Bassman Warns Of ‘Full-On Recession’ From Housing ‘Halt’

I am not sure how fast the Fed will start to cut rates because CPI will not decline meaningfully for a while, but we are going to be in a full-on recession by then as the housing market will have come to a nearly complete halt.

A Commentary by Harley Bassman

Quipped my good friend and ex-Merrill Lynch sparring partner David Rosenberg: “Cycles die; and you know how they die? The Fed puts a bullet in their forehead.”

Last month I penned “Soft Landing,” and if you printed out a hard copy, my advice is to repurpose it to line your bird cage.

Fed Chair Powell clearly stated at his September 21 post-meeting press conference that their policy rate was headed to 4.6% sometime early next year unless inflation materially declined, which is unlikely to occur due to its lagging component structure.

The pressing question is which breaks first: The bond market, the stock market, the housing market, or the economy via rising unemployment.

As detailed previously, political shenanigans delayed Mr. Powell’s confirmation, paralyzing the Fed in the summer of 2021 when CPI was already cooking at 5.4%. The Fed tried to paper over the delay in raising its policy rate by asserting (perhaps sincerely) that this inflation was “transitory.” Painfully chagrinned, they finally lifted rates in March 2022 when CPI had reached 7.9%.

To affirm its credibility and Mr. Powell’s legacy, the Fed has indicated they will continue to raise rates until inflation meaningfully descends to its 2% “target rate,” notwithstanding that CPI is a lagging indicator.

With “transitory” becoming a dirty word, the Fed has (temporarily) lost the ability to conduct policy based upon its projections, no matter its confidence.

Thus, they are handcuffed to headline inflation, which cannot decline quickly enough to stave off further policy tightening (figure below).

I shed no tears for the embarrassment of Team Transitory, who vociferously insisted that the Fed was not printing money, and that inflation was the result of short-term imbalances that would quickly correct. However, I do have some sympathy for the Fed who, despite claiming independence, are still an arm of the government trying to balance competing interests.

No matter, the Fed has effectively purchased a berth on the Titanic after it hit the iceberg. Mr. Powell is conducting the band while the market is sending up rescue flares and we all wonder who will find a lifeboat.

The MOVE Index was the first to sniff out trouble as it has tripled to the 150s after bottoming in the low 50s in September 2021 (figure below).

As the creator of this Index, let me say that both 50 and 150 are the “wrong number.” A level near 50 can only occur when the Fed actively constrains risk, while a level near 150 occurs when the Fed has lost control.

The MOVE at 150 infers interest rate changes of about 9.5bps per day, a volatility that is unsustainable if only because human beings cannot tolerate such stress for long periods of time.

Much has been written about the clairvoyance of the yield curve, a popular version being the 2s10s which tends to invert 14 months before a recession. As such, there is the case to be made that a recession is not due any earlier than Q2-2023, and thus Fed policy is presently not too aggressive.

However, the spread between the five-year and 30-year swap rates (figure below) is not nearly as sanguine — in fact, it is screaming: Panic!

This spread has rarely breached zero over the past 30 years, yet last month it touched negative 90. (Note: There are a few technicalities that make this not quite an apples-to-apples comparison over time, but trust me, these blips are not worth 90bps.)

One of my favorite indicators is the relationship between the Fed funds and the five-year, five-year rate. The Fed soon cuts rates after they touch (figure below).

With a 5yr-5yr rate near 3.5%, there might only be one more hike ahead and as such, an indicated rate target of near 4.6% would be a massive policy mistake that could have rather dire financial and economic consequences.

To be clear, I am not predicting a 1987-style stock market crash, but stocks will not find a bottom until sometime near the end of the hiking cycle.

Our banking system is in terrific condition with ample reserves. Moreover, there will not be a repeat of the 2007/08 housing collapse since post-GFC regulations require mortgage lenders to affirm that the borrower has sufficient income.

But let us not forget the stock market impact in 1987 when the Fed hiked rates from 6% to 7.5% with inflation barely above 4% (figure below).

The infamous practice of “portfolio insurance” accelerated the speed, but it was the ten-year rate advancing from 7% in January 1987 to 10.25% in October that ultimately broke the market. (And yes, I was on the Merrill Lynch trading floor when it happened — rather surreal.)

Beyond the yield curve, other markets are showing signs of extreme stress. My favorite measure of mortgage bond value has reached levels only visited during the GFC and COVID (figure below).

Remember: MBS have no credit risk.

And not to be too wonky, but the MBS risk profile has improved since they are less negatively convex, and thus are easier to manage in a portfolio.

Some pundits are noting that IG credit spreads have widened by 50bps to near 100bps, indicating stress in the system (figure on the left, below).

Perhaps true, but more importantly, the full cost to borrow for IG firms has exploded from 1% to 5% (figure on the right, above). This will slam the brakes on growth as well as trim profits and stock buybacks.

What will break first is still unclear, as these sorts of events tend to be a surprise, notwithstanding the obvious signals.

A taste of this occurred last month when the UK bond market broke — hard. The Bank of England had to step in buy “unlimited securities” to save their $1.8 trillion pension system that was over exposed to derivative margin calls.

I have warned that rising rates might break the correlation between stock prices and bond yields (figure below), the cornerstone of the 60/40 portfolio.

Since the start of the year, the SPX is down 23% while core bonds are 15% lower.

The big enchilada is the housing market, though. While there will not be a GFC-style crash in home prices or bank stocks, the business of buying and selling homes is about to come to a screeching halt. This is the market sector the Fed is going to break. (Actually, it is already busted.)

With the retail mortgage rate now at 6.5%, a $1,900 monthly payment can only finance $300,000. Assuming a constant $50,000 down payment, a house price must decline from $500,000 to $350,000, or 30%, for the same cash flow cost.

It is unlikely house prices will decline by 30% as supply will be scarce. Homeowners who locked in a 3% rate cannot afford to move to a new house with a 6.5% mortgage, and better credit borrowers will offer few default sales.

To get a sense of scale of this shock to the residential housing market, consider the figure (below), courtesy of Grant’s Interest Rate Observer.

I have taken the liberty of updating the dollar cost to buy a median priced home at the prevailing mortgage rate. An 80% increase in the cost to purchase a median priced home, in nine months, cannot occur without significant consequences.

With 18% of the economy tied to housing, that’s is where the “crash” will occur.

So, where are the air bags? Below is a screen shot of the Fed funds 30-day future contracts.

The column on the left is the start date of the next thirty-day average Fed funds interest rate. The next column is the interest rate expressed as 100 minus the contract price. So, for example, the October 2022 contract is priced at 96.90, which is a rate of 3.1% (100 – 96.90).

Notice the November 2022 contract is priced at 3.745% (100 – 96.255) because the market is almost certain the Fed will raise rates by 75bps at their next meeting. In fact, this is how the pundits calculate the odds of an increase. 3.754% minus 3.10% is 65.5bps of a possible 75bps increase, so the market is pricing the odds at 87.3%. (65.5bp / 75bp = 87.3%)

Notice the lowest price (and highest yield) is the May 2023 contract at 95.345, which is a yield of 4.655%, almost an exact match to the FEDs 4.60% “Dot plot” projection for their policy rate. The market has fully priced that rate level.

That was the closing price grid for Monday, September 26, the date the UST two-year note was auctioned at 4.29%. I would suggest that unless one thinks the Fed will take rates above 4.60% next spring, this will be the peak for UST 2s.

I am not sure how fast the Fed will start to cut rates because CPI will not decline meaningfully for a while, but we are going to be in a full-on recession by then as the housing market will have come to a nearly complete halt.

Harley S. Bassman

October 4, 2022

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