The year 2022 will be remembered as the year of the great reset. The reversal of monetary policy from an unconventional, steady state of QE to a classic, conventional state has surprised most market participants. In hindsight, even central bank governors could not have imagined that markets would grant them an exit that has so far occurred without major systemic collateral damage. The change is most evident in the level of long-term 30-year U.S. real interest rates. This long-term real discount rate rose from -0.50% at the beginning of the year to +1.84% at present. A remarkable adjustment that catapults us close to an average level of 2.00% in 30-year real interest rates observed in 2000-2008. In fact, central banks have decisively increased their room for maneuver. You can go back to the interest rate policy toolkit to manage cyclical or countercyclical outcomes. What a result!
Since the pace of the adjustment has been so brutal, it will take a while for monetary policy to filter through. It works with a lag and trickles down to the level at which investment decisions are made, whether households or firms. This last sentence deserves to pause. It is important to realize that such a sudden shift could have changed the potential economic growth downward, as it changes the plans of households and private companies under financial constraints.
At the household level, there is the dream of buying a house. The home affordability index for first-time buyers fell to 68 toward the end of the second quarter of 2022. This series began in 1986. The last time such a value was reached was in the summer of 2006. Between 1986 and 2006, the index averaged 80. I want to include the Bloomberg description of this index because it embodies the U.S. middle class: "This affordability index shows the ability of renters who are potential first-time buyers to qualify for a mortgage for a first home. If this index is 100, the typical first-time buyer can afford a typical first home with a 10% down payment under the given financial conditions. Median income represents the typical income of a renter family with wage earners between 25 and 44 years old.
The rise in long-term nominal and real interest rates has pushed the 30-year fixed mortgage rate toward 7.25%, near the highest levels reached in 1999-2000. October's Homebuilder Sentiment Index fell to 38, approaching the March 2020 pandemic outbreak low of 30 and a far cry from the 90 at the end of 2020, when central banks pushed long-term interest rates to historic lows. Housing demand is faltering rapidly. The monthly supply of new homes entering the market has risen to over 10.4 months, a level not seen since – yes, again – 2008. The bigger picture becomes clear when you consider that the health of the housing market and economic growth conditions are positively correlated. Even if the U.S. real GDP growth numbers for the third quarter are correct, we can expect challenging results in the coming quarters. The financial conditions for the budgets have tightened drastically. Punktum. Similar conditions prevail in the United Kingdom, exacerbated by the conflict between a central bank pursuing orthodox policies and the Chancellor of the Exchequer wanting to pursue unorthodox fiscal policies. A combination that the markets abhor. It almost brought the gilt market to a standstill. On the European continent, housing affordability has not deteriorated to the level of the US or the UK, but the trend is clear.
If we take a quick look at the private sector, it is also clear that a cautious and hesitant management has been established. Geopolitical uncertainty, wage inflation and overall higher manufacturing costs are presenting corporate executives with difficult budget negotiations for the next year. Operating revenues will be squeezed in various recession scenarios while operating costs increase, and on top of that, qualified personnel will become a precious commodity. The CEO Confidence Index, which measures the degree of optimism or pessimism for the U.S. economy over a one-year horizon, is at 5.92. It has recovered from a mid-year low of 5.12. Interestingly, it is holding at the level of summer 2006. It is a so-called coincidence indicator that changes simultaneously with economic conditions.
So, CEOs still tend to be optimistic, even though inflation has wreaked havoc in 2022, but a credit crunch may not be around the corner and is not a base case scenario… yet.
At this point, it is important to take a look at the past and in particular at the great financial crisis of 2008. In early 2008, 30-year real interest rates hovered around 1.70%, breaking through the 2.00% resistance level in the spring. However, by the end of October 2008, the 30-year real interest rate had jumped to 3.25! The damage that resulted was enormous. Global markets were buffeted by a credit crunch, which market participants countered only by assuming that large-scale central bank asset purchases (QE) initiated in late 2008 would be able to calm the system and get credit markets back on track.
The FED is well aware that a further increase in real interest rates from current levels could lead to undesirable outcomes. The market assumes a final key interest rate of 4.75% – 5.00. A level that is expected to be reached in spring 2023. The US real interest rate for 30-year bonds of 1.84% also fully reflects this information.
The key message today is that any increase in expectations for U.S. federal funds rates beyond 5.00% could trigger a nonlinear increase in the likelihood of a credit crunch, as actually occurred in the second half of 2008. Credit spreads could soar. Shares could experience another painful downturn. At this point, the Fed has not made a policy mistake. But it is on the edge of the abyss. To continue, the baseline scenario should see a FED top rate (well) below 5%. Such a scenario, with the Fed signaling prudence, would stabilize equity markets and possibly boost bond markets. The risk scenario in which policy rate expectations rise above the 5.00% threshold could quickly turn into a black swan.
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