Morning Report: The era of low mortgage rate is over

Vital Statistics:

Last Change
S&P futures 2713 -5.75
Eurostoxx index 394.37 -1.42
Oil (WTI) 71.39 -0.08
10 Year Government Bond Yield 3.09%
30 Year fixed rate mortgage 4.69%

Stocks are lower this morning on no real news. Bonds and MBS are up small.

Slow news day. with no economic data.

The Wall Street Journal has declared the era of low mortgage rates is over. What does this mean for the industry? For the industry overall, it means a tougher fight to keep purchase business, but it also could depress home sales as a combination of higher home prices and higher rates make moving up too unaffordable. NAR estimates that the effect of a 100 basis point increase in mortgage rates can reduce sales by 8%. Mortgage rates have been on a tear this year, increasing 62 basis points since the end of 2017. The 10 year yield has increased by the same amount, and usually mortgage rates don’t move up in a 1:1 ratio with Treasuries. I wouldn’t be surprised to see mortgage rates fall if Treasury yields stall out here.

I suspect that “convexity selling” has been driving the moves in rates. Mortgages have a quirky characteristic called negative convexity. Negative convexity explains why a GN mortgage with an expected duration of 7 years will pay a higher yield than a Treasury with a duration of 7 years. Neither one has credit risk, but they have different interest rate risk. MBS investors (say mortgage REITs or hedge funds) will buy mortgages and hedge interest rate risk by selling Treasuries. As interest rates rise, they can get balanced by either selling MBS (which pushes mortgage rates up) or by buying Treasuries (which pushes interest rates up). Whenever you see big moves in rates during a short period of time, you are often seeing convexity hedging exacerbating the move, which is why you will see a retracement in rates after the re-hedging activity finishes. We saw a big move this week as Treasuries broke the 3.1% level. Mortgage rates have shot up as well.

Do credit cycles drive the business cycle or is it the other way around? Historically, business cycles have driven credit cycles. In other words, business dries up, making debt harder to service, which causes banks to retrench and raise cash. The last two cycles however, the credit cycle drove the business cycle. Credit tightened up first, and then the economy rolled over. Is this a new trend? My guess is that it probably isn’t, as the last two economic booms were driven by bubbles in stocks (late 90s) and residential real estate (mid 00s). This time around, asset prices are high, but we don’t have anything comparable to the stock market or real estate bubbles this time around. Your major macro credit risk is that the Fed overdoes it, not that a bunch of debt backed by garbage assets implodes.

Everyone loves ETFs these days. They have low fees, provide instant diversification, and are liquid. In the fixed income market however, the liquidity is probably a bit of an illusion. Corporate bond issuance has soared since the bottom of the cycle in 2012, yet the amount of market-making capacity has been shrunk by 80-90%. The issue for ETF investors is that they expect to have liquidity in these instruments, but in a crisis the underlying assets of these bond funds will experience a tremendous shock. Why? Because Dodd-Frank’s Volcker Rule has essentially ended market-making as a business for banks. Market-making activity means that when everyone wants to sell, the banks who issued these bonds would usually step in and act as the buyer of last resort. This time around, that won’t happen and ETFs will trade at huge discounts to their supposed net asset value. There is no such thing as a financial free lunch, and investors are going to discover the downside of low fees, tight spreads and marginal cost commissions the next time the credit cycle turns.

Morning Report: Housing starts disappoint again

Vital Statistics:

Last Change
S&P futures 2705 -3.5
Eurostoxx index 393.19 0.82
Oil (WTI) 70.93 -0.38
10 Year Government Bond Yield 3.06%
30 Year fixed rate mortgage 4.65%

Stocks are lower this morning after North Korea pushed back on the proposal to end their nuke program. Bonds and MBS are higher after the the 10 year decisively pushed through the 3% level yesterday.

The 10 year hit 3.10% yesterday on no real news. If the inflation numbers aren’t all that bad, why are rates increasing? Supply. The government will need to issue about $650 billion in Treasuries this year compared to $420 billion last year. Note that one of the downsides of protectionism will be seen here – when the US buys imports from China, they usually take Treasuries in return. Less trade means less demand for paper.

Rising rates may present problems for active money managers. The average tenure is 8 years, so this is the first tightening cycle they have ever seen. For the past decade, cash and short term debt have not been any sort of competition for stocks and long term bonds. Note that the 1 year Treasury finally passed the dividend yield on the S&P 500. Stocks and bonds are going to see money managers allocate more to short term debt.

Despite rising rates, financial conditions continue to ease. The Chicago Fed National Financial Conditions Index is back to pre-crisis levels. Note that doesn’t necessarily mean we are set up for another Great Recession – the index can stay at these levels for a long time, and we don’t have a residential real estate bubble. That said, this index can be one of those canaries in a coal mine for investors – at least selling when it goes from negative to positive.

NFCI

Mortgage Applications fell 2.7% last week as purchases fell 2% and refis fell 4%. The refi index is at the lowest level in almost 10 years, and the refi share of mortgage origination is at 36%. The typical conforming rate fell a basis point to 4.76%.

April Housing starts came in at 1.29 million, down 4% MOM but up 11% YOY. The Street was looking for 1.32 million. Building Permits 1.35 million which was right in line with estimates. Multi-family was the weak spot. Note that March’s numbers were unusually strong (relative to recent history), so April was a bit of a give-back.

Industrial production rose 0.7% last month while manufacturing production rose 0.5%. Capacity Utilization rose to 78%.

New York State is suing HUD to force them to continue to use the Obama-era standard of enforcing AFFH. HUD delayed the rule after numerous local governments were unable to implement policies in time.  Andrew Cuomo’s statement: “As a former HUD Secretary, it is unconscionable to me that the agency entrusted to protect against housing discrimination is abdicating its responsibility, and New York will not stand by and allow the federal government to undo decades of progress in housing rights,” Cuomo said in a statement. “The right to rent or buy housing free from discrimination is fundamental under the law, and we must do everything in our power to protect those rights and fight segregation in our communities.”  Of course overt housing discrimination hasn’t existed for half a century, but that isn’t what this is about.  The issue is zoning ordinances and multi-fam construction. Expect to see more of this sort of thing in blue states as the housing shortage gets worse.