Towards the end of economic expansions, interest rates usually start to rise as strong loan demand bumps up against central bank tightening.
At first the effect on the broader economy is minimal, so consumers, companies and governments don’t let a slight uptick in financing costs interfere with their borrowing and spending. But eventually rising rates begin to bite and borrowers get skittish, throwing the leverage machine into reverse and producing an equities bear market and Main Street recession.
We are there. After a year of gradual increases, interest rates are finally high enough to start popping bubbles. Consider housing and autos:
Mortgage Rates Up, Affordability Down, Housing Party Over
The past few years’ housing boom has been relatively quiet, but a boom nonetheless. Mortgage rates in the 3% – 4% range made houses widely affordable, so demand exceeded supply and prices rose, eventually surpassing 2006 bubble levels in hot markets like Denver and Seattle.
But this week mortgages hit 5% ...
The average rate on the 30-year fixed loan sat just below 4 percent a year ago, after dropping below 3.5 percent in 2016. It just crossed the 5 percent mark, according to Mortgage News Daily. That is the first time in 8 years, and it is poised to move higher. Five percent may still be historically cheap, but higher rates, combined with other challenges facing today’s housing market could cause potential buyers to pull back.
“Five percent is definitely an emotional level inasmuch as it scares prospective buyers about how high rates may continue to go,” said Matthew Graham, chief operating officer of MND.
Home sales have been sliding for much of this year, and total annual sales are expected to come in lower than last year. Affordability is the clear culprit. With rates now more than a full percentage point higher than a year ago, that adds at least $200 more to a monthly mortgage payment for a $300,000 loan. It also knocks some borrowers out of qualification because lenders are strict on how much debt a borrower can carry in relation to his or her income.
In Italy, Ferrari and Pirelli plunged and were halted Limit-down... with China cracking down on luxury goods and broader auto fears...
As Bloomberg reports, Autos "preannouncement gloom continues," according to a note from Evercore ISI says, adding that as feared “we are testing the floor as the group traded down again yesterday on negative news from coating provider PPG,” which has ~35% exposure to Automotive OEM, Parts & Aftermarket, according to the brokerage.
Additionally, Evercore ISI notes that 2H18 will be “ugliest reporting season” for suppliers since 2015.
European Autos are trading at their lowest levels of the Trump era...
The cure for the last crisis always turns into the cause of the next one...
The economies of southern Europe – Greece, Italy, Spain and Portugal – nearly collapsed in 2011, and Europe’s monetary authorities responded with negative interest rates. So did Japan.
Europeans and Japanese pay to hold cash or own 10-year German government bonds, whichmeans that every pension fund and insurer will fold in a finite time horizon. They responded by exporting more, saving more, and buying American assets that still pay a positive, if low, real yield.
Hedging the foreign exchange risk in this half-trillion-dollar per year business has exhausted the balance sheet of the global banking system. That explains a large part of the jump in the US 10-year note yield to 3.2% last Friday from 2.85% in early September. Hedging the foreign exchange risk in these massive flows created a derivatives mountain, and it has started to spew smoke and lava.
If the foreign bid for US debt dries up, the cost of financing America’s $1 trillion annual budget deficit will rise, and so will interest costs around the world.
European banks are running out of borrowing capacity. After five years of negative short-term rates, their profitability is low, their stock prices are falling and their credit is deteriorating. They can no longer borrow the dollars required to construct the hedges that local investors need.
Foreign exchange derivatives form the biggest mountain of obligations in the world financial system – a notional amount of about $90 trillion, up from $60 trillion in 2010.
For more than one year, international bank regulators and the International Monetary Fund have warned that the banking system no longer can support these enormous flows.
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