Yield Curve – The Daily Tearsheet

Morning Report: The US yield curve inverts

Vital Statistics:

	Last	Change
S&P futures	2890	-41.5
Oil (WTI)	55.49	-1.64
10 year government bond yield		1.61%
30 year fixed rate mortgage		3.88%

Stocks are lower after disappointing overseas economic data. Bonds and MBS are up on the flight to safety.

Overnight, the US yield curve officially inverted with 2s/10s trading at negative 1.7 basis points. This has historically been considered a recession indicator. You can see the chart below, which plots the difference between the 10 year bond yield and the 2 year bond yield, and not that the shaded grey bars (which represent recessions) have historically followed after the line goes to zero. One caveat to keep in mind however: In the past, we didn’t have the sort of activism out of central banks that we have now. Quantitative easing (where the central bank tries to directly influence long term rates) are a new phenomenon, and therefore investors should take that signal with a grain of salt. Still, it does speak to a global slowdown, and that will inevitably pass through to the US.

The German Bund yields negative 64 basis points, which is a record low. Their economy contracted by 0.1% last quarter. This is what is driving stocks lower and bonds higher. The trade war is being blamed on their economic weakness. China reported the slowest industrial growth since 2002.

The FHA announced they will widen the credit box for condos, in an attempt to revive the entry-level condo market and help the first time homebuyer. “This is set to really expand homeownership,” said Ben Carson, secretary of the Department of Housing and Urban Development, which oversees the FHA. FHA will now begin insuring loans in unapproved buildings, provided no more than 10% of the units have a FHA loan.

Mortgage applications increased 21.7% last week as purchases increased 2% and refis increased 37%. The average contract interest rate fell from 4.01% to 3.93%, and has dropped about 80 basis points this year. The government refi index is at the highest level since 2013, driven by VA refis.

Morning Report: Existing Home Sales rise

Vital Statistics:

	Last	Change
S&P futures	2955	4.5
Oil (WTI)	57.79	0.24
10 year government bond yield		2.03%
30 year fixed rate mortgage		4.01%

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

Business sentiment in Germany hit a 5 year low, which is pushing Bund yields lower. The US Treasury market is being pulled by overseas weakness, but many are trying to interpret the US yield curve’s flattening as a recessionary indicator. Don’t buy it. Rates will probably meander lower unless we get indications of persistent 2%+ inflation. Separately, Trump tweeted that the Fed doesn’t know what it is doing, though he denied considering demoting Jerome Powell.

We have a lot of housing data this week, with the Case-Shiller and the FHFA Home Price indices. We will also get new home sales. The only potential market mover is personal income / personal spending on Friday. The third revision of first quarter GDP will be released on Thursday.

Existing home sales rose 2.5% in May, according to NAR. Total Sales came in at 5.34 million, a drop of 1% on a YOY basis. The median home price rose to $277,700 from $265,100 a year ago. Falling mortgage rates are helping home sales as the 30 year fixed rate mortgage flirts with the 4% level again. Inventory is still tight however, at only a 4.3 month supply.

Economic activity picked up in May, according to the Chicago Fed National Activity Index. Production-related indicators led the increase, which jumped from -.48 to -.05. This means the economy is more or less growing on trend after a weak April. The CFNAI is a meta-index of 85 economic indicators, so it really is a lagging index. It isn’t a market-mover.

Signs of life in the private label securitization market? Cerberus (a large private equity firm) did the first post-crisis HELOC securitization last week. HELOC securitization was only done during the bubble years, and many of these loans turned sour in the housing bust. Cerberus only issued the most senior AAA tranche, and it priced at L+105, a bit worse than the initial price talk. Cerberus did not sell any of the junior pieces.

Ginnie Mae has let Loan Depot out of the penalty box. Ginnie Mae has been focused on prepayment speeds for VA loans, which is an indication that a lender is churning VA loans through the IRRRL process. “The removal of such a restriction is based on the Issuer having demonstrated to Ginnie Mae’s satisfaction that (a) its prepayment speeds are substantially in-line with those of equivalent multi-Issuer cohorts, and (b) such improved performance is sustainable,” the agency said in a statement.

Freddie Mac is rolling out a new rehab loan: the CHOICERenovation loan. It will allow the buyers to roll the renovation costs into the loan, permit them to begin renovations after they move in, and the homeowner can act as his own contractor. “There’s a fair amount of housing with deferred maintenance,” Danny Gardner [Senior VP of single-family affordable lending at Freddie Mac] said in an interview. Cash-strapped buyers “should be very willing to undertake those issues if they can get houses at an affordable price.” The program is not available quite yet, but it should be out sometime this summer.

Contrary to expectations, professional investors are still buying starter homes and renting them out. Investors purchased 20% of the houses in the bottom third of the national price range in 2018, which is 5% more than the historical average. Many expected the REO-to-Rental trade to fizzle out as investors would ring the register. So far, that hasn’t happened, as home construction remains firmly mired in recessionary territory.

Morning Report: Toll disappoints and the government targets VA cash-outs

Vital Statistics:

	Last	Change
S&P futures	2657	-42
Eurostoxx index	346.51	-7.2
Oil (WTI)	51.46	-1.45
10 year government bond yield		2.90%
30 year fixed rate mortgage		4.83%

Stocks are lower this morning as the global sell-off continues. Bonds and MBS are up.

While stocks are moving lower, the big news these days is the bond market rally. What appeared to be window-dressing last Friday (a sub 3% yield on the 10-year) has just kept going. A lot of market commentators have been scrambling to come up for a reason. Trade tensions make a convenient, if unsatisfying explanation. China and the US have reached an agreement to cool things off for 90 days, which should be good news. Economic data has been strong, and while we have had some slightly dovish comments out of the Fed, it is nothing dramatic. It feels like a major asset allocation trade out of equities into fixed income, but who or why is anyone’s guess. In other words, this could be just random noise, and therefore temporary. Note that 2s/10s (the difference in yield between the 10 year and the 2 year) got to single digits. Historically such behavior would signal a slowdown, but the Fed’s footprint in the Treasury market wasn’t so large before.

The business press is pushing out all sorts of “recession imminent?” articles, but if you read the ISM report on manufacturing, you will see nothing of the sort. New orders, production, and employment are all at historically very strong levels. The business press mirrors the mainstream media, and they are talking their ideological book a little.

In terms of MBS trading, they lagged the move big-time. On Tuesday, where yields touched 2.88% we saw only a couple of investors re-price for the better. So, all of those LOs who were running scenarios hoping to see an improvement were disappointed. TBAs did increase by 6 or 7 ticks, but the aggregators largely ignored it.

Construction spending fell 0.1% MOM in September, but was up almost 5% YOY. Residential construction fell 0.5% MOM and rose about 1.7% YOY. Lodging and office construction were up high / mid teens YOY, but resi (42% of total construction spending) continues to lag.

Speaking of resi construction, Toll Brothers reported a big drop in orders (down 13% in units / 15% in dollars). The cancellation rate jumped from 7.9% to 9.3%. Toll was one of the first builders to recover from the slowdown, making big bets on luxury urban apartments along with their traditional McMansion fare. California is the problem area, which is being hit by higher prices, higher rates, diminished foreign demand and new tax treatment. The whole sector was smacked, with the homebuilder ETF down about 5%. The XHB is down about 25% from its mid January levels.

Mortgage applications rose 2% last week as purchase activity rose 1% and refis rose 6%. Mortgage rates dropped about 4 basis points.

The VA is taking a closer look at predatory behavior in VA lending. From the Federal Register on November 30:

“VA is concerned that certain lenders are exploiting cash-out refinancing as a loophole to the responsible refinancing Congress envisioned when enacting section 309 of the Act. VA recognizes there are certain advantages to a veteran who wants to obtain a cash-out refinance, and VA has no intention of unduly curtailing veterans’ access to the equity they have earned in their homes. Nevertheless, some lenders are pressuring veterans to increase artificially their home loan amounts when refinancing, without regard to the long-term costs to the veteran and without adequately advising the veteran of the veteran’s loss of home equity. In doing so, veterans are placed at a higher financial risk, and the lender avoids compliance with the more stringent requirements Congress mandated for less risky refinance loans. Essentially, the lender revives the period of subprime lending under a new name.”

The government has already dealt with the serial refinancings by adding new seasoning requirements for loans to be eligible for standard Ginnie MBS, but that was about protecting MBS investors. This is different. For many veterans, it may sound like a great deal to be able to lop 50 bucks off your monthly payment and maybe get to skip a month or two, but that 3.3% funding fee is expensive, even though you get to finance it. If you are doing a VA cash-out to refinance credit card debt, it amounts to an expensive debt consolidation loan, though the drop in your rate and the tax treatment does offset that a bit.

Morning Report: The Fed worries about the yield curve

Vital Statistics:

	Last	Change
S&P futures	2903	3
Eurostoxx index	386.36	.8
Oil (WTI)	68.91	0.02
10 Year Government Bond Yield		2.87%

30 Year Fixed rate mortgage 4.58%

Stocks are higher this morning on optimism over trade talks with Mexico. Bonds and MBS are down.

We saw a strong buildup of inventory in July, both at the retail level and the wholesale level. Inventory growth was negative in the second quarter, which depressed GDP growth slightly. This improvement in inventories will provide a boost to the third quarter numbers. Durable goods and autos led the increase, with retail inventories up 0.4% and wholesale inventories up 0.7%.

Redbook reported that same store sales rose 5.1% last week, which was the third fastest pace this year. This bodes well for the back-to-school numbers which are the best predictors of the holiday shopping season. Consumption has been generally strong and these numbers bear that out.

Consumer confidence jumped to 133.4 in August according to the Conference Board. This is the highest level since late 2000.

House prices rose 6.2% in June, according to the Case-Shiller home price index. Las Vegas, San Francisco, and Seattle reported double-digit increases. The laggards included New York, Chicago and Washington DC which reported low single-digit gains. Las Vegas is one of the fastest growing US cities in terms of population and employment growth, which explains the rise there. Seattle and San Francisco has restricted supply along with foreign demand. On the other side, the Northeast continues to stagnate.

The Urban Institute looked at mortgage denial rates along demographic lines and found that most of the studies that report discrimination overstate denial rates because they fail to take into account incomes and credit scores. While they still found some evidence of racial disparity it is much lower when you correct for these things. Not sure if the difference is statistically significant though. Given that CRA loans are worth more than traditional loans (all things being equal) it is surprising that there is any difference at all.

As the long end of the curve continues to rally, we will have a steady diet of recession prediction stories in the business press. The latest Reuters story cites a Federal Reserve study that suggests the market may be warning of a potential recession: “In light of the evidence on its predictive power for recessions, the recent evolution of the yield curve suggests that recession risk might be rising,” wrote San Francisco Fed research advisers Michael Bauer and Thomas Mertens.

The flattening yield curve provides plenty of fodder for the Wall of Worry, however there are a couple of things to bear in mind. First, the yield curve almost always flattens during a tightening cycle. Take a look at the chart below, and you can see the yield curve flatten as short term rates rise.

The behavior of the yield curve is 100% normal. Not only that, longer term interest rates are being held artificially low due to the behavior of central bankers throughout the world. The Fed is still buying Treasuries, albeit at a slower pace, while Japanese and European central bankers are pushing down long-term rates, which influences US rates. The signal-to-noise ratio of the yield curve is extremely low right now. Finally, the short Treasury trade is probably the biggest macro bet on the Street right now. Every wiseguy is short, and that means you will sometimes get these rallies for no apparent reason.

Morning Report: Tough times in mortgage banking

Vital Statistics:

	Last	Change
S&P futures	2840	0.75
Eurostoxx index	388.33	-0.84
Oil (WTI)	69.29	0.8
10 Year Government Bond Yield		2.95%
30 Year fixed rate mortgage		4.58%

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

The week after the jobs report is invariably data-light and this week is no exception. We will get inflation data on Thursday and Friday and JOLTS data tomorrow and that is about it.

Everyone knows that 2018 has been an awful year for mortgage banking. How bad is it? Check out the graph below courtesy of Garrett Macauley:

The one thing that jumped out at me (aside from the -8 basis points this year) is how little the industry made during the bubble years. Is it as simple as saying the mortgage business lives and dies on the refinance business and even in great purchase markets (like 04-06) mortgage banking is a marginal activity at best?

If you are tired of hearing predictions of an inverted yield curve, check this out. Jamie Dimon thinks the 10 year bond yield should be 4% right now, and is saying that 5% is a possibility. “I think rates should be 4 percent today,” Dimon said from the gala, according to Bloomberg News. “You better be prepared to deal with rates 5 percent or higher – it’s a higher probability than most people think.” While it is impossible to rule that forecast out, take a look at the chart below: Interest rate cycles are long and during periods of low inflation they just don’t move around all that dramatically. It took rates 20 years (1946 – 1966) to go from 2% to 5%. What was inflation in 1966? 5%. With the core CPI sitting at 2%, a 5 handle on inflation seems pretty unlikely. Not saying it is impossible – lots of differences between the mid 20th century and today – but….

Chinese buying has been supporting prices in some big West Coast markets, and it is drying up. While trade war concerns are probably playing a role, we are seeing declines in other global real estate markets, like London and Vancouver. This is a signal that the issue is probably internal to China, which has a real estate bubble of its own. The government has issued regulations limiting the purchase of foreign property, and seems worried about the currency. If the Chinese real estate bubble bursts, expect to see more selling in West Coast markets because that will be the only way for Chinese investors to raise cash.

Morning Report: The Fed is looking for new recessionary indicators

Vital Statistics:

	Last	Change
S&P futures	2790	16
Eurostoxx index	384.01	2.61
Oil (WTI)	70.92	0.54
10 Year Government Bond Yield		2.86%
30 Year fixed rate mortgage		4.53%

Stocks are higher after China made some conciliatory comments regarding the trade situation. Bonds and MBS are flat.

Inflation at the consumer level remains under control, with the consumer price index rising 0.2% MOM / 2.9% YOY. Ex-food and energy it rose 0.2% / 2.3%. These numbers were more or less in line with Street expectations. Energy, especially petroleum drove the increase in the index. Housing also pushed up the index, while autos and utilities exerted downward pressure.

Initial Jobless Claims fell to 214,000 last week, which is at levels we haven’t seen since the early 1970s (when we had a draft).

Loan performance continues to improve, according to CoreLogic. The 30+ DQ rate fell from 4.8% to 4.2% in April. DQ rates are near historic lows, except for FL, TX, and LA which are still dealing with the fallout from Hurricane Harvey. The national foreclosure rate fell by 10 basis points to 0.6%. Home price appreciation of 7% is helping matters. In fact, home equity is increasing rapidly, but HELOC are not.

As the 2s-10s spread decreases, many in the financial press are worrying whether the slope of the yield curve is signalling a recession. We already have some strategists calling for the yield curve to invert sometime in 2019. An inverted yield curve (where short term rates are higher than long term rates) has historically been a strong recessionary signal. As a general rule, the yield curve flattens during tightening cycles. In fact, it did invert in the late 90s (before the stock market bubble burst) and during the real estate bubble (before the Great Recession).

Recent Fed research indicates the 2s-10s spread may not be the best signal of an upcoming recession. It suggests the spread between the 3 month T bills and 18 month Treasuries could be more predictive. Another signal is the Eurodollar futures market. The idea is that the Fed would use these indicators as a yellow signal and stop tightening before they risk a recession.

To me at least, the last two recessions had very little to do with the Fed. We had a stock market bubble, and we had a residential real estate bubble. To say the Fed caused those recessions implies that these bubbles would have kept on going had the Fed just stayed away (or stopped tightening sooner). That is a big assumption – all bubbles eventually come to an end, and when they do you have a recession. The tightening may have been the catalyst to initiate the recession, that is a question of “when,” not “if.” We were going to have a recession given we had a bubble in place already. And the Fed might have been guilty of causing the bubble in the first place, but that is a separate question.

Of course, all bets are off when it comes to this yield curve versus the past. The size of the Fed’s balance sheet relative to the economy is vastly different this time around. Pre-Great Recession, the Fed had about $800 billion worth of assets. Now it is about $4.4 trillion. To draw comparisons, you would have to estimate where the 10 year would have been without Operation Twist, QE1, QE2, and QE3. Punch line, the yield curve may in fact invert if the Fed continues to tighten and inflation remains under control. The signal-to-noise ratio of the yield curve is extremely low, so take it with a grain of salt.

Morning Report: New Home Sales jump

Vital Statistics:

	Last	Change
S&P futures	2745	-14.5
Eurostoxx index	379.79	-5.22
Oil (WTI)	69.07	0.49
10 Year Government Bond Yield		2.89%
30 Year fixed rate mortgage		4.57%

Stocks are lower this morning on continued trade tensions. Bonds and MBS are up

Economic activity decelerated in May, according to the Chicago Fed National Activity Index. Production-related indicators were a drag on the index (probably an effect of trade issues) while employment-related indicators had a positive impact once again. This index is a meta-index of 85 different sub-indices, and while it is backward-looking and generally not market moving, it provides a good global snapshot of the economy.

The trade war is beginning to have some real economic effects as the CFNAI indicated. While it is primarily limited to steel, many companies that use it as an input are raising prices, which is going to have a few negative effects on the economy – first firms that use steel and cannot pass on price increases are probably going to lay off workers, while the inflationary pressures from increased prices will keep the Fed raising interest rates. Retaliatory tariffs from our partners are causing US exporters to shift production overseas. Note that lumber tariffs are increasing the price of home construction, which is another drag on the economy.

Given the recessionary potential of trade wars the shape of the yield curve is going to become a bigger talking point for the business press and will be watched closely by the Fed. The shape of the yield curve essentially means the difference between short term rates and long term rates. The most common description is the 2s-10s spread, which is about 34 basis points at the moment. When the yield curve is strongly upward sloping (in other words, the 10 year yield is a lot higher than the 2 year yield) it generally means one of two things: either (a) the market is worried about inflation, and is therefore requiring a high interest rate to entice people to invest in Treasuries long term, or (b) the economy is so strong that investors prefer to put their money in more risky assets and therefore Treasuries have to offer a higher rate to get people interested. For the most part, the US yield curve has been in the second camp.

As the Fed has been raising the Fed Funds rate, the yield on shorter-term paper (like the 2 year) has been going up faster than the rate on the 10 year. Historically, the yield curve has flattened during tightening cycles, so this is nothing to be alarmed about. If the yield curve inverts, then that has historically been associated with the Fed overdoing it and it is taken as a recessionary signal. In the current environment, the flattening of the yield curve looks more like typical curve behavior during a tightening cycle, and not a signal of a recession. Don’t forget the yield curve has been highly influenced by central bank behavior. The Fed could drive up long-term rates by hinting at the possibility of selling some of its portfolio. Bottom line, the business press will be talking about the curve more and more, especially if the trade war begins to snowball and we start seeing a combination of rising input costs with a slowing out output.

New Home sales increased 6.7% MOM and 14.1% YOY to a seasonally adjusted annual rate of 689,000. This is the highest print since November last year. Interestingly, sales rose in the South, but fell everywhere else. In the West, where the supply shortage is most acute, sales fell by 9% MOM and are flat YOY. Both the median and average sales price fell, which is surprising given the torrid pace of home price appreciation in the home price indices like Case-Shiller and the jump in existing home sales prices according to NAR. It appears that more sales at the lower price points was behind the drop. Luxury sales have been more or less flat for the past year. Eventually tax reform is going to have an effect on the top end of the market, as luxury real estate is simply more expensive due to the changes in mortgage interest and the fact that most of the $1MM+ inventory is in high tax states. We will get more of a read on new homes this week as Lennar and KB both report earnings.

Fears of rising interest rates have clearly had no negative effects on new home sales. Given the acute housing shortage and the fact that rates are still very low historically, this isn’t really a surprise.

The Trump Administration announced a plan to reorganize many governmental agencies. The biggest one would merge the Department of Labor and the Department of Education into one agency. On the housing side, USDA loans would be moved from USDA to HUD, which is where they probably belonged in the first place. VA loans will remain under the VA however. Community Development Block Grants would move to Commerce from HUD. The document discusses the need to reform the GSEs and lays out broad ideas, but nothing concrete.

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.

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.