Traction
Well…it took a day but the market is smellin’ what Bernanke is cookin’. After yesterday’s FOMC announcement that QE2 was a “go”…the market pulled back a bit. The 30 year bond had obvious reason to sell off…it will receive no material price support from QE2. The short end of the curve however will see the bulk of the Feds dollars. In my view the most interesting thing to happen yesterday was that the 10-year Treasury traded off immediately after the announcement. It didn’t make much sense and I wrote yesterday that I wouldn’t count on it staying above 2.60% for long. Mortgages are priced off the 10-year Treasury, and a refi wave is a significant part of the Feds plans, so you know they aren’t going to let the 10-year yield remain elevated.
This morning it appears that yesterday’s FOMC announcement has been fully digested by the market. The 10-year Treasury is up over ¾’s of a point in price to trade at 2.48%. It’s difficult to see rates going any higher in the face of the Fed spending $850 to $900 Billion in Treasuries over the next 8 months. On the upside…for those who were upset that China was the single largest holder of US Treasury debt…rest easy…the Fed will have the title by the end of QE2. Some really quick math shows they will own roughly $1.2 Trillion in Treasuries by that point…China only has around $800 Billion.
What’s gonna happen?
There are several pieces of this puzzle at work. The first impact is that the Fed drives the Treasury curve lower. Most products that banks invest in are spread to the Treasury curve. If spreads don’t change and the Treasury curve drops then you will have lower yielding investment options. We all get that.
If spreads widen as the curve drops then the downshift in yields will be less pronounced. Spreads are not likely to widen however as one of the goals of this QE2 program is to make Treasury yields so low that it pushes people out of this sector and into other asset classes. When investors get to the next market with decent spreads they will squeeze it until the juice runs out…then they will move to the next one and do the same.
The future that the Fed sees is one where spreads on all types of risky assets get tighter…yields will drop on everything as money flees low yielding Treasuries and moves into the next best level. Agency, MBS, and Corporate bond yields will drop, stock prices will rise, people will feel rich because their holdings have increased in value and while they won’t become the spenders they used to be…they will at least move in that direction.
This leg of the QE2 strategy is to re-inflate asset prices which will usher in the “wealth effect” and get people to spend more. The wealth effect just means that if you “feel” rich you’ll “act” rich. For the record I’m not saying I agree with this plan of action…I’m just saying that’s what their plan is…I don’t want anyone trying to kill the messenger here.
The second impact is the Fed’s desire to ignite a refi wave. This has been an elusive goal from the outset. It’s important to them, and they are determined to get this done. If people can refi they will have extra spending money…plain and simple. Not everyone can refi…but those that can…will. Driving the 10-year Treasury lower and keeping it low is an important piece of this plan.
We are already seeing increasing prepay activity. The refi index has more than doubled since May.
Here is an important point that you probably haven’t heard anyone mention. While the Refi index will not likely return to the highs we saw back in 2003…it doesn’t have to get that high to wreak havoc.
In 2003 the mortgage market was very efficient. Hundreds of mortgage companies were pushing lots of new products that helped virtually anyone refinance. The refi index surged to 10,000 (recent lows have been in the 1,800 range). 300+ mortgage companies are now out of business, you actually need income to get a loan, borrowers are underwater, and it’s more difficult to refinance now. So it’s unlikely that we will see another 10,000 print on the refi index…but we don’t need to.
MBS are now trading at much higher premiums than we saw during 2003 so you don’t need speeds to come in as fast to do as much damage. A lower speed can now cause a lot of damage because many investors are carrying MBS on the books at prices far higher than we saw in 2003.
Now what?
Where does this leave bank investment portfolios? It leaves us in a place where the Fed is committed to holding the overnight rate at zero, and just as committed to driving the 1 to 10 year portion of the curve lower as well.
If you were in the camp that thought the Fed would be raising rates next year it looks like you need to pack up the tent and move. QE2 won’t even be completed until 2Q 2011. It’s difficult to see how they’d be raising rates immediately after QE2 expires…and this assumes that they don’t extend it like they did QE1. To give you an idea of where some of the bigger players see this going, Goldman Sachs predicts that the Fed won’t raise rates until 2015. It’s officially one day since the announcement of QE2 and the headlines are already appearing about QE3…this market doesn’t appear to have a lot of confidence that QE2 is going to be the fix to all of our woes.
Random notes on investments
MBS
If you are a buyer of MBS we continue to push structure as the primary consideration. With premiums where they are we continue to prefer the lowest premium we can find, and/or the best structures we can get (those that minimize both the incentive to refi and the risk of negative yields). Choices are admittedly limited, but as rates drop we will be seeing more low coupon MBS come to market at lower prices which should help.
The landscape is currently littered with bonds that have negative yields under prepay scenarios that aren’t far off current levels. We have a report that can show your book yield under the 1, 3, and 6 month historical CPR speeds, AS WELL AS the Bloomberg Prepay Model shock scenarios. If you own any MBS at higher premiums you will want to see this report. If you were pursuing a strategy of buying high premium MBS because they wouldn’t prepay then you definitely want to see this report.
If you’d like me to run this report for you just shoot me a copy of your most recent bond accounting report (including your book price). If you send this in electronic format (excel or PDF) it should be less than 24 hour turn-around time on the report.
AGY
The Agency market continues to see a huge amount of step-up structures. Step-ups remain a popular way to pick up yield in the Agency market.
Shorter final Agency paper is-what-it-is…yields are low and getting lower. This morning a new issue 3 yr non-call 3 month came at 0.80%. In some cases (as recently as this morning) we can find very low premium CMO’s that beat short agency callables under almost all rate scenarios.
Muni
Muni’s continue to do well as a wide swath of this curve still offers spreads of +100 to Treasuries.
SBA
For those that want yield 20 year Fixed Rate SBA bonds continue to sell briskly. These offer a full faith and credit (zero risk weight) investment with an average life anywhere from 5 to 10 years and yields north of 3.00%. These trade with larger premiums (105 to 112) but historically they’ve paid slowly.
Floating Rate SBA’s are at the other end of the spectrum. If you are concerned about rising rates/inflation then you can get a full faith and credit piece that floats quarterly off of Libor with no cap. Structures vary.
That’s all folks
That’s it for now. The market is rallying, yields are going lower, and stocks are moving higher. If you have money to spend I would spend it sooner rather than later. If you think these yields are ugly just wait until you see them after the Fed has spent another Trillion dollars on Treasuries.
If you have any questions or if there is anything I can do for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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