Is the yield curve a crystal ball into the future?
Mortgage rates remain unchanged over the past few weeks as investors try and gauge the impact and direction of the trade war. As long as the outcome of the trade wars remains uncertain we don’t expect much movement in rates. Since my last update a few weeks ago, we have seen more of the same positive economic news which normally would have caused rates to rise. June employment data just released last week showed unemployment ticked up slightly from 3.8% to 4.0% due to an increase in participation rate; meaning more people are looking for work now. Average hourly wages still not rising much, barely keeping up with inflation at 2.7%. Today the JOLTS report was released and and came in higher than expectations showing over 6.5 million unfilled jobs. Companies are having a hard time finding skilled workers. If you don’t like your job, now is the perfect time to learn a new skill and make a move to a better career.
The Fed raised its interest rate in June but mortgage rates stayed the same. There is a misconception that the Fed rate directly changes mortgage rates. While the Fed rate can affect mortgage rates, they are not the same. The Fed raises rates because the economy is improving to make sure it does not overheat. Investors who purchase mortgage bonds watch for signs that the economy is improving and when they see the outlook is improving, they pull back on mortgage bond purchases causing mortgage rates to rise; so in this aspect, the Fed raising rates does impact mortgage rates.
The Fed interest rate is the rate it charges banks. There is an immediate and direct impact when the Fed increases its rate on what banks charge for short term loans such as credit cards, auto and other short term bank loans. Typically mortgage rates follow suit to the Fed rate because they are both moving on economic conditions, but this is not always the case as one is a short term outlook and one is a long term outlook.
Now that we know the difference between the Fed rate and mortgage rates, let’s talk about the yield curve. The yield curve is the difference between short term and long term bonds (rates). Typically you would expect a higher yield (return on investment) for a longer term bond since the investment is riskier when you purchase a bond that matures in 10 years versus one that matures in 2 years. Right not we are seeing a flattening of the yield curve. One year ago today the difference in the yield curve was 98 bps, in January 2018 it was 54 bps, and today it is at 29 bps difference. So as an investor, would you take a longer term maturity in order to make only 29 bps more? Usually the answer is No. However, if you feel the longer term economic outlook is not good- then you may want to park your money for safety. That is why once the yield curve flattens and then inverts, meaning the yield on short term rates verses long term are actually better, a recession has always followed.
So will the yield curve invert? My crystal ball is fuzzy but the Fed says they are planning for 2 or more rate hikes this year which will increase short term rates. If the 10 year stays where it is, we will invert.
Not so fast. The bigger question is whether or not the yield curve is still a reliable indicator. The Fed’s manipulation of the markets with its aggressive bond buying program may have changed normal indicators causing a different or unexpected result. The truth is we are in unprecedented territory and we don’t know if normal economic principles still apply. Stay tuned, this is a topic we will build on.
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