Rebecca Patterson: Inflation being higher & stickier changes how the 10Y is reacting to policy

Key Concepts

• Housing market dynamics
• Federal Reserve (Fed) rate cuts
• Ten-year Treasury yield
• Inflationary environment vs. disinflationary environment
• Labor market softening
• AI investment and its impact on employment
• Tariffs and input costs
• Insurance premiums
• Productivity and disinflationary "Goldilocks" boom

Housing Market and Interest Rates

• Housing Market Downturn: Housing starts and permits are down for four consecutive months, a trend not seen since 2008.
• Treasury Secretary's View: The Treasury Secretary believes that Fed rate cuts will support growth and help consumers buy homes by injecting liquidity into the market.
• Complicating Factors: Rebecca Patterson argues that the situation is more complex than just Fed rate cuts. Other factors include:
  • Input Costs: Tariffs are increasing input costs for home builders.
  • Labor Costs: Immigration policies are impacting labor costs.
  • Insurance Premiums: Skyrocketing insurance premiums are a significant challenge for housing affordability.
• Ten-Year Yield vs. Fed Funds Rate: Mortgage rates are primarily influenced by the ten-year Treasury yield, not the Fed funds rate.
  • Example: Last year, and earlier this month with the Bank of England, rate cuts spurred expectations for more growth and inflation, pushing up the ten-year yield and hurting the housing market.
• Mortgage Rate Behavior: Mortgage rates bottomed last fall as the Fed began to cut rates, contradicting the common notion that Fed cuts automatically lead to cheaper mortgages.

Inflationary Environment and Bond Behavior

• Different Regime: The current environment is different due to higher and stickier inflation, which changes how the ten-year yield reacts to policy changes.
• Historical Context: For the past 20 years, with extremely low inflation, the market focused on jobs and the Fed. Fed cuts helped jobs, and all was good.
• Bonds as Diversifiers: In a low-inflation environment, bonds served as diversifiers during recessions due to safety concerns.
• Inflationary Regime Impact: In a more inflationary regime, equities become a better inflation hedge than bonds. Bonds' behavior in an inflationary, supply-demand-challenged environment will differ from the past 20 years.

Labor Market and AI

• Softening Labor Market: There are increasing signs of a softening labor market, expected to accelerate towards the end of the year and into next year.
• Conference Board CEO Survey: 34% of CEOs expect job cuts in the next 12 months, the first time this has happened since COVID.
• AI Deployment: Companies are deploying AI at an unprecedented rate, which could potentially push away from inflation.
• AI Investment vs. Efficiencies: Companies are investing heavily in AI infrastructure and training, which requires significant upfront costs.
• Offsetting Costs: To offset AI investment costs, companies are considering headcount reductions through hiring freezes or actual trimming.
• CFO Perspective: CFOs are being pressured by CEOs, shareholders, and boards to invest in AI and reap efficiencies, but this requires finding offsets elsewhere, often through headcount management.

Productivity and Disinflationary Boom

• Uncertainty about AI Impact: The timing and degree of the disinflationary "Goldilocks" boom from AI are uncertain, even among Hyperscaler CEOs.
• Build-Out Phase: Currently, companies are in the build-out phase, spending money to integrate AI and train staff.
• Timing of Disinflationary Effects: It's still a while away from seeing the disinflationary effects of AI.

Conclusion

The relationship between Fed rate cuts and the housing market is complex and influenced by factors beyond just the Fed funds rate. High inflation, tariffs, labor costs, and insurance premiums all play a role. The impact of AI on the labor market and inflation is uncertain, with companies currently focused on investing in AI infrastructure, which may lead to near-term cost-cutting measures like headcount reductions. The disinflationary benefits of AI are expected, but the timing and magnitude remain unclear.