Volatility returned to the market this week as tensions between the United States and North Korea escalated.  The VIX index, which is known as the “fear index” and is used to measure near-term volatility, rose over 40% on Thursday in response to both the aforementioned geopolitical tensions and some disappointing earnings reports.  While bond yields have been drifting mildly lower, interest rates did not drop dramatically even with the uptick in volatility and the sell-off in equities.

Economically, lackluster reports both Thursday and Friday on inflation also did not push yields lower, which is somewhat surprising given that inflation is a major threat to bonds and the tame inflation numbers on the CPI and PPI usually correlates to lower interest rates.  However, the Fed’s intention to both continue to raise short-term interest rates and reduce its balance sheet have left the markets wondering how bond yields will respond to these policies. This has most certainly helped keep rates higher given the current circumstances this past week.

With mortgage bond prices near the 2017 highs, rates at the 2017 lows, and the 10-year yield at its recent low, we are biased toward locking in interest rates at current prices.

Longer dated US bond yields traded higher in response to a stronger than expected US jobs report.  However, the 10-year US Treasury is trading under 2.300%, and still priced very attractively.  There is concern from some prominent economists (Alan Greenspan is one of them) that global bond yields are artificially low, and that when interest rates finally move higher, volatility from both bonds and equities will be violent.

All eyes were carefully watching the U.S. jobs report which was out this Friday morning. The focus was on whether the report would confirm the Federal Reserve’s thesis, that job inflation is likely to be seen sooner than later.

The jobs report was a good one, with 209,000 jobs created in July, nicely above the 181,000 expected. The unemployment rate fell to 4.3% from 4.4%, the lowest since March 2001.  Average hourly earnings rose by 0.3%, in line with estimates and up from 0.2% in June. Year-over-year wages grew 2.5% compared with 2.4% in June. The U6 number was unchanged at 8.6%.  The U6 is total unemployed which includes all persons marginally attached to the labor force, as well as, the total employed part-time for economic reasons, as a percent of the civilian labor force. The Labor Force Participation Rate is at 62.9 from 62.8, still historically low.

However, job inflation continues to remain in check and that is one reason why the bond sell-off was mild. Given that the stock market is trading at all time highs, the current U.S. administration is pro-growth. The jobs reports continue to beat expectations. We are happy to see bond yields hang in there. However, we remain cautious (as we have for quite some time) and are biased toward locking in interest rates given the current economic and political environment.

Surprisingly, the stock market has continued to rally around the unpredictable political environment in Washington. Bonds yields have moved up as global central bankers continue to discuss the improving global economy, and the need to re-adjust the ultra-low interest rate policies we have all become accustomed to.

Economic growth improved in the second quarter, but the 2.6% reading combined with the 1.2% in the first quarter, is still reflecting a 2% annual growth rate. Given how much stimulus has been thrown at growth, one would think our economy would be doing much better. This low growth rate has benefited bond yields and is one reason we have not seen higher interest rates to date.

The inflation-reading Employment Cost Index rose 0.5% in Q2, from 0.6% in Q1, and measures workers’ wages and benefits.  From a year earlier, total compensation rose 2.4%, while wages were up 2.3% from a year ago.  The lack of wage growth continues to be a tailwind for low rates.  If wages don’t grow, inflation typically remains stagnant, as we have seen for a long time. This too is good news for Bonds.

The second and final read on July Consumer Sentiment came in at 93.4 versus the final read of 95.1 in June. The first reading for July was 93.1. This also supports Bond prices. The yield on the 10-year Treasury Note is well off the worst overnight levels and hovers near 2.30%.

We continue to believe interest rates can move higher and believe locking-in interest rates is a good idea given the posture of the Federal Reserve and their desire to move interest rates up.  However, we do believe the rise in yields will be gradual and somewhat predictable.

Bonds held up well in the face of a very strong jobs report, although interest rates did rise for the week in volatile trading. The muted response by the bond market to the June Jobs Report reminds me of the aphorism “buy the rumor and sell the news”.  Bond managers most likely hedged positions ahead of the June job report. The Fed’s Open Market Committee meeting notes were released on Thursday. These notes shined some light on the projected path of short term rate hikes, the Fed’s own view on inflation, as well as how the Fed plans to wind down its enormous balance sheet. Both the U.S. and European Central Banks have opined on the push for higher interest rates as the fear of deflation has subsided. With the German Bund ticking relentlessly higher, it makes it very difficult for U.S. yields to come back down. The German Bund yield sits at nearly two-year highs after the recent breakout. In the absence of a retreat in global yields abroad, it is hard to see much lower rates in the near term domestically.

Jobs Report

The June jobs report was robust with 222,000 new jobs created versus 185,000 expected. The Labor Force Participation Rate ticked up to 62.80%, but still remains at multi-level lows. However, wage inflation remains stubbornly flat and was a tonic for bonds. Inflation is the arch enemy of the bond market, and with no wage inflation one would think this to be the a reason for the lack of higher yields today, given the overall strong report.

We continue to closely watch bonds with an eye toward the ever so important line in the sand of 2.600% on the 10-year Treasury note. Our feeling is that it’s prudent to remain cautious and we are biased towards locking-in interest rates given the positive economic news that we are seeing out of both the U.S. and Europe.

Volatility finally returned to the global bond markets, with higher international yields, sparked by the European Central Bank’s comments on market normalization. The US Fed’s comments on the necessity of raising short-term rates moved up mortgage and treasury yields. This combined with the prospect of rising European bond yields, the US bond yields touched multi-monthly highs.

We are continuing to closely watch the German 10-year Bund yield (.45%) and the U.S. 10-year yield (2.27%). If they rise above resistance at .50% and 2.30%, respectively, then yields could very likely push even higher, causing mortgage rates to most likely tick higher also.

In economic news, housing remains strong and inventories are low, which is putting pressure on home affordability. Inflation remains muted with the Federal Reserve’s favorite measure of inflation, the Personal Consumption Expenditures (PCE) Index, falling to its lowest level in months: – 1.400% year-over-year, which is well below the Fed’s 2.00% target. We have previously noted that the Fed believes low inflation is transitory and that higher wage and consumer inflation will return.

We are biased toward locking in interest rates given the chatter from both the European and US central banks.

Rates remain near unchanged in a quiet trading week on Wall Street. The continued low levels of inflation, along with a flattening yield curve, make us wonder about the true state of the U.S. economy. A flattening yield is usually a precursor for a slowing economy. Speaking of flat, the S&P is flat for the week, oil is unchanged, and the 10-year yield is at 2.16%, also hovering near unchanged week-over-week.

Technically, the 10-year Treasury is trading just above resistance, as it has been for the past few weeks, which is why we remain biased toward floating interest rates for now.

You might think the big economic news this week was the .25% increase in the Federal Funds Rate to a range of 1% to 1.25%, but the real news is that the Federal Reserve raised short-term rates even though there are signs that inflation is cooling. With unemployment at 4.3%, economists have been confounded as to why wage inflation has not appeared. The Fed explained their rationale for raising rates on the basis that price inflation and wage inflation will eventually make its way into the economy and that low inflation is probably temporary. Overall, inflation remains below the 2% target rate. The jury is still out whether or not the Fed’s thesis will hold true.

Psychologically, the Fed’s rate increase telegraphs its confidence an overall improvement in the US economic picture. Surprisingly, bonds rallied lower Wednesday in anticipation of this announcement with the 10-year U.S. Treasury touching its lowest level this year. Equities also traded well. Bond traders are closely watching the 2-year-to-10-year Treasury spread which continues to flatten and may be signaling a slowdown in the economy. A flattening yield curve is never a good sign, but so far the markets have not been deterred by this pattern.

In other news, May housing starts fell 5.5% from April to an annual rate of 1.092 million units, well below the 1.227 million expected. It was the lowest rate since September 2016 and the third straight month of declines. Starts are down 2.4% from May 2016. A larger drop was seen in the multi-family home sector. A slowdown in housing starts is likely to weigh on economic growth, which is good news for bonds and the continued trend of low interest rates.

We continue to watch rates and rate spreads as we advise clients on mortgage rates and remain cautiously biased toward floating interest rates given that bond yields responded well to the Federal Reserve’s decision to raise short term rates.

Bond yields ended the week a touch higher after a wild week of political uncertainty culminating with the testimony of former FBI Director James Comey. The equity markets responded favorably as the testimony revealed a potentially inappropriate private conversation between President Trump and the former director, confirmed that the President was not under investigation, and revealed that many news outlets had been misinforming the public on the Trump-Russia connection.

Across the pond in Europe, the UK votes delivered a stunning blow to Prime Minister May and her conservative party. The vote raises the possibility of whether the Brexit negotiation should be put on hold while the British sort out their political crisis. The UK pound plummeted in response to this vote. Uncertainty typically benefits bonds and the low European rates have helped keep our rates in the U.S. low.

The idea of “buy the rumor and sell the news” held true for U.S. bonds as rates rose as fear eased this week. The next big economic event is the Federal Open Market Committee’s meeting next week. All eyes will be on what the Fed has to say about the state of the economy and on short-term interest rates.

With mortgage and treasury bonds trading close to their 200-day moving average, we remain biased toward locking in interest rates. We envision too many scenarios that could push rates higher and not enough catalysts to lower interest rates.

Surprisingly, U.S. equities traded higher Friday morning to new all-time highs in reaction to a very poor May U.S. jobs report. Bonds also benefited from the poor report with the 10-year Treasury note touching 2.140%, breaching the 200-day moving average of 2.170%. Even though the unemployment rate fell to 4.30%, the lowest reading in 16 years, the concern within the report was the drastic slowing of new hires. The expectation for new jobs in May was 184,000 versus actual new job creation of 138,000. Finally, the labor force participation rate fell to 62.90%, and has trended near the lowest level in 30 years.

The drop in unemployment supports the belief that the U.S. economy is near full employment. Ironically, wage inflation remains flat which is one reason why bonds continue to trade attractively. The soft report supports the need for tax reform and infrastructure spending to boost job growth.

It is widely believed this report did little to change the trajectory of the Federal Reserve’s short-term interest rate forecast. The odds are very much in favor of a June quarter point (.25%) rate hike for short-term interest rates.

We continue to be biased toward locking in interest rates at these lower than expected levels.

For the first time in quite some time, U.S. bond and equity markets showed increased volatility on the heels of President Trump’s firing of FBI Director Comey. In tandem with that, there was increased turbulence in the White House surrounding allegations of possible Trump-Russia collusion, though no hard evidence has surfaced as of yet. Investors seem less concerned with the potential conflicts with Syria and North Korea. There is a lack of certainty over the Trump administration’s ability to pass promised pro-growth tax reform. Trump’s unorthodox style came to a head on Wednesday, which saw a massive rally in bond yields and also a violent sell-off in stocks due to the aforementioned concerns. The markets traded better on Friday as this market has proven to have a short memory.

Overall, U.S. earnings were strong for the first quarter, and ultimately the stock market trades on earnings and earnings growth. The one question on everyone’s mind is how the stock market will react to the Trump administration’s actions on policies on tax cuts, deregulation, and infrastructure spending. The success or failure of tax reform will have big consequences later in the year with respect to interest rates.

With the 10-year Treasury note closing below 2.25%, we remain biased toward floating rates. We are closely watching support (2.16%) and resistance (2.61%) on the 10-year note. Breaking below or above these levels could mean much lower or much higher interest rates. For the moment, we are delighted for the positive week and better pricing for our borrowers with the drop in interest rates.