewhat, as the Manheim Used Vehicle Value Index fell to 217.3 in June (1995=100), the lowest level since August 2021.
Labor Market:
Unemployment held steady at 3.6% in June, and nonfarm payrolls grew by less than expected for the month. Nonfarm payrolls have recovered all of the jobs eliminated when the economy was shut down in response to the pandemic, but that still doesn’t account for growth, which would have added roughly four million jobs relative to where we are today. This explains the gap between current job openings and the trend level of openings in 2019. To reach equilibrium will require either another year or more of above-trend payroll growth, or a recession to bring down the level of job openings. The latter appears more likely; job openings have declined by more than 2 million since March 2022 and the rate of voluntary quits is down sharply since April of this year, while initial jobless claims are elevated.
GDP Growth and Economic Expectations:
GDP increased by just 1.3% in the first quarter after growing by a revised 2.6% in the fourth quarter. The economy is expected to weaken further in 2023. Indicators include the inverted yield curve mentioned above; consumer sentiment at recessionary levels; flagging manufacturing indicators; and LEI year-over-year in negative territory.
Inflationary Pressures:
CPI is up 4.0% year-over-year as of May. While the headline reading is down from the 9.0% peak in 2022, core inflation pressures remain, which are expected to influence the FOMC to tighten at least one more time this cycle, in July.