Stocks are lower this morning as tech leaders talk about “slowing down” AI development. Bonds and MBS are down as oil rises.
The week ahead will be dominated by the FOMC meeting on Tuesday and Wednesday. The current consensus is that the Fed will hike rates by 25 basis points like the ECB did last week.
Aside from the FOMC we will get housing starts, NAHB Homebuilder sentiment and retail sales. We will also get earnings from homebuilder Lennar.
The Fed Funds futures have a 88% chance for a rate hike at the September meeting. Typically with a September meeting we will get a set of projections and a new dot plot, but with Kevin Warsh’s desire to communicate less, we might not get what we have been used to.
Consumer sentiment declined in early September as gas prices rose according to the University of Michigan Consumer Sentiment Survey. “Consumer sentiment receded less than 4 index points for the second consecutive month of decreases. Democrats and Republicans alike posted sizable declines, while independents were little changed from August. Year-ahead expectations for both personal finances and business conditions plunged. With a resurgence in fuel prices and trade tensions, consumers anticipate greater pressures on their pocketbooks to come. Five-year expected business conditions remained stable at readings well below their historical average, suggesting that consumers believe that emerging risks this month may not have further worsened the long-run outlook. Overall, sentiment is now 16% below February, prior to the start of the Iran conflict, and 13% lower than a year ago.”
Inflation expectations rose from 4% to 4.6% for the year ahead and longer-term expectations rose from 3.3% to 3.4%.
The Wall Street Journal is out with a piece talking about prepayment risk in mortgage backed securities. This is something that hasn’t been an issue since 2022 when the Fed started hiking rates. After the big refi boom of 2020 and 2021, most everyone refinanced into ultra – low 3% mortgages which haven’t had any incentive to refinance since. This created the mortgage rate lock-in effect which is part of the reason why home sales have been disappointing.
That said, as 3% mortgage rates fade into the rear view mirror, the entire mortgage space is resetting to higher and higher coupons. The share of mortgages with 5% rates or higher is now over 40%.
Despite higher rates, people still move, people still do cash-out refinancings and life moves on. This is setting the seeds for a refinance boom if rates begin to fall. This should be good news for the mortgage banking industry which has been through tough times for the last few years.
Interestingly, MBS spread should reflect this and they are not. If you look at the difference between the 30 year fixed rate mortgage and the 10 year bond, the spread has narrowed over the past few years. This indicates that either MBS investors are in denial or perhaps they think the move in the 10 year bond is temporary (i.e. driven by the war in Iran and tariffs). Finally it could be the mortgage market betting that we aren’t going to see lower rates for a long time.
If this reverses, the most vulnerable assets will be agency mortgage REITs and mortgage servicing rights. Right now MSRs are priced for perfection and prepayment risk is treated as a benefit, not a risk because models are pricing in some recapture profits on the refi. It will be interesting to see how MSR values reset when we see a refi wave.
The Fed is about to embark on a tightening regime and historically those have caused economic slowdowns which translate into lower down the road. In the near term, that could cause defaults to rise (and repurchase risk to increase) however a refi boom could be the reward at the end.
