Former President Bill Clinton had a way with words. His erudition may have been less evident in his suggestion that there were alternative definitions of the word “is”, but it was more apparent in his robust response to Alan Greenspan after he’d been apprised by the then Fed Chairman of the need to keep the bond market happy or face disastrous consequences. Clinton’s acknowledgement that the fortunes of the economy, and thereforehis re-election prospects, lay with the the actions of bond markets and their interplay with the Federal Reserve is arguably even truer today than it was in the early 1990s.
While the focal point for market commentators today is the Federal Reserve’s ‘tapering’ announcement and the supposed profundity of its consequences, the reality is that policy tightening has been taking effect for months, courtesy of a 1% point increase in the cost of mortgage borrowing. This has caused a sharp slowdown in lending activity in the housing market, moderating an already moderate expansion.
Whether the Fed ‘tapers’ or indeed decides to ‘pause tapering’ again as one Fed policymaker recently put it, is probably of little relevance, aside from its propensity to provoke price volatility. Indeed, the focus on Fed policy at large is an unhelpful distraction, with its importance in determining mechanistically the potency or otherwise of economic growth being grossly over-stated. Market beliefs about growth and inflation (and the risks thereof) – as reflected in longer-term bond yields – have a tendency to exert a more powerful influence over the real economy.
The chart below shows the close relationship between changes in the 30-year mortgage rate and the borrowing behaviour of the US household sector. The two series are contemporaneous (with the yield shown inverted, so a downward move in the line is consistent with higher interest rates). What is most notable is the acute sensitivity and timeliness of response from borrowers to changes in the cost, on a week-by-week basis.
It is also worth noting that the recovery in mortgage applications that took place through 2011 and 2012 has entirely reversed, with this series back at its lowest since 2000 – under the relatively modest provocation of a 1% rise in rates. Increased rate sensitivity is a clear consequence of higher levels of household debt outstanding over this period. In a world where this was perceived as being the response to an active policy decision (to lift rates by 1%), it would argue for a reversal of that decision.
Ben Bernanke’s comments on 21st May may well be the proximate cause of all of this, but the fact of the matter is that higher 30-year Treasury yields and the consequential increase in mortgage rates have, over the second half of this year, exerted a tightening force on the US housing market which has continued despite ‘Fed guidance’ veering (albeit within a narrow path) from ‘taper’ to ‘no taper’ through the second half of this year.
By the time the Fed gets around to raising rates, the subsequent real economic impact may be indiscernible, with the bond-market having already done most of the heavy lifting. Over-focussing on the linguistic nuances being applied at the ‘policy end’ of the yield curve risks missing the more meaningful shifts that have already taken place at the longer end.