Thursday, May 17, 2018

Interest rate and gas price watch

 - by New Deal democrat

For nearly a decade, this "little expansion that could" has dodged a lot of bullets. But I suspect that the recent trend of rising interest rates and gas prices - if they continue - may finally be the cause of its ultimate demise (not now, but maybe in 18 or 24 months).  

Initial points to watch are 5% on mortgage rates and $3/gallon on gas prices.

So let's take a look. First, here are mortgage rates through yesterday (from Mortgage News Daily):

In 2016, these were as low as about 3.4%. Even after the US Presidential election, last year they hovered at about 4%. As of yesterday, they were 4.78%. Compared with mid-2016, about $375/month has been added on to the monthly payment for a new $300,000 mortgage.

Still, we're not quite at the 5% level yet (to reiterate: my best guess is that it will take 5.25% rates for at least 6 months to overcome the demographic tailwind in the housing market).

Next, here are gas prices through yesterday (from GasBuddy):

These have risen to $2.92/gallon. I suspect we will see $3/gallon shortly.

I've seen commentary that it will probably take $5/gallon for consumers to cut back on spending generally. This comes generally from the work done by Prof. James Hamilton in which he posits that consumers aren't "shocked" by a mere return to formerly high price levels. But I suspect that, as time goes on, consumers get more and more used to lower prices, so it might not take that much.

As an example, I give you the 1980s. Gas prices had risen from $.40/gallon to $.80/gallon in the 1974 Arab embargo, and then to roughly $1.35/gallon in the second shock in 80. In the early 1980s, they hovered near that mark before falling abruptly at mid-decade. They started rising again by 1989, and spiked to about $1.35/gallon during Saddam Hussein's invasion of Kuwait (red line below):

YoY real GDP started to fade in 1989, and rolled over in 1991 coincident with that invasion.

While it's noisy, when we compare real retail sales with gas prices, generally we see a 1:1 substitution in consumer spending into 1989, and then that fades as well until the shock in 1990:

In 1990, gas prices were less than 10% above their 1980 peak by this measure. In other measures, they didn't even quite reach that peak. In today's terms that would mean about $4.50 (compared with 2008's $4.23).

At $3/gallon, we will reach a point comparable with 1989. So my suspicion is that consumers will simply re-allocate spending from luxuries like entertainment at first. That will still cause $$$ to flow out of the US to petrosheikhdoms. If we get above $4/gallon towards, $4.50, that will probably be enough for consumer retrenchment.

Mind you, I'm not saying that we *will* reach these interest rate and gas price levels. But it's time to start watching.