Slower Economic Growth

Bad news for stocks was good news for bonds again this week. Weaker than expected economic data hurt stocks and helped mortgage rates improve to the best levels since Thanksgiving.

At the start of the year, investors were optimistic that the momentum in economic growth seen during the second half of 2013 would continue during 2014. So far, though, the economic data has been disappointing. The Employment report set the tone early in the month. Then the shortfall in China caused global stock markets to fall. The US economic data released this week was weaker than expected as well. Durable Orders, Home Sales, Personal Income, and Jobless Claims all contained downside surprises. That said, it's difficult to determine how much the unusually severe weather experienced this winter affected the data.

The last Fed meeting, when the Fed decided to begin to scale back its bond purchases, was a major market moving event. There was little drama in this Wednesday's Fed meeting, however. As expected, the Fed announced that it will scale back its bond purchases by another $10 billion to $65 billion per month. The Fed statement was very similar to the prior statement. According to the Fed, "growth in economic activity picked up" in recent quarters. In other Fed news, Janet Yellen takes over as Fed Chair starting February 1. Investors expect that the Fed under her leadership will look and act very similar to the Bernanke Fed.

Chinese Manufacturing Slows

The driving force for mortgage rates this week came from an unexpected source. Chinese manufacturing data fell short of expectations, causing sharp losses in global stock markets. Investors shifted to relatively safer assets, helping mortgage rates end the week lower.

On Thursday, China's PMI manufacturing index dropped to 49.6, below the consensus of 50.3. Readings below 50.0 indicate a contraction in the sector. China has been an important engine of growth for the world economy, so a slowdown would have significant implications for global markets. In fact, the news from China completely overwhelmed the strong results in Europe, which showed that manufacturing in the euro zone reached the highest level since the summer of 2011. The Chinese data caused concerns about the pace of global economic growth, and investors sold stocks. This resulted in an increase in demand for bonds, including mortgage-backed securities (MBS).

This week's Existing Home Sales data showed that, despite a slowdown in the fourth quarter, 2013 reflected a year of solid gains. Over five million existing homes were sold in 2013, an increase of 9% from 2012, and the highest level since 2006. While the gains may be more modest, most analysts expect the improvement to continue in 2014 as well. The National Association of Realtors (NAR) projects a very small increase in home sales next year, but both Freddie Mac and the Mortgage Bankers Association (MBA) forecast home sales to increase about 5% in 2014.

Inflation Remains Tame

Mortgage rates began the week with downward momentum following last Friday's big miss on the Employment report. That, combined with low inflation, more than offset this week's slightly stronger than expected economic growth data, and mortgage rates ended the week a little lower.

With the Fed's recent decision to reduce its bond purchases, investors were left evaluating what they believed to be the appropriate level of mortgage rates for the current economic environment. In short, moderate economic growth and low inflation represent relatively favorable conditions for mortgage rates. This week, the December Retail Sales report revealed gains consistent with moderate growth. Since Retail Sales account for about 70% of economic activity, investors pay close attention to this data. Two of the more significant monthly inflation reports also were released this week, the Consumer Price Index (CPI) and the Producer Price Index (PPI), and both confirmed that inflation remains tame. Core CPI was just 1.7% higher than one year ago, well below the Fed's target level of 2.0%, while Core PPI was even lower at 1.4% on an annual basis.

JOLTS, another report released this week, is quickly gaining prominence with investors because it is considered to be a favorite of incoming Fed Chair Janet Yellen. The JOLTS survey measures Job Openings and Labor Turnover levels, providing another level of insight into labor market conditions. Since the Unemployment Rate has been heavily influenced recently by people leaving the labor force rather than by job gains, investors and Fed officials are eager for additional details to judge the strength of the labor market. The November JOLTS data showed that Job Openings unexpectedly rose to the highest level since March 2008. The percentage of people quitting their jobs was nearly unchanged.

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Job Gains Fall Short

Investors were focused on the strength of the labor market this week. A strong reading for job gains in Wednesday's ADP report caused mortgage rates to move a little higher. The ADP data turned out to be a poor indicator for Friday's weaker than expected Employment report, however, and mortgage rates ended the week lower.

Against a consensus forecast of 200K, the economy added just 74K jobs in November. This was the smallest monthly increase in jobs since January 2011. Given that several other labor market indicators showed greater strength in December, many investors were skeptical about how accurately the data reflects the strength of the labor market. For one thing, bad weather likely was a factor in the shortfall, as the construction sector was particularly weak. Upward revisions to the November data also partly offset the December results, leaving average gains of about 160K over the last two months. Bottom line, though, the report fell short of expectations, causing mortgage rates to move lower after the news.

In another twist, the Unemployment Rate unexpectedly declined from 7.0% to 6.7%, the lowest level since October 2008. Looking below the surface, reported job gains accounted for just 0.1% of the decline, while a large group of people leaving the labor force was responsible for the remaining 0.2% decline. While the headline Employment report is based on data collected from just large employers, the Unemployment Rate is derived from a separate survey of individual households. According to this survey, there were job gains of about 150K in December, while roughly 350K people were no longer seeking work and thus were removed from the labor force. Since the Unemployment Rate is simply the number people in the labor force seeking work divided by the total labor force, it counts equally whether a person stops seeking work by finding a job, giving up on the job search, or retiring.

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