During this morning’s usual reading and research I ran across an posting by Josh Brown which was discussing the “#1 Threat To The Market.” When you first read the headline of the article you immediately assume that the main risk would be Syria, earnings growth or the pending debt ceiling debate. However, I think Josh gets the primary argument correct in identifying interest rates as the real issue. He states:
“So of the litany of current market fears – Syria, Egypt, China’s banking system, the Taper, the debt ceiling, the budget battle, the twerking epidemic, high oil prices, etc, the one I am most worried about is the effect of higher rates on the housing market.”
As I have stated so many times previously (see here, here and here) rising rates are an anathema to the economy and, ultimately, the stock market. Rising rates impact borrowers, consumption, capital expenditures and housing. The table below shows the percentage contribution of each subsector of the economy to overall GDP. (Note: Josh references data that suggests that housing made up 40% of the most recent GDP report. It was actually closer to 15% but the net impact to housing from rising mortgage rates is significant nonetheless.)
Since the primary borrowers of consumer credit are generally those that are living “paycheck to paycheck” rising interest rates reduce disposable incomes which impacts future consumption. The latest report on personal spending suggests that this is likely already manifesting itself and will negatively impact economic growth through the end of the year. Furthermore, rising interest rates, as Josh suggests, will negatively impact the housing market as rising interest rates price buyers out of the market. This point is especially important since the bulk of buying has been driven by speculators purchasing homes to turn them into rentals.
Rising rates lowers the profitability of rental properties which will slow the speculative buying frenzy. Eventually, if rates rise enough, it will force a “rush to market” of these homes as speculators try and capture price gains. The problem will become who the buyers will be as rising rates have priced many first time home buyers out of the market place. With residential home ownership already at the lowest levels since the 80’s the push higher in rates poses a real potential threat to the housing market and its contribution to GDP.
Lastly, rising interest rates puts businesses on the defensive as increasing borrowing costs have a negative impact on refinancing activities, returns on capital investments and increases inventory holding costs.
So, as you can see in the chart above, the real threat to the economy is from higher interest rates which negatively impacts the two major contributing factors of personal consumption and private investment. Which leads me to the one point where I disagree slightly with Josh which is on the impact of the Federal Reserve and their ongoing monetary intervention programs. Josh states that:
“…supporting the housing market should be the Fed’s number one goal right now, not chasing phantom asset bubbles. The good news is that the Fed itself seems to be aware of this. Recently a trial balloon had been floated in the direction of Goldman’s chief economist, who is now talking about a taper that could involve maybe buying less Treasuries each month but more mortgage backed securities (MBS), thus supporting housing (see: Goldman’s Latest on the September Fed Announcement at Zero Hedge).”
The reality is that the Fed’s intervention programs are what is causing interest rates to rise currently. The chart below shows the 10-year Treasury rate on a 6-month rate of change basis. As you can see volatility in interest rates was more tied to variations in economic activity in years leading up to 2009. However, once the Fed begin its various intervention programs volatility spiked dramatically.
It is important to note that the current spike in interest rates is NOT ANY different in terms of velocity or magnitude relative to what we have already seen twice before. What will be different will be the drag on economic growth and eventually the stock market.
The point here is that if the Fed is really serious about supporting the housing market, and the economy, then they should immediately set a future date for when their monetary interventions, in its current form, will cease. As that date approaches, just as has occurred at the end of the previous two programs, interest rates would begin to fall as money rotated back into Treasuries for “safety” as the stock market corrected.
The problem is that the drop in the markets also negatively impacts the economy as consumer confidence wanes and consumption declines. This, of course, is not beneficial; so the Fed continues to intervene with continuing rounds of interventions. As I stated above the real threat to the economy is the impact of the Fed’s interventions on interest rates. However, like a patient dependent on life support, it is only with these interventions that the economy can maintain a pulse. Welcome to the liquidity trap.
There are certainly more than enough things to impact the market currently, as Josh correctly notes, and the spike in interest rates is likely the most important from an economic perspective longer term. However, I certainly wouldn’t completely dismiss the other issues either. We are now very long in the tooth in the current economic expansion and with valuations, profits and earnings per share all at levels that have historically only been seen near the end of cyclical bull markets rather than the beginning. As I stated in that post:
Courtesy: Lance Roberts
“While there may not be an asset bubble currently; valuations by both of the metrics (CP/S and EPS) studied here are clearly rich. However, for investors, it is important to remember that valuation measures are horrible short term market timing devices. In the long run valuations mean everything. While I am not suggesting that the market is about to plunge into its 3rd major reversion for this century, even though that possibility does exist, I am suggesting that future returns will likely not be anything to write home about either.”
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