Morning Report: Why mortgage rates don’t exactly mirror Treasury rates

Vital Statistics:

 

Last Change
S&P futures 2788 7
Oil (WTI) 59.1 0.1
10 year government bond yield 2.26%
30 year fixed rate mortgage 4.24%

 

Stocks are higher this morning on no real news. Bonds and MBS are down small.

 

First quarter GDP was revised downward from 3.2% to 3.1%. Increased exports offset a downward revision in residential fixed investment (homebuilding). The inflation number was also revised downward and is well below the Fed’s 2% target. The Fed funds futures are now forecasting a more than 80% chance of a rate cut this year.

 

Initial Jobless Claims ticked up to 215k from 212k the prior week.

 

In market environments like yesterday, I always seem to get the following question: “Brent, the 10 year is down from 2.4% to 2.25% over the past two weeks. I just ran a scenario and only saw a small improvement in pricing. How come?” The short answer to that question is that mortgage rates are tied to the prices of mortgage backed securities which are influenced, but not determined by the 10 year. (This is why my opening statement always talks about bonds and MBS – they are different animals and will behave differently to changing market conditions)

 

To make things even more complicated, mortgage backed securities will behave differently depending on the coupon. Take a look below at what a typical MBS screen looks like. This lists the TBAs (stands for to-be-announced) mortgage backed securities that correspond to Fannie Mae loans. If you do a Fannie Mae loan, it is probably going to go into one of these securities. You can see that there is a different security for each month of delivery and note rate. On the far left hand side you can see the coupon groupings. It starts at 3%, then goes to 3.5%, then to 4% and so on. The delivery months are also listed: June, July, and August. Note that the price falls as you go out in the future. This is why a 45 day lock costs more money than a 15 day lock.

 

During the day, mortgage backed securities will trade and prices will be updated pretty frequently. So, if the 10 year bond rate falls by, say 5 basis points, you could see the implied yield of the Fannie 4% of August drop by 5 basis point, 2 basis points, whatever. It will be a function of the supply and demand for that mortgage backed security. Since these prices are the inputs to the rate sheets you see every day, this is the security that really matters, not the 10 year.

 

MBS

 

If you take a look at the 4% coupon, you’ll see them trading at just under 103. An investor who buys a mortgage backed security is paying 103 for a bond that will pay 100 at some time in the future. Why would a rational investor do that? The answer lies in the interest. The 4% interest payment is higher than the corresponding rate you would get on the benchmark Treasury, which is 2.375%. That difference is the compensation for paying more than par. The investor is betting that they will get that extra interest for a long enough period to cover the extra 3 points they paid. If the mortgages pay off earlier than expected, then the investor is out of luck. This is why early refinancings are a no-no and why Ginnie Mae is taking action to prevent early refinancings of VA loans.

 

So, when interest rates fall, like we have seen over the past couple of days, the rates on mortgages don’t fall in lockstep. MBS investors will re-evaluate their prepayment models and figure out the right price to pay given the fact that the period they will get that extra interest has changed. Before, they might have expected to get it for, say 7 years. Now they expect to get it for 6 years. When they crunch the numbers, they come up with a right price to pay for that 4% mortgage backed security. And the price for that mortgage backed security will then be used for everyone’s rate sheets. To make things even more complicated, the change in price for a 3% security will differ from a 4% security. The name for this whole phenomenon is called convexity, and it gets into some gnarly bond math. But the punch line about convexity is that mortgage backed securities have a lot of it, which causes them to behave differently than the 10 year. So, when you see on CNBC that the 10 year bond yield fell 10 basis points, you can’t expect to see a corresponding 10 basis point improvement in mortgage rates. It just doesn’t work that way.

Advertisements

Morning Report: New home sales still anemic historically

Vital Statistics:

 

Last Change
S&P futures 2821  9
Eurostoxx index 380.4 1.8
Oil (WTI) 58.12 -0.14
10 year government bond yield 2.60%
30 year fixed rate mortgage 4.28%

 

Stocks are higher this morning on overseas strength, particularly in China and Japan. Bonds and MBS are up.

 

New Home Sales fell to 607,000 in January, according to the Census Bureau. This is down 7% MOM and 4% YOY. New Homes Sales is a notoriously volatile number, and the margin for error is generally in the mid-teens %. Still 607,000 is roughly in line with historical averages over the past 50 years. That said, population has grown since then, so it isn’t really comparable. Take a look at the chart below, which is new home sales divided by population – we are still only at levels associated with the depths of prior recessions. In other words, we are still in very early innings with the housing recovery, and you can make an argument that the recovery hasn’t even begun yet.

 

new home sales divided by population

 

Industrial Production rose 0.1% in February, and January’s initial 0.6% drop was revised upward to -0.4%. Manufacturing production fell 0.4%, while January’s 0.9% drop was revised upward to -0.5%. Capacity Utilization fell to 78.2%, while Jan was revised up again. So, Feb wasn’t great, but January wasn’t as bad as it initially appeared to be.

 

We have entered the quiet period for the Fed ahead of their meeting next week. No rate hikes are expected, although we will get new economic forecasts and a new dot plot. Sentiment regarding the Fed has changed massively over the past few months. As of now, the the Fed funds futures are estimating that there is a 75% chance the Fed does nothing this year, and a 25% chance they cut rates by 25 basis points. The fed funds futures are pricing a 0% chance of a hike. While Trump’s jawboning of the Fed was bad form, and you generally don’t want to see presidents doing that, you also can’t escape the fact that the Fed Funds futures and the markets think he was right!

 

 

Morning Report: Home sizes decrease

Vital Statistics:

 

Last Change
S&P futures 2664 -6
Eurostoxx index 357.22 -1.11
Oil (WTI) 51.69 0.06
10 year government bond yield 3.06%
30 year fixed rate mortgage 4.89%

 

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

 

We have a lot of Fed-speak today, with 4 different speeches. As we approach the December Fed meeting, the markets will hang on every word, looking for clues about 2019. The Fed funds futures are increasing their probability of a December hike, which is up to 80% compared to 66% a month ago.

 

Economic growth accelerated a touch in October, according to the Chicago Fed National Activity Index. The CFNAI is a meta-index of some 85 different statistics, and in October employment-related numbers (things like unemployment and initial jobless claims) were the drivers. Production-related statistics slowed a touch, but overall the economy is growing above trend.

 

Median home sizes are falling, as more and more builders focus on building starter homes. Home sizes rose during the housing bust as the luxury end of the market was about the only segment that was working. This trend was exacerbated by debt levels and employment uncertainty for the first time homebuyer. In addition, the Millennial generation tended to favor urban areas, and builders focused on apartment building. Now, we are seeing a glut of properties at the high end, and strong demand for starter homes as the first time homebuyer moves to the suburbs. Note that the latest existing home sales data had the first time homebuyer share at 31%. Historically, that number has been closer to 40%.

 

home sizes

 

Signs of things to come? The Dallas home market is cooling off, as affordability issues bite. The Dallas market is a little different than the typical US housing market – Texas has some limitations on cash-out refinances that meant it largely avoided the big boom / bust of the real estate bubble. Prices are 50% higher than they were in 2007, which is similar to MSAs like San Francisco. On the other hand, Dallas homebuyers are more likely to finance their purchases than the typical foreign cash buyer on the West Coast. Builders have a glut of inventory and are cutting prices / adding features to move properties.

Morning Report: Homebuilders are either cheap of the recovery is still a ways off

Vital Statistics:

Last Change
S&P futures 2928 -5.7
Eurostoxx index 383.56 -0.73
Oil (WTI) 71.89 1.11
10 Year Government Bond Yield 3.09%
30 Year fixed rate mortgage 4.87%

Stocks are lower this morning as oil rallies and China cancels trade talks. Bonds and MBS are down.

We have a lot of important economic data this week, including housing data, GDP, personal income / spending, and also the FOMC meeting. Given how much rates have jumped over the past month, the markets are set up well for a dovish surprise. In other words, if the Fed’s language isn’t as hawkish as people are fearing, we could see a snapback lower in rates. 2s-10s are trading at 26 bps, up from 21 a week ago.

Several strategists think the Fed is going to slow down the pace of normalization if they see the yield curve invert. While inverted yield curves don’t cause recessions, they tend to forecast them. Overseas weakness will play a part here, with Europe and China potentially slowing down. Of course this time is indeed different, as this is the first time the Fed has owned so much of the market. As I have said before, the signal to noise ratio of the yield curve’s slope is pretty lousy right now, and should be taken with a grain of salt.

Economic activity continued to hum along in August, according to the Chicago Fed National Activity Index. Production-related indicators increased, while employment was flat.

NAR notes that the housing market is becoming more balanced (with respect to leverage) between buyers and sellers, however it is still largely a seller’s market. Inventory is nowhere near a balanced level but, it is showing signs of at least bottoming out. 2015-2017 were years of high single-digit reductions in inventory. Affordability issues driven by rising rates and prices are drawing out more sellers, and making buyers more cautious. We are still nowhere near a balanced market, let alone a buyer’s market, but the imbalance may be reversing.

Ultimately, the key to balance is supply, as in homebuilding. Builders have been able to rely upon rising prices to drive growth, however affordability issues are going to make that a harder slog. Ultimately they will have to build more units to exhibit the growth that investors want to see. The age of homes in the US has been increasing for a long time.

age of homes

Note that JP Morgan just downgraded the whole sector, although valuations are close to peak cycle levels. P/E ratios for the big players are in the 8x – 12x range, which is typically where they bottom. The homebuilding sector is very cyclical, which means they will trade at single digit P/E ratios during the boom cycles, and 30x-50x ratios during down cycles. Generally speaking those valuation levels would normally be associated with housing starts in the 1.5 – 2.0 million unit range. This presents something of a conundrum: either investors are wrong about the homebuilders and they are cheap, or the return to normalcy in terms of housing starts is still years away on the horizon.

Wells announced that they will look to cut the workforce by 5% – 10% over the next 3 years, through attrition and displacements. The mortgage business wasn’t mentioned specifically in the press release. The bank is going through a big restructuring, and making an investment in technology, risk management and compliance. USAA announced job cuts as well. The industry is heading into the dreaded Q4 and Q1 and volumes / margins are lousy.

The FHFA is creating a new index that determines housing affordability. Current affordability indices generally use rules of thumb (house prices versus incomes) and generally create a static model of incomes. FHFA’s index will include a pro-forma analysis of what the mortgage will look like 3 years down the road. It is still a work in progress, but it will be interesting to see what an affordability plot looks like over time. Here is one that looks at the typical mortgage payment as a percentage of income (using 20% down and median home prices / incomes). While home prices are high relative to income, rates are still extremely low compared to the 90s, let alone the 80s.

mortgage payment as a percent of income

Morning Report: Markets take down chances of 4 hikes this year

Vital Statistics:

Last Change
S&P futures 2705 4
Eurostoxx index 384.58 0.1
Oil (WTI) 67.12 0.39
10 Year Government Bond Yield 2.84%
30 Year fixed rate mortgage 4.45%

Stocks are slightly higher this morning as Italian bonds bounce. Bonds and MBS are down.

US Treasuries touched 2.76% yesterday on the flight to quality trade. The Fed Funds futures are now predicting a 81% chance of a hike in June. The biggest effect of the Italy situation can be seen in the December Fed Funds futures. A couple of weeks ago, we were looking at a coin toss for 4 hikes this year. Now it is closer to 20%. The dot plot consensus is 3, so the markets are aligning a little closer to what the Fed thinks it is going to do.

fed funds probability 2

Why is Italy worrying the markets so much? Italy has a huge amount of debt – 1.9 trillion euros worth. Its debt to GDP ratio is 130%. The fear is that the uncertainty over this issue over the summer will depress Euro growth, while the banking sector (which already has some issues) will take further hits. As of now, this is a political, not an economic issue – Italian yields are around 3%, nowhere near the 8% level they hit in 2012. Note that Spanish yields are beginning to creep up as well.

Mortgage Applications fell 3% last week as purchases fell 2% and refis fell 5%. This is the 8th consecutive decline. The refi index is down to the lowest level since December 2000. “Rates slipped slightly over the week as concerns over U.S. trade policy and global growth sent some investors back to safer U.S. Treasuries,” said MBA Associate Vice President of Economic and Industry Forecasting Joel Kan. “Minutes from the most recent Federal Open Market Committee meeting also yielded a more dovish tone, which added to the downward pressure in rates. Our 30-year fixed mortgage rate decreased two basis points over the week to 4.84 percent as a result. Both purchase and refinance activity decreased despite the drop in rates, part of which was due to slowing activity before the Memorial Day holiday.”

The second estimate for GDP came in at 2.2%, right in line with the first estimate. Inflation was revised downward a touch from 2% to 1.9% and consumption was revised downward from 1.2% to 1%. Inventories were revised downward, while business investment was revised up to 9.2% – a big number.

Whether the increase in business investment was a direct result of the tax cuts remains to be seen, but so far tax cut effects aren’t showing up in corporate profits which were more or less flat in the first quarter with last year.

The economy created 178,000 jobs in May, according to the ADP Employment Report. The Street is looking for 190,000 jobs in Friday’s report, although the ADP and BLS reports have been pretty far away the last few times around. The key number will be wage growth, not payroll growth in any case.

Interesting data points in the ABA survey of the nation’s banks. QM has actually caused banks to decrease non-QM lending (which was the opposite of the intended effect). About half retained servicing. Almost nobody lends to FICOs below 620.

The Fed is set to announce proposed changes to the Volcker Rule, which severely limits proprietary trading activities for commercial banks. The current rules are so vague that JP Morgan Jamie Dimon once quipped that traders would need a lawyer and a psychiatrist by their side to determine whether they were in compliance with the law. The Fed will probably tweak the rules only modestly, and will not usher in a return to pre-2008 rules. That would require legislation, which isn’t happening.

Morning Report: Don’t fret the flattening yield curve

Vital Statistics:

Last Change
S&P futures 2701.75 -8
Eurostoxx index 381.94 0.11
Oil (WTI) 69.26 0.79
10 Year Government Bond Yield 2.90%
30 Year fixed rate mortgage 4.44%

Stocks are lower as commodities surge. Bonds and MBS are down.

The US imposed sanctions on Russia’s Rusal, which has sent aluminum prices up 30% and nickel to 3 year highs. This has the potential to spill through to finished products and bump up inflation. As a general rule, commodity push inflation generally isn’t persistent. An old saw in the commodity markets: the cure for high prices is… high prices.

Initial Jobless Claims ticked up to 232,000 last week, still well below historical numbers.

Investors are starting to worry about the inverted yield curve. An inverted yield curve (where short term rates are higher than long term rates) has historically signaled a recession. The spread between the 10 year and the 2 year is around 41 basis points, which is a 10 year low. Is that what the yield curve is telling us now? I would answer this way: the yield curve is so manipulated by central banks at the moment, that the information it is putting out should be taken with a boulder of salt. We are in uncharted territory, where long term rates are no longer set purely by market forces.

Also, take a look at the chart below, where I plotted the last 4 tightening cycles. In the last 2 cycles, the yield curve inverted, by a lot. In late 2000, the yield curve inverted by 100 basis points – that would be like the Fed taking the FF rate up to 4% while the 10 year hovers around here – at 3%. I would note that the mid 90s tightening cycle didn’t cause a recession, and the late 90s and mid 00s tightening cycles didn’t result in recessions immediately – it took years before the economy entered into a recession.

The question is whether the Fed caused these recessions. It is possible, and the Fed was probably the catalyst to burst the late 90s stock market bubble and the mid 00s real estate bubbles. But these were going to burst anyway. It doesn’t really matter what the catalyst is. This time around, we don’t really have a similar bubble – we may have pockets of overvaluation, but we don’t have bubbles that the typical American is invested heavily in. Not like stock or houses. I think the Fed is happy to gradually get off the zero bound and once we are at 3% on the Fed funds rate will be content to stop. I could see the 10 year going absolutely nowhere during that time.

tightening cycles

My take is this: take the shape of the yield curve as a very weak and distorted economic signal – the labor data will tell you what is really going on, and the labor data is signalling expansion, not recession.

Don’t forget that bond rates are set in a global market, and relative value trading between sovereign bonds will play a role. The US 2 year is at a multi-decade premium to the German 2 year, and in theory, that should mean that investors sell Bunds to buy Treasuries. The reason why that isn’t happening? The US dollar, which isn’t buying the Administration’s rhetoric.

Facebook wants to get into the semiconductor business. Really. First Zillow wants to get into the house flipping business and now this. I don’t understand why companies with great business models want to dilute them. Both companies have a competitive moat with a largely recession-proof business model. The semiconductor business is one of the most cutthroat, lousy businesses this side of refineries and airlines. Take a look at QCOM today.

The NAHB remodeling index dipped in March, driven by bad weather in the Northeast and the Midwest. With home affordability slipping due to higher interest rates and home prices, remodeling remains a good substitute for moving up.