Implications:  Existing home sales continued to struggle in May as a lack of available listings dissuaded potential buyers.  Sales of previously-owned homes fell 0.4% in May to a 5.43 million annual rate.  Sales were tepid in much of the country, with only the Northeast region (which represents the smallest portion of overall activity) posting a gain. As a result, sales on a year-over-year basis declined for a third consecutive month.  Looking forward, we expect sales of existing homes to tread water due to two factors: a lack of inventory and a shift in taste toward new homes.  In May, only 1.85 million unsold existing homes remained on the market at months end.  That may sound like a lot of homes, but it's the fewest available units for any May since records began being kept in 1999.  Inventories, down 6.1% in the past year, have now declined on a year-over-year basis for 36 consecutive months.  The months' supply of existing homes – how long it would take to sell the current inventory at the most recent sales pace – was 4.1 in May.  According to the NAR, anything less than 5.0 months (a level we haven't breached since 2015) is considered tight supply.  Although some analysts might suggest weakness in existing home sales might reflect higher mortgage rates, we doubt that's the case: new home sales continue to show healthy gains in spite of higher mortgage rates.  As we mentioned in yesterday's report on housing starts, there is a potential source of relief on the horizon for existing home sales.  Both the level of new construction activity and the pace developers are completing new units are at their fastest since the recession. As properties are completed, and more homeowners choose to trade up or down into a new home, more existing homes should make their way onto the market.  This will help alleviate the supply problems that have pushed up the median age of homes in the U.S. from 31 years in 2005 to 37 years in 2015, the most recent data available. Even with the current lack of choices, demand for existing homes has remained remarkably strong, with 58% of homes sold in May remaining on the market for less than a month.  Higher demand and a shift in the "mix" of homes sold toward more expensive properties has also driven up the median sales price, which is up 4.9% from a year ago.  Some analysts may be concerned about the impact of tax reform on home sales, but few homeowners exceed the new thresholds for deductibility and newer homes, where growth has been faster, carry a higher price and are therefore more likely to trigger the cap on mortgage deductibility.

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Implications:  Housing starts rebounded sharply in May, easily beating consensus expectations to reach the highest level since 2007.  Starts rose 5.0% in May to a 1.350 million annual rate, and are now up 20.3% in the past year.  The Midwest was entirely responsible for the gain, surging 62.2%, while other regions had declines.  This May was unusually strong relative to the trend, while May 2017 had the slowest pace for housing starts in all of 2017 - that pushed the year-over-year gain above trend.  We expect further gains in the year ahead, although we expect the pace of gains to slow.   One way to cut through the monthly noise is to compare the first five months of 2018 versus the same period in 2017.  By that measure starts are up 10.2% from a year ago.  New single-family construction continues to be the main driver of trend growth, as the chart to the right demonstrates.  We expect further strength from single-family starts in the years ahead, and a continued transition to more growth in single-family construction from multi-family will be good news for the overall economy.  On average, each single-family home contributes to GDP about twice the amount of a multi-family unit.  The worst news in today's report was that permits for future construction fell 4.6% in May, as both single-family and multi-unit permits showed declines.  That said, overall permits are still up a healthy 8% in the past year.  Further, the horizon is brightening, with the number of units currently under construction at the highest pace since 2008.  Developers are also completing units at the fastest pace since the recession, freeing them up to start construction of new homes.  Housing starts are still up in spite of a significant uptick in mortgage rates, which some analysts claimed would derail the housing recovery.  As we have argued, higher interest rates can be sustained as long as jobs and incomes are rising.  Based on population growth and "scrappage," look for housing starts to rise to an average of about 1.5 million units per year by late 2019.  And the longer this process takes, the more room the housing market will have to eventually overshoot that mark.  That said, there are a couple factors that seem to be holding this process back.  The National Association of Home Builders claims 84% of developers cited labor shortages and the rising cost of building materials as one of their biggest problems in 2018.  Both these issues seem set to continue as an increasingly tight labor market keeps the number of job openings in construction elevated and tariffs on lumber, steel, and aluminum drive up input costs.  Highlighting these issues, the NAHB index, which measures homebuilder sentiment, fell slightly to 68 in June from 70 in May, primarily reflecting concerns about rising lumber costs that have added an estimated $9,000 to the price of a new home since January 2017.  We understand why some would look at this as a negative, but the Homebuilder Index is still at a high level and we remain bullish on housing in the year ahead.

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We've always been skeptical that bond yields carry deep meaning about the future.  Low Treasury bond yields in recent years were said to be a signal of slower growth, or possibly a recession, ahead.  And the bond world said stocks were over-valued.

Clearly, the forecasted recession never came.  Not only is the economy accelerating, but the recovery is likely to become the longest on record.  And stocks have handily outperformed bonds.

Now, low bond yields are supposed to signal the Fed is getting close to being too tight.  Either too many rate hikes will cause a recession, or the Fed will hike rates only twice next year as the economy slows.  And, of course, the bond world says this too is bad for stocks.

We see at least two mistaken beliefs that are influencing bond bulls these days.  The first mistake is that the Fed will lift rates only once or twice in 2019.  We believe four rate hikes are more likely, with more to follow in 2020.  The reason is simple.  Nominal GDP is accelerating, and likely to grow at a rate of 5%+ over the next few years.

But four rate hikes of 0.25% in 2019, after two more in 2018, will only push the federal funds rate near 3.5%.  History (in 1969, 1973, early 1980s, late 1980s, 2000, and 2007) shows that, in order for the Fed to create a recession, it needs to push the federal funds rate above nominal GDP growth.  Right now, the Fed is chasing growth, and bond markets are underestimating how much rates must rise before policy becomes "tight."

This, we believe, has pushed the long-term bond market into what appears to be a bubble.  At a 2.92% yield, the implied Price-Earnings (PE) ratio for the 10-year Treasury Note is 34.2, with zero chance of an increase in earnings in the next 10 years.

That doesn't sound like a very good investment to us.  Real GDP is likely to grow at a 3% rate this year, while consumer prices should rise 2.5%.  In other words, nominal GDP – total spending in the US economy – will rise by 5.5% in 2018, which means revenue at the "average" company will grow at that pace, as well – double the yield on a 10-year Note.

Corporate profits are growing even faster than GDP – most likely 20%+ this year – and hundreds of companies have raised dividends in the past year.  The PE ratio of the S&P 500 is 21 based on trailing twelve months' earnings, and less than 17 on forward earnings.

Yet, even with all that data in front of them, many bond investors are convinced the 10-year yield is likely to decline in the next year, making long-term bonds a slightly more palatable investment.

Instead, it looks like the bond market is acting like the stock market in 1999, when our capitalized profits model said stocks were 62% overvalued.  But, like all bubbles, a vast majority of investors still believed stocks could go higher.  Obviously, they were wrong.

The second mistake animating the bond market is the belief that the narrowing spread between the federal funds rate and the IOER (Interest Rate on Excess Reserves) signals a developing shortage of reserves – a sign of tight Fed policy.

Yet, there are still $1.9 trillion in excess reserves in the banking system – which contradicts any belief that Fed policy is remotely close to being tight.  There are very few banks that actually trade federal funds, because they simply don't need them. 

Meanwhile, the Fed has been doing reverse repos with institutions (like Fannie Mae and Freddie Mac) because it is not allowed to pay them interest on reserves.  What has happened is that those reserves (the Fannie/Freddie kind) have now been mostly drained from the system, which means the difference between these short-term rates is narrowing.  This is not a sign of a lack of bank reserves, just that excess liquidity outside of the banking system is getting tighter and more competitive.

As a result, the IOER is becoming the most important short-term rate in the monetary system.  Today, at 1.95%, it is still too low.  The key question is whether the Fed can pay banks enough not to lend out that money, even as accelerating growth creates more profitable opportunities to lend.  If the Fed can do that – pay banks not to lend – then excess reserves are not a sign of easy money.  But, lending rates are still much higher than IOER, and banks have excess capital as well.

In other words, the Fed is nowhere near "tight," and the market is mis-pricing both growth and inflation risks to bond yields.  Rates look far more likely to rise than fall.

Brian S. Wesbury - Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

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Source: St. Louis Federal Reserve FRED Database

Implications:  After hitting the highest level on record in April, industrial production slipped 0.1% in May, primarily due to a major fire at a parts supplier in central Michigan that does business with many automakers around the country.  Due to the disruption, auto production fell 6.5% for the month, the largest single-month decline since 2011.  But excluding the drop in autos, industrial production increased 0.3% in May, a perfectly respectable number.  The worst news in today's report was that manufacturing excluding the auto sector, what we call "core" production, declined 0.2% in May.  That said, it's not unusual for that number to bounce up and down from month to month while the trend moves higher. For example, the past year has seen core production rise 2.0% despite seven of the twelve months showing declines.  The best news in May came from mining, which rose 1.8%, the fourth consecutive monthly gain, on the back of healthy increases in oil and gas extraction.  In the past year, mining is up 12.5%.  And the rig count has continued to rise in recent weeks, suggesting gains in mining production will continue in the months ahead.  Meanwhile, utilities output remained strong, rising 1.0%, as the warmest May on record drove up demand for air conditioning.  In other manufacturing news this morning, the Empire State index, a measure of factory sentiment in New York, surged to 25.0 in June from 20.1 in May, signaling growing optimism in the region.

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