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Vince Foster: Weak Wage Growth and Tight Supply Keep Bond Market's Long-Term Interest Rates in Check
Perhaps the bond market feels that the tepid growth rates in wages, retail sales, and personal consumption are now structural.
Vince Foster    

Thursday's non-farm payrolls report showed the economy added 288,000 jobs in June, blowing past the 215,000 estimates. The unemployment rate fell to 6.1%, the lowest of the recovery. The immediate spin from Wall Street was to bring forward expectations for Fed rate hikes. Some even questioned why the Fed was still providing accommodation at all. The economic elation was widespread and equity investors sent the Dow Jones (INDEXDJX:.DJI) above 17,000 for the first time.

With all the talk of economic acceleration and Fed rate hikes, you would have thought bond prices would be under significant selling pressure, as investors recalibrate their assessment of where interest rates should be priced. However bond yields took the number in stride. The 30-year Treasury backed up to the important 3.50% five-year pivot level and held strong, rallying back to nearly unchanged on the day at 3.47%. How is this possible? I was told the Fed is going to be raising interest rates sooner than expected. Bond yields should be rising.

Long-term interest rates price off of structural growth rate in nominal GDP, which is mainly a function of consumption growth, which is itself a function of wage growth. Absent credit growth, consumers can only spend what they earn. The June year-over-year growth in average hourly earnings came in at 2.0% -- a tick better than the 1.9% estimate, but down from May's 2.1% growth rate. This weak wage growth has been the norm since the economy emerged from recession. Since 2010 the YoY growth in wages has averaged 2.0%, with a remarkably tight range of 1.5% to 2.3%.

Average Hourly Earnings YoY



Economic bulls will tell you that wages are trending higher, that labor market tightness will soon push wage growth out of this anemic 2% range and that interest rates are soon to follow. Despite accelerating payrolls and a falling unemployment rate, that push is not happening; and despite anticipation for higher short-term interest rates, the long end of the curve is anchoring at this lower, and potentially structural, growth rate in wages.  
Last week the Federal Reserve Bank of New York released its June 2014 Survey of Consumer Expectations which includes the outlook on wages:

Median earnings growth expectations also remained flat at 2% annual growth. Mean household income growth expectations declined slightly to 2.3%, but remained within the narrow band (2.0 - 2.6%) observed over the last 12 months.
 
Wage Growth Expectations
 

The chart of future wage growth expectations looks just like the chart of the historical wage growth: flat at 2.0%. When you look at the demographic breakdown, the situation looks far weaker. Over the past 12 months the only groups anticipating over 2% wages are ages under age 40 at 2.7%, college educated at 2.47%, and those making over 100K at 2.5%. The weakest groups are over age 60 (baby boomers) at 1.3%, and those earning 50K or less at 1.7%.

Economic strategists on Wall Street, who are likely earning over 100K, can continue to anticipate a breakout in wage growth, but the rest of earners don't share their enthusiasm. This tepid income growth is likely one of the main contributors to weak mortgage credit demand since last year's 100-basis-point move in long-term interest rates. I addressed this decline in mortgage credit demand and impact on interest rates back in February in For Interest Rates, Mortgages Are the Tail Wagging the Dog:

In the interest rate complex, mortgages are the tail wagging the dog. Mortgages represent the single largest form of consumer credit demand, and nominal interest rates are a function of nominal spending, which is highly sensitive to changes in the price of credit. Absent mortgage credit demand, there is little pressure on the cost of credit, thus it's hard to see MBS yields rise in the context of a shrinking supply of mortgage loans.

Last week Bank of America Merrill Lynch MBS strategists Chris Flanagan and Gregory Fitter addressed this supply deficit as a catalyst for low interest rates.

Gross supply is projected to drop by $1.1 trillion, from $7.4 trillion to $6.3 trillion, and net supply is projected to drop $150 billion, from $1.8 trillion to $1.7 trillion. In both instances, the declines are driven primarily by the drop in agency MBS production.
 
BAML Cross-Sector Gross and Net Issuance

 
It needs to be stated once again. The residential mortgage market is unique among all credit markets because it once was the largest market in terms of size and it has been ground zero for post-crisis litigation, which, in our view, has permanently, or at least for a very long time, altered the "trust" part of the mortgage credit decision. As a result, it is no longer the dominant market it once was, which has dramatically altered the technical conditions of the US and global fixed income markets. Very simply, what we think that means is that while the Fed continues to provide extraordinary policy accommodation, it likely will continue to appear as if there are not enough fixed income assets to go around. That will be especially true in securitized products. We continue to have difficulty envisioning meaningful, sustainable upward pressure on yields, especially longer term yields, and spreads while this weakness in residential mortgage production persists.

This echoes what I said ex-ante back in February, and there is no doubt, the decline in mortgage supply has been stark.  The annual supply of MBS agency securities has been running at a $1.5 trillion pace over the past four years, however through the first half of the year production is running at half that amount.

Clearly the higher cost of credit dampened credit demand and, maybe worse, the ability to qualify for credit. This presents an interesting paradox for fixed income investors. As interest rates rise and the cost of credit becomes more expensive to borrowers, there is less supply of production for investors to own, at a time when these cheaper assets would presumably attract more demand. The market may already be reflecting this supply/demand imbalance, just as I concluded in Mortgages Are the Tail Wagging the Dog:

MBS market participants substantially reduced exposure due to Fed tapering, and in the process, pushed yields to levels that substantially reduced credit demand. As the Fed transitions ownership of new origination to economic buyers, the market will seek equilibrium interest rates where MBS demand can find mortgage credit supply. Evidence suggests this rate is at best in line and at worst much lower. Mortgages aren't cheap, but neither is anything else. And with higher yields cutting off supply, they may be near fair value, thus keeping the overall level of interest rates low.

The July 5, 2013 payroll report saw a 25-basis-point bloodbath taking the 10-year from 2.50% to 2.75% and the 30-year from 3.50% to 3.75%. A year later, the story in fixed income markets is that these yields have exhibited the same lack of volatility as wage growth and today are essentially in the same spot, as are wages.

Ten-Year and 30-Year Yield



It's as if the yield curve knew where it needed to be and went straight there. Meanwhile the market has had a year to figure out where it should be as the Fed begins raising rates, and it hasn't moved -- maybe because wages are growing at 2.0%, corporate revenues are growing at 2.8%, retail sales (ex food and autos) are growing at 2.8%, and personal consumption expenditures are growing at 3.4%. Maybe the bond market sees these growth rates as structural. 

The consensus sees long-term interest rates much higher once the Fed starts raising interest rates. But bond market participants do not buy 3.5% 30-year bonds because they think they are worth 4.5%. Bond market participants are pricing long-term interest rates around the structural growth rate in income and consumption. By that measure today they look pretty close to fair value. After Thursday's session the bond market seems to agree.

Twitter: @exantefactor
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No positions in stocks mentioned.
Vince Foster: Weak Wage Growth and Tight Supply Keep Bond Market's Long-Term Interest Rates in Check
Perhaps the bond market feels that the tepid growth rates in wages, retail sales, and personal consumption are now structural.
Vince Foster    

Thursday's non-farm payrolls report showed the economy added 288,000 jobs in June, blowing past the 215,000 estimates. The unemployment rate fell to 6.1%, the lowest of the recovery. The immediate spin from Wall Street was to bring forward expectations for Fed rate hikes. Some even questioned why the Fed was still providing accommodation at all. The economic elation was widespread and equity investors sent the Dow Jones (INDEXDJX:.DJI) above 17,000 for the first time.

With all the talk of economic acceleration and Fed rate hikes, you would have thought bond prices would be under significant selling pressure, as investors recalibrate their assessment of where interest rates should be priced. However bond yields took the number in stride. The 30-year Treasury backed up to the important 3.50% five-year pivot level and held strong, rallying back to nearly unchanged on the day at 3.47%. How is this possible? I was told the Fed is going to be raising interest rates sooner than expected. Bond yields should be rising.

Long-term interest rates price off of structural growth rate in nominal GDP, which is mainly a function of consumption growth, which is itself a function of wage growth. Absent credit growth, consumers can only spend what they earn. The June year-over-year growth in average hourly earnings came in at 2.0% -- a tick better than the 1.9% estimate, but down from May's 2.1% growth rate. This weak wage growth has been the norm since the economy emerged from recession. Since 2010 the YoY growth in wages has averaged 2.0%, with a remarkably tight range of 1.5% to 2.3%.

Average Hourly Earnings YoY



Economic bulls will tell you that wages are trending higher, that labor market tightness will soon push wage growth out of this anemic 2% range and that interest rates are soon to follow. Despite accelerating payrolls and a falling unemployment rate, that push is not happening; and despite anticipation for higher short-term interest rates, the long end of the curve is anchoring at this lower, and potentially structural, growth rate in wages.  
Last week the Federal Reserve Bank of New York released its June 2014 Survey of Consumer Expectations which includes the outlook on wages:

Median earnings growth expectations also remained flat at 2% annual growth. Mean household income growth expectations declined slightly to 2.3%, but remained within the narrow band (2.0 - 2.6%) observed over the last 12 months.
 
Wage Growth Expectations
 

The chart of future wage growth expectations looks just like the chart of the historical wage growth: flat at 2.0%. When you look at the demographic breakdown, the situation looks far weaker. Over the past 12 months the only groups anticipating over 2% wages are ages under age 40 at 2.7%, college educated at 2.47%, and those making over 100K at 2.5%. The weakest groups are over age 60 (baby boomers) at 1.3%, and those earning 50K or less at 1.7%.

Economic strategists on Wall Street, who are likely earning over 100K, can continue to anticipate a breakout in wage growth, but the rest of earners don't share their enthusiasm. This tepid income growth is likely one of the main contributors to weak mortgage credit demand since last year's 100-basis-point move in long-term interest rates. I addressed this decline in mortgage credit demand and impact on interest rates back in February in For Interest Rates, Mortgages Are the Tail Wagging the Dog:

In the interest rate complex, mortgages are the tail wagging the dog. Mortgages represent the single largest form of consumer credit demand, and nominal interest rates are a function of nominal spending, which is highly sensitive to changes in the price of credit. Absent mortgage credit demand, there is little pressure on the cost of credit, thus it's hard to see MBS yields rise in the context of a shrinking supply of mortgage loans.

Last week Bank of America Merrill Lynch MBS strategists Chris Flanagan and Gregory Fitter addressed this supply deficit as a catalyst for low interest rates.

Gross supply is projected to drop by $1.1 trillion, from $7.4 trillion to $6.3 trillion, and net supply is projected to drop $150 billion, from $1.8 trillion to $1.7 trillion. In both instances, the declines are driven primarily by the drop in agency MBS production.
 
BAML Cross-Sector Gross and Net Issuance

 
It needs to be stated once again. The residential mortgage market is unique among all credit markets because it once was the largest market in terms of size and it has been ground zero for post-crisis litigation, which, in our view, has permanently, or at least for a very long time, altered the "trust" part of the mortgage credit decision. As a result, it is no longer the dominant market it once was, which has dramatically altered the technical conditions of the US and global fixed income markets. Very simply, what we think that means is that while the Fed continues to provide extraordinary policy accommodation, it likely will continue to appear as if there are not enough fixed income assets to go around. That will be especially true in securitized products. We continue to have difficulty envisioning meaningful, sustainable upward pressure on yields, especially longer term yields, and spreads while this weakness in residential mortgage production persists.

This echoes what I said ex-ante back in February, and there is no doubt, the decline in mortgage supply has been stark.  The annual supply of MBS agency securities has been running at a $1.5 trillion pace over the past four years, however through the first half of the year production is running at half that amount.

Clearly the higher cost of credit dampened credit demand and, maybe worse, the ability to qualify for credit. This presents an interesting paradox for fixed income investors. As interest rates rise and the cost of credit becomes more expensive to borrowers, there is less supply of production for investors to own, at a time when these cheaper assets would presumably attract more demand. The market may already be reflecting this supply/demand imbalance, just as I concluded in Mortgages Are the Tail Wagging the Dog:

MBS market participants substantially reduced exposure due to Fed tapering, and in the process, pushed yields to levels that substantially reduced credit demand. As the Fed transitions ownership of new origination to economic buyers, the market will seek equilibrium interest rates where MBS demand can find mortgage credit supply. Evidence suggests this rate is at best in line and at worst much lower. Mortgages aren't cheap, but neither is anything else. And with higher yields cutting off supply, they may be near fair value, thus keeping the overall level of interest rates low.

The July 5, 2013 payroll report saw a 25-basis-point bloodbath taking the 10-year from 2.50% to 2.75% and the 30-year from 3.50% to 3.75%. A year later, the story in fixed income markets is that these yields have exhibited the same lack of volatility as wage growth and today are essentially in the same spot, as are wages.

Ten-Year and 30-Year Yield



It's as if the yield curve knew where it needed to be and went straight there. Meanwhile the market has had a year to figure out where it should be as the Fed begins raising rates, and it hasn't moved -- maybe because wages are growing at 2.0%, corporate revenues are growing at 2.8%, retail sales (ex food and autos) are growing at 2.8%, and personal consumption expenditures are growing at 3.4%. Maybe the bond market sees these growth rates as structural. 

The consensus sees long-term interest rates much higher once the Fed starts raising interest rates. But bond market participants do not buy 3.5% 30-year bonds because they think they are worth 4.5%. Bond market participants are pricing long-term interest rates around the structural growth rate in income and consumption. By that measure today they look pretty close to fair value. After Thursday's session the bond market seems to agree.

Twitter: @exantefactor
< Previous
  • 1
Next >
No positions in stocks mentioned.
Daily Recap
Vince Foster: Weak Wage Growth and Tight Supply Keep Bond Market's Long-Term Interest Rates in Check
Perhaps the bond market feels that the tepid growth rates in wages, retail sales, and personal consumption are now structural.
Vince Foster    

Thursday's non-farm payrolls report showed the economy added 288,000 jobs in June, blowing past the 215,000 estimates. The unemployment rate fell to 6.1%, the lowest of the recovery. The immediate spin from Wall Street was to bring forward expectations for Fed rate hikes. Some even questioned why the Fed was still providing accommodation at all. The economic elation was widespread and equity investors sent the Dow Jones (INDEXDJX:.DJI) above 17,000 for the first time.

With all the talk of economic acceleration and Fed rate hikes, you would have thought bond prices would be under significant selling pressure, as investors recalibrate their assessment of where interest rates should be priced. However bond yields took the number in stride. The 30-year Treasury backed up to the important 3.50% five-year pivot level and held strong, rallying back to nearly unchanged on the day at 3.47%. How is this possible? I was told the Fed is going to be raising interest rates sooner than expected. Bond yields should be rising.

Long-term interest rates price off of structural growth rate in nominal GDP, which is mainly a function of consumption growth, which is itself a function of wage growth. Absent credit growth, consumers can only spend what they earn. The June year-over-year growth in average hourly earnings came in at 2.0% -- a tick better than the 1.9% estimate, but down from May's 2.1% growth rate. This weak wage growth has been the norm since the economy emerged from recession. Since 2010 the YoY growth in wages has averaged 2.0%, with a remarkably tight range of 1.5% to 2.3%.

Average Hourly Earnings YoY



Economic bulls will tell you that wages are trending higher, that labor market tightness will soon push wage growth out of this anemic 2% range and that interest rates are soon to follow. Despite accelerating payrolls and a falling unemployment rate, that push is not happening; and despite anticipation for higher short-term interest rates, the long end of the curve is anchoring at this lower, and potentially structural, growth rate in wages.  
Last week the Federal Reserve Bank of New York released its June 2014 Survey of Consumer Expectations which includes the outlook on wages:

Median earnings growth expectations also remained flat at 2% annual growth. Mean household income growth expectations declined slightly to 2.3%, but remained within the narrow band (2.0 - 2.6%) observed over the last 12 months.
 
Wage Growth Expectations
 

The chart of future wage growth expectations looks just like the chart of the historical wage growth: flat at 2.0%. When you look at the demographic breakdown, the situation looks far weaker. Over the past 12 months the only groups anticipating over 2% wages are ages under age 40 at 2.7%, college educated at 2.47%, and those making over 100K at 2.5%. The weakest groups are over age 60 (baby boomers) at 1.3%, and those earning 50K or less at 1.7%.

Economic strategists on Wall Street, who are likely earning over 100K, can continue to anticipate a breakout in wage growth, but the rest of earners don't share their enthusiasm. This tepid income growth is likely one of the main contributors to weak mortgage credit demand since last year's 100-basis-point move in long-term interest rates. I addressed this decline in mortgage credit demand and impact on interest rates back in February in For Interest Rates, Mortgages Are the Tail Wagging the Dog:

In the interest rate complex, mortgages are the tail wagging the dog. Mortgages represent the single largest form of consumer credit demand, and nominal interest rates are a function of nominal spending, which is highly sensitive to changes in the price of credit. Absent mortgage credit demand, there is little pressure on the cost of credit, thus it's hard to see MBS yields rise in the context of a shrinking supply of mortgage loans.

Last week Bank of America Merrill Lynch MBS strategists Chris Flanagan and Gregory Fitter addressed this supply deficit as a catalyst for low interest rates.

Gross supply is projected to drop by $1.1 trillion, from $7.4 trillion to $6.3 trillion, and net supply is projected to drop $150 billion, from $1.8 trillion to $1.7 trillion. In both instances, the declines are driven primarily by the drop in agency MBS production.
 
BAML Cross-Sector Gross and Net Issuance

 
It needs to be stated once again. The residential mortgage market is unique among all credit markets because it once was the largest market in terms of size and it has been ground zero for post-crisis litigation, which, in our view, has permanently, or at least for a very long time, altered the "trust" part of the mortgage credit decision. As a result, it is no longer the dominant market it once was, which has dramatically altered the technical conditions of the US and global fixed income markets. Very simply, what we think that means is that while the Fed continues to provide extraordinary policy accommodation, it likely will continue to appear as if there are not enough fixed income assets to go around. That will be especially true in securitized products. We continue to have difficulty envisioning meaningful, sustainable upward pressure on yields, especially longer term yields, and spreads while this weakness in residential mortgage production persists.

This echoes what I said ex-ante back in February, and there is no doubt, the decline in mortgage supply has been stark.  The annual supply of MBS agency securities has been running at a $1.5 trillion pace over the past four years, however through the first half of the year production is running at half that amount.

Clearly the higher cost of credit dampened credit demand and, maybe worse, the ability to qualify for credit. This presents an interesting paradox for fixed income investors. As interest rates rise and the cost of credit becomes more expensive to borrowers, there is less supply of production for investors to own, at a time when these cheaper assets would presumably attract more demand. The market may already be reflecting this supply/demand imbalance, just as I concluded in Mortgages Are the Tail Wagging the Dog:

MBS market participants substantially reduced exposure due to Fed tapering, and in the process, pushed yields to levels that substantially reduced credit demand. As the Fed transitions ownership of new origination to economic buyers, the market will seek equilibrium interest rates where MBS demand can find mortgage credit supply. Evidence suggests this rate is at best in line and at worst much lower. Mortgages aren't cheap, but neither is anything else. And with higher yields cutting off supply, they may be near fair value, thus keeping the overall level of interest rates low.

The July 5, 2013 payroll report saw a 25-basis-point bloodbath taking the 10-year from 2.50% to 2.75% and the 30-year from 3.50% to 3.75%. A year later, the story in fixed income markets is that these yields have exhibited the same lack of volatility as wage growth and today are essentially in the same spot, as are wages.

Ten-Year and 30-Year Yield



It's as if the yield curve knew where it needed to be and went straight there. Meanwhile the market has had a year to figure out where it should be as the Fed begins raising rates, and it hasn't moved -- maybe because wages are growing at 2.0%, corporate revenues are growing at 2.8%, retail sales (ex food and autos) are growing at 2.8%, and personal consumption expenditures are growing at 3.4%. Maybe the bond market sees these growth rates as structural. 

The consensus sees long-term interest rates much higher once the Fed starts raising interest rates. But bond market participants do not buy 3.5% 30-year bonds because they think they are worth 4.5%. Bond market participants are pricing long-term interest rates around the structural growth rate in income and consumption. By that measure today they look pretty close to fair value. After Thursday's session the bond market seems to agree.

Twitter: @exantefactor
< Previous
  • 1
Next >
No positions in stocks mentioned.
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