The Average Joe is Miffed
The benchmark 30yr US mortgage rate hit 8% today. This is the rate for cream of the crop borrowers. God help you if you have bad credit and need to borrow money.
While those who locked in rates in 2020 or 2021 are doing OK, nobody wants to borrow new money at these rates. Consequently, the market for home purchases has effectively slammed shut.
Here’s the math:
The monthly payment for a new $500,000 mortgage has risen from $2,103 to $3,623, a 72% increase. Someone who can only afford the original $2,103 monthly payment can now only handle a $300,000 mortgage.
That’s putting downward pressure on house prices.
This isn’t just about houses.
The cost of survival – food, shelter, warmth – has risen substantially over the past couple years. Understandably, people are miffed.
Grocery shopping is depressing and most people are cutting back on out of home dining and drinking. Sentiment is in the toilet.
Stocks: The Bulls are Daydreaming
As bond yields continue to rise, the equity risk premium declines. It now sits at its lowest level since the dot-com crash.
When a 2yr Treasury bond provides an easy 5% yield, it takes a lot more convincing for investors to move up the risk spectrum. With the earnings yield not much higher than the 10yr yield, investors aren’t adequately compensated for adding risk. Sure, stock earnings grow over time and equity market total returns average about 10% over the past several decades, but not without considerable downside risk over the short term. Regardless, that misses the point: investors are historically accustomed to a greater premium for taking on added risk.
Deterioration
While retail spending remains surprisingly resilient, the storm clouds ahead are obvious to anyone paying attention.
This is not just about the consumer. Higher borrowing costs are starting to impact businesses. That affects profitability, risk and share prices. As bond yields climb, interest coverage ratios have deteriorated. This process occurs with a lag – since businesses only issue new bonds periodically – so as long as yields remain elevated interest coverage should continue to deteriorate.
Analysts are starting to incorporate this and the cacophony of other issues created by a higher cost of debt into earnings expectations. Consequently, equity downgrades currently dominate upgrades.
Bonds: Who Dares Wins
Long duration bonds were utterly destroyed over the past couple years.
The 20yr US Treasury Bond, for example, lost over half its value – the worst drawdown in history. Why? Propelled by a return of inflation, yields – held down during the pandemic by a flight to quality and central bank buying – sprang from the depths of the Covid low.
Today, yields are closer to normal and inflation is weakening – it is reasonable to think the worst for bonds is behind us. Of course, one should remain fluid and incorporate new information as it comes to light. Higher for longer is possible. However, as of today the upside/downside to bonds is asymmetrical to the positive.
If one believes we are near the interest rate peak and that a recession might be coming, it is reasonable to forecast rates will decline. If and when that occurs, long bonds will rally hard.
Despite this, the short end of the curve just feels comfortable. It’s been a long time since we’ve seen a guaranteed 5%. After a horrendous couple of years, it takes guts to buy the more interest rate sensitive end of the curve.
