foxex: Will Falling Interest Rates Boost or Spook the Stock Market?

Chart Advisor | Focus on the Price

Thursday, March 28, 2019

1. Can falling mortgage rates lift homeowners?

2. S&P 500 stuck in consolidation range

3. Traders pricing in Fed rate cuts by end of 2019

Major Moves

I've been talking a lot about the 10-year Treasury yield (TNX) during the past few weeks because it has been experiencing a rather dramatic decline, falling to levels not seen since December 2017.

One of the reasons I reference the TNX so frequently is it is tied to a variety of assets, indexes and indicators in the financial markets, including the 30-year fixed rate mortgage.

The 30-year fixed rate mortgage is the most popular mortgage among individual home buyers. According to Freddie Mac, approximately 90% of home buyers choose a 30-year mortgage when financing their homes.

So what's the connection between the TNX and the rate on a 30-year mortgage?

These two rates have a positive correlation. When the TNX moves higher, the 30-year mortgage rate tends to move higher. Conversely, when the TNX moves lower, the 30-year mortgage rate tends to move lower.

In fact, these two rates move so consistently together that mortgage brokers will often approximate what the 30-year mortgage rate is going to be in the short term by finding the TNX and adding 2% to it. For instance, if the TNX is at 3%, you could estimate that the 30-year mortgage rate is going to be approximately 5% (3% TNX + 2% Risk Premium = 5%).

Of course, the spread between the two rates isn't always equal to exactly 2%. Currently, the spread between the TNX at 2.39% and the 30-year mortgage rate at 4.06% is only 1.67% (4.06% - 2.39% = 1.67% spread), but it's pretty close to the 2% rule of thumb.

More important than the actual spread between the two rates, however, is the trend those rates are experiencing.

The TNX topped out at 3.24% on November 8, 2018, before turning lower into its current bearish downtrend.

The 30-year mortgage rate was soon to follow, topping out at 4.94% on November 15, 2018 before starting its decline to its current level of 4.06%.

This steady decline in the 30-year mortgage rate has helped stabilize the bullish run that residential home builders – like Lennar (LEN), D.R. Horton (DHI), NVR (NVR), PulteGroup (PHM), Toll Brothers (TOL) and KB Home (KBH) – have been enjoying during early-2019.

The cheaper mortgage rates are, the easier it is for prospective home buyers to qualify and afford new mortgages, which means more people can buy more homes. This is great news for home builders.

If this trend of falling rates continues, watch for the housing sector to continue its strong performance.

S&P 500

The S&P 500 went virtually nowhere today.

To see just how little the index moved, all you have to do is look at the candlesticks. You can fit all of today's candlestick within yesterday's candlestick, and you can fit all of today's candlestick body within yesterday's candlestick body.

Traders could be waiting for any number of things – Brexit votes in British parliament, inflation and consumer sentiment economic announcements or this weekend's Sweet 16 and Elite 8 March Madness rounds (probably not) – but until we get some news to knock things loose, we may be in for an extended consolidation.

Top U.S. Housing Market Indicators

Why the Housing Market Won't Crash Like 2008: Robert Shiller

Risk Indicators - Federal Funds Futures

Earlier this week, I talked about the inversion in the belly of the Treasury yield curve and the longer-term warning sign it is for the stock market.

Today, I'm looking at the short end of the Treasury yield curve and focusing on the Federal Funds rate.

Even though the short end of the yield curve is currently higher than the belly of the curve, traders are starting to anticipate the Federal Open Market Committee (FOMC) is going to try and address that by cutting the Federal Funds rate.

How can you tell if traders are pricing in rate cuts or rate hikes on the Federal Funds rate?

It's actually quite simple. You look at the Federal Funds futures contracts.

When futures traders believe the FOMC is going to hike rates, they push the price of the futures contracts down. Conversely, when futures traders believe the FOMC is going to cut rates, they push the price of the futures contracts up.

For example, the chart below shows the Federal Funds futures contract that expires in December 2019. During late-2018, when traders thought the FOMC was going to continue hiking rates throughout 2019, they pushed the value of these futures contracts lower. However, as soon as the FOMC signaled it was going to take a break from its steady pattern of raising rates, traders started to push the value of these futures contracts higher.

Traders have become increasingly aggressive pushing the December 2019 Federal Funds futures contract higher in the wake of the FOMC's latest monetary policy meeting, where the FOMC signaled it might actually start thinking about cutting rates again.

To get a sense for what rates traders are pricing in, you find the current value of the futures contract and subtract it from 100.

In this case, the current value of 97.855 suggests traders are pricing in a Federal Funds rate of 2.145% (100 – 97.855 = 2.145) by December 2019 – because that's when this particular futures contract expires.

Seeing as how the current Federal Funds target range is 2.25% to 2.5%, the price of the current Federal Funds futures contracts suggests that traders believe the FOMC is going to make a 25 basis point cut to rates – bringing the target range down to 2% to 2.25% – by the end of the year.

The FOMC typically only cuts rates when it sees an economic slowdown on the horizon, or already in progress. That tells us if traders are correct, and the FOMC is going to start cutting rates before the end of 2019, we could be on our way toward an economic slowdown in 2020.

What are the differences between the Federal Funds Rate and LIBOR?

How Do Interest Rates Affect the Stock Market?

Bottom Line - Falling Interest Rates

Determining how falling interest rates – whether they be bond yields or mortgage rates – are going to impact the stock market can be incredibly difficult, especially in the short term.

Sometimes traders react with excitement to falling rates because they indicate it will be easier for businesses and individuals to borrow money and expand the economy. However, sometimes traders react with dread and apprehension because falling interest rates can also indicate the economy is contracting and needs help.

During the bull market that lasted from 2009 to 2018, traders chose to react bullishly to falling interest rates. Unfortunately, it's still too early to tell what they might do in 2019.

Read more:

What You Need to Know About Lyft's IPO

The Impact of an Inverted Yield Curve

Learn the basics of investing

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