First signs of rate-driven weakness in the housing sector

Today Citi and some other banks quoted the 30-year conforming mortgage rate at 4.625%. Others are quoting the rate even higher (see national averages below).

Source: Mortgage News Daily 

Once again, it's a low rate by historical standards, making many economists think that the housing sector is unlikely to be impacted. The markets say otherwise. Over the past three months, the Philadelphia Housing Index has underperformed the S&P500 by 9%.

Source: Ycharts

For the first time in a while, US homebuilders are becoming concerned. While sales expectations continue to be strong (given demographics-driven housing demand), the ISI Homebuilders Sales Survey turned down in recent weeks.

Source: The ISI Group

These higher rates may already be showing up in the employment numbers. In spite of the strong US employment report today, on a seasonally adjusted basis almost no new jobs have been created in residential construction in June (chart below).

SoberLook.com

From our sponsor:

US, EMG nations are on different economic cycles - adding to pressure on developing economies

Emerging markets are under pressure once again. The Turkish lira is touching new lows, driven by a number of factors, including civil unrest in Egypt and more importantly rising rates in the US. Turkey also surprised investors with a higher than expected inflation reading of 8.3%.

USD/TRY (Turkish lira per one dollar; source: Investing.com)

The Indian rupee touched a new low of 61 and currencies are weakening elsewhere in emerging markets as well - as capital flight continues.

Bond yields are moving up across the board, just when emerging markets nations can least afford it. The HSBC emerging markets composite PMI index hit the lowest level since 2009, showing stagnating growth in developing economies.

Source: Markit

What makes this particularly troubling is that the US and emerging market nations are on a different economic cycle. As US rates rise, many emerging nations in fact need interest rates that are stable or lower. Brazil for example does not need government bond yields above 11% right now. But that's exactly what the nation is dealing with for maturities longer than three years.

Moreover, liquidity in emerging market bonds has collapsed as market makers exited. Just as the case with US corporate bonds (see post), US dealers no longer hold significant inventories of emerging markets bonds (thanks to the Volcker Rule). At the same time international investors' holdings of emerging market debt have been at historically high levels. Remember that most bonds don't trade on an exchange - they are over-the-counter products that require market makers for the market to function well. So when people call their broker to sell that emerging markets bond ETF, there are not many people to buy the actual bonds on the other end. That makes selloffs sharp and disorderly, forcing more active investors to run for the exits.

SoberLook.com

From our sponsor:

As Portugal's yield curve flattens, Draghi is put on the spot once again

Financial news junkies love the Eurozone. Just when things seem to quiet down, something always flares up in the region. This time around it is Portugal that has been grabbing the headlines.

The Economist: - NO ONE is likely to emerge a winner from the political disarray triggered in Portugal by the resignations of the finance and foreign ministers. For two years the country has won plaudits as the best behaved of peripheral Europe’s bailed-out countries. But voters have tired of the relentless austerity that Portugal has had to endure under the terms of its €78 billion bail-out programme, and the repercussions appear to have split the two-party coalition government. Portugal’s international creditors, the “troika” of the EU, the IMF and the European Central Bank, are seeing their star pupil brought low by the political and social costs of implementing their rescue plan.

CDS spread hit the high for the year - though nothing close to historical highs.

Source: DB (dates in European format)

And while the media has been focused on the 10-year bond yields spiking, the real action has been in the short end of the curve. The 2-year paper for example moved by some 150 bp in a matter of days.

Source: Investing.com

In fact the yield curve flattened in a manner reminiscent of the dark days of the Eurozone crisis (see post).

One of the concerns with respect to Portugal is that officially the nation may not qualify for the OMT support - the ECB's bond buying guarantee. That's because when the OMT program was announced (less than a year ago), it was aimed at nations that have not yet received the full bailout package from the EU/IMF (which Portugal has). The idea was to limit it to nations that still have "market access". And without the OMT backstop - which is expected to target the short end of the curve - Portugal's short-term paper is vulnerable, resulting in higher short-term yields. That will hurt Portugal's economy because now even shorter dated loans will become expensive (in spite of ECB's overnight rates at 0.5%).

The IMF has been pressuring  Mario Draghi to include Portugal in the OMT program for some time. The IMF is clearly concerned about having to provide additional support for Portugal (see post) and would rather see the ECB come to the rescue.

Bloomberg: - “Eligibility to the ECB’s Outright Monetary Transaction [OMT] program would also go some way in helping improve the monetary transmission mechanism [see post] in Portugal and secure durable market access,” the [IMF] said in a staff report about the seventh review of the aid program for Portugal.

Now the pressure is on the ECB to make an exception for Portugal. From the beginning analysts have said that Portugal should be the first candidate for the program (see discussion). However if the central bank does so, Greece may request the same support from the ECB as well, making the whole process politically tricky. The ECB certainly does not want to be buying Greek bonds at this juncture. Mario Draghi, who officially stated that Portugal will be excluded from the OMT (see post), is once again asked to solve structural and political problems that should not be the purview of an independent central bank.

SoberLook.com

From our sponsor:

Two contributors to crude oil spike

While nobody wanted to pay any attention to Egypt ten days ago (see post), all of a sudden the situation there is grabbing headlines. These protests were planned, June 30th was the starting date, and the military has been posturing for some time. And now that we've had the coup, the generals own Egypt's economic mess.

Crude oil popped above $101 in response to Egypt's unrest and its potential implications for the Middle East as a whole. The "Middle East premium" is back in play.

But another, more domestically based surprise driving WTI crude higher was an unexpected and quite sharp decline in US crude oil inventories.

Source: EIA

Some are attributing this decline in crude stocks to higher interest rates, which make storage of crude (cost of carry) more expensive. Perhaps. A better explanation however is the improved transport to the Gulf Coast refineries and a somewhat higher demand for refined products.

Source: EIA

This is not great news for the US consumer. The higher mortgage rates and the end to the mortgage refinancing spree were to some extent offset by a bit lower gasoline prices (although prices are still up on the year).

Source: GasBuddy.com

But given the spike in crude, that benefit of lower gas prices has ended for now. Consumers will pay more at the pump - and spend less elsewhere.

SoberLook.com

From our sponsor:

This 4th of July let's celebrate all the economic improvements in the US

As we approach the 4th of July weekend, there are plenty of reasons to celebrate all the economic improvements we've witnessed in the US recently. After all, the Fed is talking "taper" because economic conditions are so much better than they were a year ago when the current round of quantitative easing was launched. Among other things, the nation is undergoing a manufacturing Renaissance. Except we ran into a bit of a "soft patch" this spring.

Chris Williamson, Chief Economist, Markit [June Manufacturing PMI]: - Manufacturing clearly down-shifted a gear between the first and second quarters, and is at risk of losing further momentum as we head into the second half of the year.

Output growth remained well down on the robust pace seen at the start of the year and persistent weak order book growth suggests the sector is at risk of stalling. Domestic demand is far from lively, but it is a deteriorating export scene that is causing the real problems. Export orders are being lost at the fastest rate since the height of the financial crisis in mid-2009.

Firms are responding to the increasingly worrying order book trend by pulling back on recruitment. The employment picture from the survey is the weakest for almost three-and-a-half years, consistent with roughly 30,000 jobs being lost per month in the manufacturing sector. We will need to see a swift turnaround in this employment trend if the Fed’s projection of a drop in the unemployment rate to 7.0% by the end of the year is to be achieved.

Right, the old order book, which is the key forward looking indicator for manufacturing, seems to show some pull-back.

Let's just ignore this Markit PMI measure for now. Instead we want to focus on the ISM Manufacturing index, which did in fact show an improvement in June - all thanks to the Fed's securities purchase program.

Finding it a bit difficult to hang your hat on this June "turnaround"? No worries. Manufacturing represents only a fraction of total US output and hiring. After all, it's a service economy. So let's take a look an the latest non-manufacturing indicator.

Bloomberg: - Service industries in the U.S. unexpectedly expanded in June at the slowest pace in more than three years, indicating widespread progress may elude the world’s largest economy even as manufacturing improves [?].

The Institute for Supply Management’s non-manufacturing index dropped to 52.2 last month, the lowest reading since February 2010, from 53.7 in May, a report from the Tempe, Arizona-based group showed today. The median forecast in a Bloomberg survey called for a rise to 54. A reading greater than 50 indicates expansion in the industries that make up almost 90 percent of the economy

Oops. Maybe this ISM measure is a lagging indicator and things will improve going forward. All this QE has to go somewhere. Let's see what the forward-looking indicator, the order book, shows for the US service economy.

Source: Institute for Supply Management

It's actually the worst reading in 4 years. An economic improvement from a year ago? Maybe not so much. But that's OK - we always have beer and BBQ (for now). Enjoy the holidays.

SoberLook.com

From our sponsor:

France and the Eurozone recovery

The biggest threat to near-term recovery in the Eurozone is not the periphery. It's France - which represents over a fifth of the area's GDP.

CNBC:  - The figures showed the euro zone's second-largest economy, hit by lagging trade competitiveness and a caught in a shallow recession, will not be able to count on its traditional driver - consumer spending - to rebound.

The sickly growth will leave France's 2013 public deficit near 4 percent of economic output, overshooting an already revised target of 3.7 percent and further away from an EU goal of 3 percent, the state auditor said in a report on Thursday

French consumer confidence is now worse than the lows of the Great Recession.

In contrast, German consumer sentiment (as measured by GfK) jumped to a 5.5-year high in June.

GfK German Consumer Sentiment (Bloomberg)

Even Italy is showing improved consumer mood, which is now at a 15-month high. Assuming the banking system deleveraging slows (and many expect that it will), stabilization of economic conditions in France could set the stage for recovery in the Eurozone as a whole.

SoberLook.com

From our sponsor:

One reason for recent Brent-WTI spread narrowing originated outside the US

For the first time in some 2.5 years Brent-WTI spread (discussed here) has traded around $5/barrel. The two types of crude oil represent nearly the same product but have been trading at a wide spread due to difficulties of transporting sufficient amounts of North American crude from Cushing Oklahoma, where WTI is settled, to the Gulf of Mexico where it could be delivered to major US refineries or shipped elsewhere as a replacement for the more expensive Brent crude. These delivery challenges have been significantly reduced in the past couple of years. At the same time some technical issues in the North Sea have been resolved to stabilize Brent pricing.

Bloomberg: - The drop in the gap between Brent, a gauge for more than half the world’s oil, and WTI shows how improved pipeline networks and the use of rail links have helped to unlock a glut at America’s oil-storage hub at Cushing, Oklahoma, in line with a prediction made by Goldman Sachs Group Inc. as long ago as February 2012. WTI rose 5.2 percent in the first half of this year. Brent dropped by 8.1 percent as North Sea supplies have stabilized following oilfield maintenance.

“The spread is coming in on anticipation that we’re going to see pipelines get built and more rail capacity put in place,” said Bill O’Grady, chief market strategist at Confluence Investment Management in St. Louis, which oversees $1.4 billion. “There is now a likelihood that not only will U.S. imports drop further, but that the country will be exporting before long.”

But there is one question that still remains unanswered. A major portion of the spread compression to $5 has taken place just in the past few weeks. Moreover, the volatility of the spread has fallen dramatically.

It is highly unlikely that the market just came to a realization in mid-June that "improved pipeline networks and the use of rail links have helped to unlock a glut at America’s oil-storage hub at Cushing". The transport dynamics in the US have been improving for some time - so why should the spread collapse now?

Something else happened in mid-June that started this steady decline. It was the Iranian elections.

CNN: - Iranian centrist candidate Hassan Rouhani won the Islamic republic's presidential election Saturday after campaigning on a "hope and prudence" platform in which he appealed to traditional conservatives and reform-minded voters alike.

Rouhani spoke of reforms without threatening Iran's supreme leader or its institutions, of which he is a product. The former national security council chief promised an environment with greater personal freedoms and even indicated he would free political prisoners and jailed journalists.

The outcome of this election greatly reduced the risk of a major conflict with Iran, thus lowering the "Iran premium" priced in Brent-WTI spread. This premium existed because a military clash with Iran would impact Brent (and similar regional blends) supply and pricing to a far greater extent than WTI. This change also opens the door for a potential lifting of the sanctions against Iran, making supply disruption risks even lower. Given Iran's nuclear work, the risks are clearly still there, but the market is perceiving them to be materially reduced.

While the transport fundamentals in the US have definitely driven the spread lower over the past year, it was the elections results in Iran that precipitated the rapid collapse in this widely watched spread.

SoberLook.com

From our sponsor:

Banks benefiting from "taper" on both sides of the balance sheet

US equity markets are continuing to price in higher premiums for bank shares relative to the overall market. The increased steepness of the yield curve will mean higher net interest income, as banks borrow at historically low rates from depositors and lend longer term at the highest rates in two years. The chart below compares the S&P bank index (KBE) with the S&P500 index (SPY) over the past 5 days.

Not only are banks increasing the longer term rates at which they lend, but they also have lowered rates they pay on various types of deposits.

Checking accounts that pay interest (source: Bankrate.com)

Money market accounts (source: Bankrate.com) -
Note: these are bank savings accounts, NOT money market funds

Even without growing their balance sheets - and for now US banks' balance sheet growth has stalled - banks can improve their margins simply through lower interest expense. That's part of the reason for bank share ongoing outperformance.

In the mean time, in spite of higher rates elsewhere, US savers are hurting.

SoberLook.com

From our sponsor: