Morning Report: High frequency traders and mortgage rates

Vital Statistics:

 

Last Change
S&P futures 2907 -16.5
Oil (WTI) 53.33 -1.74
10 year government bond yield 1.50%
30 year fixed rate mortgage 3.78%

 

Stocks are lower this morning on trade issues. Bonds and MBS are flat.

 

The holiday-shortened week ahead looks to be relatively quiet, with the exception of a spate of Fed-speak on Wednesday and the jobs report on Friday. The September Fed Funds futures are pricing in a 100% chance of another 25 basis point cut, and the Fed seems to be in market-following mode, so the data should take a backseat.

 

Manufacturing activity slipped in August, according to the ISM Manufacturing Survey, which came in at 49.1, well below expectations. This was the first contraction in the manufacturing sector since mid-2016. The level for the ISM typically corresponds with 1.8% GDP growth.

 

Separately, construction spending rose 0.1%, which was lower as well, however the previous month’s drop was revised upward from -1.3% to -.7%.

 

Home prices rose .5% MOM / 3.6% YOY in July, according to CoreLogic. Home price appreciation slowed in 2018 as rates rose. That effect will reverse over the next year, and Corelogic expects annual home price appreciation rates to settle in around 5%. Tight supply, especially amongst starter homes will support prices, as well as a robust labor market and a move out of urban areas to the suburbs. About 37% of the US housing stock in the top 100 MSAs is overvalued. This metric is based on wage growth and housing supply.

 

Hurricane Dorian is expected to miss direct landfall, however it is slow-moving and dumping a lot of rain. Coastal areas will be at risk of flooding as the storm parallels the Eastern Seaboard this week.

 

The WSJ has an interesting article this morning about thinning liquidity in the markets. Late summer is often characterized by thinning liquidity, which means fewer active investors are trading, which causes exaggerated market movements when a big buyer or seller wants to execute an order. They mention what has been going on in the Treasury market:

Some analysts point to high-frequency traders. They have dominated the government-bond market, making up a big chunk of trading activity compared with slower counterparts, according to JPMorgan analysts. These traders withdrew last month, the firm said, suggesting that they amplified turbulence. Investors said liquidity worries are even more pronounced in riskier corporate bonds.

“As you go further down the credit spectrum, it starts to get a bit more volatile,” said Gautam Khanna, a fixed-income portfolio manager at Insight Investment. “Liquidity is definitely thinner in this market than it has been.”

This might help explain why mortgage rates have lagged the move in Treasuries. In essence, high frequency traders help establish a liquid market, where it is easier for large investors such as banks, sovereign wealth funds, pension funds, etc to trade large positions. When these high frequency traders withdraw, bid / ask spreads widen, and volatility increases. Here is the issue: MBS investors hate volatility because it makes their portfolios hard to hedge, and adds uncertainty about prepayment speeds. This causes them to be more conservative with respect to the prices they are willing to pay for mortgage backed securities, which flows through to mortgage rates falling less than the move in Treasuries would predict. Below is a chart of 10 year Treasury futures volatility. You can see the spike in the index beginning in August, which corresponds with the dramatic drop in rates, and the exit of high frequency traders from the market.

 

treasury futures volatility

 

 

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