Hi, I’m Aziz! This is my newsletter, Home Economics, where I contextualize America’s housing market using data visualization. This is a long-form post and the first of three deep dives into mortgage rates. In the future, some of these posts will be for paying clients only. If you find posts like this helpful, please consider signing up as a paying client—I am running a sale for 50% off annual subscriptions for one more week.

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My wife and I were in the Catskill mountains in upstate New York last weekend, taking in the changing leaves and doing some hiking. It rained the whole time. Our waterproof boots and gore-tex jackets kept us dry, but walking uphill for hours through a storm can test the enthusiasm of even the most avid outdoorsman. 

On one especially long ascent, I got to thinking about the parallels between hiking—the kind you do in the woods, using your legs—and the kind the Fed is doing, in financial markets, using interest rates. Aside from the cute semantic overlap, there is also a philosophical parallel: once you can see the top, the rest of the way up feels a bit less painful.

Anyone who is shackled to the bond market for their life plans or their livelihood has experienced some pain over the past two years. Prospective homeowners have been forced to shelve their purchases amidst a calamitous fall in affordability. For those in the housing industry, higher yields have translated most tangibly into less business—less financing activity, fewer transactions, and all of the ancillary business that comes with it. While some participants—like new home builders—have benefitted, most are eager for the hiking to be over.

Here is some good news: if it’s too soon to call the top, it’s at least in sight. 

Inflation is retreating. The broken supply chains and soaring energy prices incited by the war in Ukraine that propped up prices in late 2021 and throughout 2022 have dissipated (even if that war goes on as another begins). Housing is now the main contributor to inflation, but we know this will abate as the decline in rent we’ve seen over the past year is gradually folded into the official measure of prices. 

Sure, the Fed isn’t waving the “mission accomplished” sign just yet. The labor market is still too tight. Wage growth is outside the Fed’s comfort zone.

But investors have seen the top, and most of the pain is behind us. After a month of carnage, bonds are fully pricing-in what remains of the ascent: a possible final hike next week or at the December Fed meeting. Historically, bond yields fall significantly immediately following the final Fed hike. 

The bottom line is that interest rates are likely to be lower—perhaps even lower than many optimists think—in the weeks and months to come. A year from now I think it’s more likely than not that mortgage rates are back under 6%.

Mortgage interest rates track the yields on mortgage-backed securities (MBS)—which in turn track US treasury bond yields, plus a spread. Mortgage rates are therefore largely determined by the same factors as US treasury bonds: investor expectations about the path of Fed monetary policy, and a “term premium”—a catch-all factor that encapsulates supply and demand and interest rate volatility, amongst others.

This article will focus on the first of these drivers: the outlook for the Fed’s monetary policy.

Since early 2021, the Fed’s challenge has been to return spiraling inflation to its target of 2%. The Fed’s preferred inflation gauge—core PCE—peaked at 5.6% in February 2021, and now stands at 3.9%. I’ll argue here that, in fact, the Fed’s work is mostly done.

Sorry, you’ll give me how much for my crappy Volkswagen?

In late 2020, I wanted to visit my family in Canada but avoid the risk of flying during a pandemic. I bought a little Volkswagen GTI hatchback. It cost $18,000. When I took the car into the dealership for servicing for the first time six months later, the manager offered to buy it—on sight alone—for $25,000. 

It was easy to think those pandemic distortions—when inflation for used cars, airfares, and other items topped 10%—would quickly fade once the vaccine was introduced, supply chains healed, and the boost from fiscal stimulus faded (I too had been on “team transitory”). 

That line of thinking was so compelling because goods (as opposed to services) had been experiencing not just low inflation, but outright falling prices for the 20 years preceding the pandemic as China integrated into the world trade system. 

This was one reason the Fed struggled to hit its 2% inflation mandate in the early aughts: it’s not that goods prices were rising too quickly but that they were not rising quickly enough. 

It took a long time but, happily, we are back to the old normal—in the latest reading, goods prices are again falling by almost 2% y/y, helping pull overall inflation back down. I guess team transitory was right, though I suppose if you wait long enough, everything is transitory. 

The rent’s too damn high, but it’s coming down

With these pandemic distortions out of the way, housing is now the main contributor to inflation. 

For the uninitiated, the Labor Department gauges inflation by tracking price changes for a basket of goods and services—the consumer price index (CPI). Each item in the basket is, in theory, weighted roughly proportionately to how much an average household spends on that item.

In the CPI index, shelter carries a weight of 34%. But there are two quirks to how the Labor Department measures the cost of housing.

First, even though about two thirds of Americans own their homes, the Labor Department doesn’t include home prices in its inflation basket. That’s because homes are both consumption and investment, and the government is only interested in measuring the consumption part. 

Instead, the Labor department measures rents—to account for prices faced by those who rent their homes—and imputes the cost of shelter for those that own their home from these rents. In other words: when it comes to the impact of housing on inflation, it's rents that matter, not home prices.

Here is the other quirk: in taking the pulse of rents, the Labor Department looks at all active rent contracts—including those that were signed years ago. That makes the shelter component of CPI a sluggish beast: even while private measures of rents—which capture only newly-signed contracts—have plummeted, the official measure of shelter inflation is still elevated due to those older, more expensive contracts. 

This means that we can very accurately forecast where the shelter component of CPI is headed based on these private measures. The answer is clear: if the Labor Department swapped out its slow-moving measure of shelter for more timely private ones, inflation would be hovering near 1% instead of almost 4%.

It’s possible that the national housing shortage will cause rents to reaccelerate. But this seems very unlikely: as CalculatedRisk by Bill McBride points out, a record number of multifamily units are under construction—these were delayed because of pandemic bottlenecks. As they hit the market over the coming months, rents are—if anything—likely to fall even further.

Chairman bites dog?

Our dog Barbosa (“Bo”) has dozens of toys. But he returns over and over to a little red ball. After a dozen years of play, the ball is mangled and perpetually slimy. As much as my wife and I try to interest him in other stuffed, squeaky things, Bo is interested only in the little red ball.

Wages are Fed Chairman Powell’s little red ball. Even as goods prices have collapsed and as shelter inflation retreats, the Fed’s focus remains squarely on the component of the inflation basket most influenced by wages: services ex-shelter. 

Jerome Powell on core services ex-shelter in November 2022:
“…this may be the most important category for understanding the future evolution of core inflation...Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”

It’s a bit ridiculous: the price index is meant to measure what we spend money on, but services ex-shelter is only 24% of overall CPI. 

To be fair, there are sound arguments for taking a narrower snapshot of prices than the entire basket of goods and services the average household consumes.

Historically, the Fed focused on “core inflation”, the part of the price basket that excludes food and energy. These components oscillate due to international factors, and are immune to our domestic monetary policy—it doesn’t make sense for the Fed to try to control them with interest rates. We saw this with the war in Ukraine—energy prices soared, and there was little the Fed could do to stop it.

But the pandemic distorted prices across a broad range of goods and services. Prices for even “core goods”, like used cars and airfares, became volatile. Rents—a big component of the “services” part of inflation—spiked as households migrated to more remote geographies with smaller housing stock. 

After lopping all goods and housing off the price basket, we are left with the smoldering heart of inflation—so-called “supercore” prices (all core services except for housing). It’s this measure that the Fed is obsessed with. In their thinking, even if supercore constitutes less than a quarter of overall CPI, it could remain high enough to prevent overall prices from declining to the Fed’s 2% target. Wages are the primary driver of supercore inflation.

Wages

Should we really be hoping for slower wage growth? After years of wage stagnation, aren’t pay rises long overdue? Yes and no. 

Yes, because—even if wages understate income gains—we have neo-feudal levels of income inequality in America. 

No, because without matching gains in productivity or a structural change that allows labor to take a larger share of income from capital, wage gains would ultimately be undone by inflation. Workers would be no better off.

We haven’t seen the structural changes that would allow wages to begin to rise at a faster, but non-inflationary, rate. And so the Fed is rightly focused on orchestrating a level of economic activity that matches demand for labor with the supply of it. Rapidly rising wages are merely a sign that demand is too strong for the amount of labor on offer.

I think the Fed’s job here is done. Employment remains at record lows, but the policy goal was never for people to get fired—just for excess labor demand to dissipate. And that’s exactly what’s happened. Some prominent economists (including Larry Summers) poured scorn on the idea of this even being possible, but we’ve just experienced “immaculate disinflation”: job openings have declined without causing job losses.

"To date, declining inflation has not come at the cost of meaningfully higher unemployment—a highly welcome development, but a historically unusual one."
—Jerome Powell

The loosening in the labor market is visible in decelerating wage gains. And we know where this is going: as economists at Capital Economics point out, “the job quits rate has proven to be the best single leading indicator of wage growth during this cycle.” Quits are decelerating—so too should wages.

Pessimists might point out that we just had a searing nonfarm payrolls (NFP) report, which showed employers adding more than 300k jobs in September—far higher than in prior months. But NFP is notoriously prone to swingeing revisions. 

In fact, recent monthly payrolls gains have been consistently revised downwards—suggesting the labor market is not as tight as we thought. Downward payroll revisions have historically been a leading indicator for the kind of labor market loosening that accompanies a recession.

The bottom line is that the Fed has already engineered a sufficient slowdown. If wage growth slows to 3.5%, as the leading data suggests it will, then—coupled with ongoing productivity gains of more than 1%—wage growth will soon be entirely consistent with the Fed’s inflation target.

Looking ahead

To be fair, inflation may yet prove more contumacious than this. 

Boomers are retiring and shrinking the labor force, posing an upside risk to wages. Households seem to still have money stored up from pandemic stimulus. This might help explain why they’ve been surprisingly resilient in the face of higher rates. Markets are not fully pricing another Fed hike—if the Fed does tighten policy again next week, interest rates would reverse some of their recent dip. 

But I think the distribution of probabilities means that if I’m wrong, it’ll be because rates fall faster than I anticipated as the economy slows unexpectedly. Three of my favorite leading indicators suggest a slowdown ahead.

First, senior loan officers at banks around the country have been tightening their lending standards. They’ve been making it harder, and more expensive, for companies and individuals to borrow money. This, in my view, is the single best leading indicator, and suggests we are overdue for a slowdown.

Second, housing starts are falling. Residential investment is not a large chunk of GDP, but plays an outsized role in economic turning points. In fact some economists argue that starts, and the change in starts, are such effective leading indicators that “housing is the business cycle”. The best leading indicator for starts—yes, now we are talking about a leading indicator of a leading indicator—is architectural billings. These are nosediving.

Third, the 2/10s yield curve is de-inverting. Its more famous cousin—the inverted yield curve—is the vanguard of recession sentries. A de-inverting yield curve is a more proximal indicator, often coinciding with a recession banging on the door. That’s not quite happening yet, but we’re awfully close.

And though the consumer has been resilient to higher rates, cracks are starting to appear. Unlike mortgages, credit card and auto loans reset quickly—delinquencies in these segments are now rising rapidly.

It’s also important to recognize that the bond market has taken pressure off the Fed to implement further hikes—this isn’t conjecture, but a widely rehashed talking point from Fed speakers over the past few weeks.

Logan: "If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate."

Kashkari: "It’s certainly possible that higher long-term yields may do some of the work for us in terms of bringing inflation back down..."

Daly: "If financial conditions, which have tightened considerably in the past 90 days, remain tight, the need for us to take further action is diminished."

Waller: "…financial markets are tightening up and they are going to do some of the work for us."

20 basis points isn't cool. You know what's cool? 200 basis points.

In my former life I was a bond market strategist at a big investment bank. We were encouraged to make bold calls, but in reality we mostly hid very close to the consensus. This, for example, was a conversion I had with our China economist one day:

Aziz: “What’s our China growth forecast?”
China economist: “6%. We are above consensus.”
Aziz: “Where’s consensus?”
China economist: “5.9%”

So in the spirit of sticking my neck out for once: mortgage rates are today close to 8%. I think they will be below 6% a year from now. In a Twitter poll I ran last week, less than 10% of respondents felt this was likely.

This needn’t be all the result of looser monetary policy—lower term premia and tighter MBS spreads, which I will write about next week—should play a part. But the bottom line is that rates are now likely heading lower, and this should be welcome news for the housing industry.

I tweeted this view out last week, but it somehow caused less of a stir than similar views from more credentialed sources who said similar things on Monday. Hedge fund mogul Bill Ackman announced that he closed his bond shorts, stating “there is too much risk in the world to remain short bonds at current long-term rates”, and “the economy is slowing faster than recent data suggests.” 

Legendary investor Bill Gross (“the bond king”) recommended going long interest rate futures, which profit if rates fall, and declared “higher for longer is yesterday’s mantra”. These statements were probably part of the explanation for the 20bp rally in Treasury yields.

Hedge fund investors operate on a smaller time frame than most. The rest of us can take the long view. A year from now I think we might look back and realize that this week’s rally was just the beginning.

Thanks for reading! Please post your questions and comments and stay tuned for next week’s long form article about the second determinant of mortgage rates and Treasury yields: the “term premium”.

In the future, some of these posts will be for paying clients only. If you think you’d find posts like this helpful, please consider signing up as a paying client—I am running a sale for 50% off annual subscriptions for one more week.

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