Top of the Street: Inflation goes MIA, financial conditions ease, the bid for credit builds and a simple guide to the ins-and-outs of QE

Low inflation gives the Fed breathing room until December. Bull markets ease financial conditions. Yield makes credit a buy. Mortgage credit eases. A simple guide to QE. Contributions from CoreLogic, DB, GS, NY Fed, JPM and Milepost.

Markets: Rates rise and fall on inflation
Inflation continues to defy Fed expectations, with Friday’s core CPI coming in below expectations and a YoY core of 1.70% marking the lowest since Feb 2015. Longer Treasury rates dropped, and economists at JPMorgan, Deutsche Bank and elsewhere revised 2017 inflation forecasts down. The Fed will almost certainly use the time between now and December to trim its SOMA portfolio starting in September and to get a clearer read on inflation. The Fed still expects a tight labor market to give it enough inflation to hike in December. But the recent soft numbers have come largely from technology-driven improvements in product quality without commensurate increases in product price, a form of backdoor deflation. This could be a new and unpredictable challenge to the Fed. See JPM, US Fixed Income Markets Weekly: Economics, 14 Jul 2017. (JPM, Milepost).

Markets: The Fed hikes, but financial conditions ease
Despite three hikes in fed funds since December and plans to reverse QE this fall, US financial conditions have nevertheless eased. Rallying equities, persistently low long rates, tight corporate and MBS spreads and low volatility have produced the equivalent of a 25 bp cut in fed funds, according to Deutsche Bank. The FOMC has noticed, with comments on asset prices from seven members since early May and discussion noted in the June minutes. The Fed traditionally uses regulation to manage potential asset bubbles and their risk to financial stability. But easing financial conditions could make a stronger case for continuing fed hikes, according to Goldman Sachs, by lifting expected growth and, with the current tight labor market, inflation. That’s the concern echoed in the June FOMC minutes. Goldman sees the easier conditions keeping the Fed on the march to higher rates. See Deutsche Bank, US Economic Perspectives: The Fed’s evolving views on financial conditions, 13 Jul 2017. See also Goldman Sachs, US Economics Analyst: The Fed and Financial Stability, 15 Jul 2017. (DB, GS, Milepost).

Markets: Demand for US credit continues
Tight spreads on corporate debt have added to a net easing of US financial conditions this year, and Deutsche Bank thinks demand will continue until rates rise globally. “Demand for US credit is likely to remain a net positive factor for as long the proportion of (global bond market) income coming from US credit stays above 20%,” the bank’s analysts write. US credit currently spins off 25% of global market income. With the aggregate global market now yielding 1.64%, the share of income from US credit could drop below 20% if global yield tops 2.00%. Investors could then find yield in places other than US credit, cooling demand. See Deutsche Bank, US Credit Strategy: The limit is near, 14 Jul 2017. (DB, Milepost).

Markets/economy: Fannie Mae eases mortgage credit a bit
Mortgage credit will soon be a little easier to get, and that should edge delinquencies and prepayments up. The top debt-to-income ratio acceptable for Fannie Mae automated underwriting will jump from 45% to 50% on July 29, the enterprise announced last week. The enterprise had allowed 50% DTI ratios but only with a loan-to-value ratio of 80% or less and at least 12 months of borrower reserves. Now Fannie Mae will lift the LTV and reserve requirements. Goldman Sachs expects to delinquencies to rise a bit. And the slight easing in credit could lift prepayments in conventional, FHA and VA loans with high LTVs. See Goldman Sachs, The Mortgage Trader, 14 Jul 2017. (GS, Milepost).

Markets/economy: Single-family rents cool
Rents on single-family homes rose 2.9% YoY in May, according to CoreLogic, continuing a streak of more than six years of monthly increases but well below the Feb 2016 peak of 4.3%. Rising supply of rental property may be cooling the market. The slowest rise in rents came in the most expensive properties, which saw a 2.0% gain, while rents on the least expensive properties rose 4.5%. Trends varied significantly across metro markets. “Cities with limited new construction and strong local economies that attract new employees to the market tend to have low rental vacancy rates and strong rent growth,” CoreLogic wrote. Rents in Seattle jumped 4.5% YoY with rents in Miami and Houston down by 1.0% or more. The CoreLogic post is here. (CoreLogic, Milepost).

Markets/economy/banking: A very simple guide to getting in and out of QE
Understanding the impact of QE on the Fed balance sheet, bank reserves and on the Treasury and public balance sheet has rarely been easy, until now. The NY Fed recently has released simple guides to how QE changes these essential parts of the financial system. The guides trace the impact of buying or selling $1 of Treasury debt or MBS from either a bank or the public. The NY Fed must want the public to understand. One of the authors is Simon Potter, who runs the trading desk executing all of this QE. The post on Treasury debt is here. And the post on MBS is here. (NY Fed, Milepost).