How Treasury Yields Add a Twist to Hopes for a Goldilocks Ending

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

The hot streak for equities cooled, with the S&P 500 and Dow Jones Industrial average each down for the week, while the tech-heavy NASDAQ finished with a slight gain. Rising bond yields were a headwind for equities and underscored how rate cuts by the Federal Reserve may take a while to work their way into the broader economy and could prove to be a less potent boost for the economy than many expect.

As we noted when the Fed was amid its rate tightening cycle, rate hikes typically have variable and unpredictable lags—which is to say that hikes don’t filter through the economy all at once, and not all aspects of the economy feel the same impact. For example, as we’ve noted, the average interest rate paid on all outstanding mortgages was slow to rise during the hiking cycle because the vast majority of outstanding home loans are 30-year fixed rate mortgages, which means they are largely insulated from higher rates. According to data from the Bureau of Economic Analysis, through June the effective interest rate on all outstanding mortgage debt averaged just 3.92 percent. On the other hand, shorter-term loans, such as credit cards and auto loans, reprice much quicker, so rate cuts have a larger impact on consumers who use short-term debt.

The same dynamic holds true when the Fed cuts rates. While short-term borrowers may feel some relief from rate cuts relatively quickly, the overall impact is far from assured. Not only are there variable lags in when rate cuts work their way through the economy, but the Fed Funds rate directly affects only the front end of the yield curve—or short-term rates. Ultimately, fixed income markets dictate intermediate- to longer-term rates. For instance, since the Fed cut rates by 50 basis points last month, which resulted in the effective Fed Funds rate going from 5.33 percent down to 4.83 percent, yields on the two-year Treasury have risen to 4.1 percent from a recent low of 3.54 percent in the week prior to the cut. Similarly, yields on the benchmark 10-year Treasury, which is the basis for mortgage rates, have risen from 3.63 percent at the time of the cut to 4.24 percent as of the end of last week. This has resulted in rates on a 30-year fixed mortgage rising from a national average of 6.58 percent to 7.21 percent at the end of last week. Further complicating the matter is that yields on Treasurys reflect expectations of the Fed cutting rates a total of 1 percent by June 2025. This means that yield on the 10-year Treasury already reflects expectations of those cuts, and if the Fed is unable to deliver due to an uptick of inflation, yields could climb even higher.

We highlight the uncertain and variable lags that result from actions by the Federal Reserve because they may be even more pronounced given the current state of the economy. During the past several months we’ve highlighted how large swaths of the economy are divided between growth and weakness. Instead of an economy that is growing with all areas contributing to its expansion, a handful of pockets are carrying the load. While this dynamic can work for a while, the longer it persists, the greater the risk that weakness eventually spreads and the economy slips into contraction. Simply put, while the Fed has begun to cut rates, it may take several months or a few quarters to determine if the Federal Open Markets Committee acted soon enough to prevent the economy from falling into recession or if it acted too soon and too aggressively, which may result in inflation reawakening.

Similarly, it may take some time before we know if the various recession signals we’ve seen over the past 12-plus months simply no longer apply in a post-COVID world. Indeed, we saw more signs for caution last week in reports such as the Conference Board’s Leading Economic Index and the State Coincident Index from the Federal Reserve Bank of Philadelphia. While some have come to question whether these measures and others (such as the Sahm rule, which focuses in the labor market) are still applicable, we worry they are still valid, but the timing of a potential slowdown has been thrown off by the historic level of fiscal and monetary stimulus that policymakers unleashed during the pandemic

Either way, when the economy eventually regains balance—whether through a soft landing or recession—previously overlooked areas of the market, we believe, will gain traction and possess strong upside potential over the intermediate and longer terms. As we have noted over the past several months, there are ample opportunities in the market—such as small and mid-cap equities—that are trading at relatively attractive valuations and should be well positioned to perform over the next 12 to 18 months whether the economy slips into a recession or a soft landing occurs and the equity market advance broadens. We continue to believe investors will be well served by following an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals.

Wall Street wrap

Cost pressures persist as economic activity slows: The latest S&P Global Composite Purchasing Managers Index (PMI) report shows that U.S. business activity rose modestly in September, with the services side of the economy driving all of the improvement. The latest preliminary data, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 54.3 (levels above 50 signal growth), up from September’s final reading of 54.0.

While the headline number suggests continued economic growth, details highlight that the economic picture remains heavily tilted toward services. The Manufacturing PMI came in at 47.8, up 0.5 points from September but still well into contractionary territory. Meanwhile, the Services Business Activity Index came in at 55.3, up from September’s final reading of 55.2.

Weak manufacturing data has been a persistent problem for the last several quarters and looks set to continue as new orders for manufacturers recorded a fourth straight month of declines. As a result, unsold inventories climbed for the month. As noted in the report, “Inventories of finished goods consequently rose for a fourth successive month, keeping the forward-looking orders-to-inventory ratio at one of the lowest levels seen since the global financial crisis to signal further near-term production weakness.” While weak sales were the primary detractor on the manufacturing side, the sector as a whole is facing widespread weakness, with each of the five components that make up the PMI score registering weakness.

The report contained good news pertaining to inflation, with both goods and services showing a sharp slowdown in selling price inflation. Combined, the monthly pace of selling prices grew at the slowest rate since May 2020. The slowdown was particularly acute on the services side, which saw the slowest pace of selling price growth in almost four and a half years. Likewise, the pace of growth of input costs also slowed—however, not nearly as sharply as retail price inflation. Services input costs eased modestly but remain at the third-highest level in the past year and still well above pre-pandemic levels. Manufacturing input costs eased to a seven-month low thanks to lower fuel costs and less demand for inputs due to slow end-product sales. Restrained selling prices at a time when input costs are still above historic norms could lead businesses to cut payroll costs to protect profit margins.

The composite employment reading declined for a third straight month and has now fallen five of the past seven months. The decline in payrolls was modest, with the bulk coming from the manufacturing side, where businesses opted not to fill vacancies caused by employees leaving.

Perhaps the most noteworthy change captured by the survey was in expectations for the future. After reaching a 23-month low in September, optimism spiked to a 29-month high in October. Much of the snapback was driven by hopes that after the presidential election, orders will start to roll in as uncertainty eases. Additionally, optimism about easing inflation and lower interest rates led to greater confidence going forward. However, as we’ve seen with the rise in yields on intermediate- to longer-term Treasurys, it may take some time before Fed rate cuts begin to make a positive impact on businesses.

Forward-looking indicators decline: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest weak economic growth ahead. The September LEI reading declined 0.5 percent after August’s 0.3 percent decline. The latest measure marks the 30th month of the past 31 readings that have been negative, with the exception being a flat reading in February of this year. The reading is now down 5.2 percent on an annualized basis over the past six months. Weakness remained widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering 35 percent, down from the prior reading of 40 percent. The Conference Board states that when the diffusion index falls below 50 and the decline in the overall index is 4.4 percent or greater over the previous six months, a recession is likely imminent or underway. For context, the diffusion index first fell below 50 in April 2022, and the overall reading first exceeded the negative 4.4 percent level in June 2022. Perhaps because LEI readings have consistently flashed warning signals for the past two and a half years, the conference board stopped short of highlighting the recessionary levels. Instead, the report noted that while the latest LEI reading signaled recession, the economy may only slow down and stop short of an outright contraction.

Beige Book suggests economy stuck in neutral: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed the pace of the economy mostly unchanged from the prior reading, with the majority of the 12 Federal Reserve districts reporting little change in economic activity; however, two reported modest improvement from the last survey.

The latest report showed a slight increase in employment, with more than half of the districts reporting slight or modest growth in hiring and the remainder reporting little or no change. It’s worth noting that the majority of hiring was done to replace workers who had left existing positions as opposed to net new payroll growth. With the pool of available workers expanding, respondents in multiple districts said the pace of wage growth was slowing. Still, larger than usual pay increases were reported for some workers, such as those in skilled trades or remote areas.

Pertaining directly to inflation, most districts reported modest price growth, with some districts noting that consumers were shifting their buying habits to less expensive alternative products. The resistance by consumers to buy higher-priced items comes at a time when businesses’ input costs continue to rise, which the report noted has resulted in margin compression and multiple districts reporting that input prices generally rose faster than selling prices, compressing firms’ profit margins. Should this continue, businesses may opt to cut payrolls (one input they can most directly control) to restore margins going forward.

It’s worth noting that this is the second straight Beige Book report that suggests growth is stagnant or declining. Indeed, the last report showed that nine districts reported flat or declining growth and only three reporting moderate growth. This is yet another example of a typically reliable economic indicator flying in the face of other measures that show solid growth. These types of conflicting measures further complicate the Fed’s task of perfectly calibrating interest rates.

Existing home sales fall while median sales prices set new record: The National Association of Realtors (NAR) reported that existing home sales in the U.S. fell 1 percent in August to a seasonally adjusted annual rate of 3.84 million units. This is the lowest level in nearly 14 years and highlights a housing market that is frozen due to the aforementioned impact of rising mortgage rates and heightened home prices creating a housing market that is unaffordable for many. On a year-over-year basis, sales are down 3.5 percent. The decline in sales occurred despite an increase in activity in the high end of the market, with sales of properties of $1 million rising 8.3 percent from year-ago levels. Mean transactions for houses valued at $500,000 or less declined year over year. This fits with an ongoing trend we’ve seen in which higher interest rates are weighing on less-affluent consumers while having a less significant impact on wealthy households.

While sales once again declined, prices continued to edge higher. The median price for existing single-family homes rose to $404,500 in September, an increase of 2.9 percent from year-ago levels. The inventory of unsold homes has risen to 1.39 million from the recent depths of only 990,000 at the beginning of the year but remains well below the normal 2 – 2.5 million prior to the pandemic. While new homes sales reported later in the week did rise to 738,000 from 709,000 in the prior month, when taken together, the two reports show that challenges remain in the housing market due to affordability and a lack of supply.

Another sign of slowing growth: While we typically discuss national economic data, regular readers know we also find value in indicators at the state level to assess whether trends in the national data are being distorted by a few outliers or represent a broad trend. One such report is the State Coincident Index produced by the Federal Reserve Bank of Philadelphia. The index looks at four state level variables to calculate a diffusion index tied to each state’s economic growth. The latest reading based on September state data shows that the index increased in 36 states, decreased in seven states and was stable in seven, for a one-month diffusion index of 58, up from 26 the previous two months (the lower the index reading, the weaker the employment picture and economy). The three-month average for the index is 48 for the second month in a row. We note that except for a three-month stretch in the fall of 2023, three-month diffusion readings at or below the latest measure have reliably coincided with recessions over the past 40 years.

The week ahead

Tuesday: The Conference Board’s Consumer Confidence report for October comes out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges in finding work.

The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for September. We’ll watch for whether the gap between job openings and job seekers has narrowed further, which could point to further easing of the employment picture. We’ll also keep an eye on the so-called quits rate to see if workers are feeling confident in their ability to find different or better jobs.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values covering September. Prices overall have moved higher in the past several months. We will be looking to see if home prices continue to rise as interest rates are expected to ease, which could lead to higher inflation readings several months from now.

Wednesday: The Bureau of Economic Advisors will release its first estimate of gross domestic product growth for the third quarter. Estimates call for overall economic growth to clock in at 2.9 percent after last quarter’s 3.0 percent. We will be looking for any significant divergence from consensus estimates.

Thursday: The September Personal Consumption Expenditures Price Index from the Bureau of Economic Analysis will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. We’ll be monitoring to see if the latest data shows continued progress in the disinflation process.

Friday: Employment will be in the spotlight as the BLS releases the October jobs report. We’ll see if the jump in job gains in September was an anomaly or a sign of renewed strength. Importantly, we will monitor wage growth and unemployment. Estimates call for the Nonfarm report to show 110,000 jobs added and the unemployment rate to hold steady at 4.1 percent. However, the actual number of new positions may come in lower due to the effects of back-to-back hurricanes that recently battered the Southeast. 

The Institute for Supply Management releases its latest Purchasing Managers Manufacturing Index. Recent readings show inflation pressures for manufacturers have risen even as activity in the sector has slowed. We will monitor it for signs of additional price pressures and the pace of growth in activity.

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