Take It Easy! Fed Risks Stoking Financial Bubble in Drive to Lift Inflation (Here We Go Again!)

Fed Chair Jerome Powell is singing “Take it easy.’

The Federal Reserve risks stoking the same sort of asset bubbles that Chairman Jerome Powell has linked to the last two recessions with its new-found eagerness to fan inflation.

The Fed’s surprise pivot away from any interest rate increases this year has boosted prices of stocks, high yield bonds and other risky assets in spite of nagging investor concerns about slowing global economic growth. Financial conditions, at least as measured by the Chicago Fed, are at their easiest since 1994. And they could well get looser.

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That would put policy makers in a pickle. In unveiling the Fed’s U-turn last month, Powell highlighted the central bank’s determination to promote price pressures by declaring that low inflation was “one of the major challenges of our time.’’ And he left open the possibility that the Fed’s next rate move might be a cut after four increases last year.

But a drive to boost inflation through low interest rates could end up threatening financial stability by encouraging supercharged risk-taking, according to Allianz SE chief economic adviser Mohamed El-Erian.

And it’s just such “destabilizing excesses” that Powell has pinpointed as leading to the last two economic downturns. First it was the dot-com stock market boom of the late 1990s that crash landed and led to the 2001 recession. Then it was the housing boom and bust of the 2000s that preceded the biggest economic contraction since the Great Depression.

Easy Policy

The quandary for the Fed is that easy monetary policy seems more effective in spurring asset values than it does in boosting prices of goods and services.

The S&P 500 Index rose by an average 8.5 percent from 2014 through 2018, while the personal consumption expenditures price index increased 1.3 percent, well below the Fed’s 2 inflation target. In January, the most recent month for which data is available, it stood at just 1.4 percent.

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Well, bank lending YoY for all but Commercial and Industrial (C&I) loan are slowing.

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Mortgage Investors Cool on Swaps as Rush for Duration Ends

Investors in mortgage-backed securities are cooling on swaps used to hedge against falling interest rates, signaling confidence that yields may have found their bottom.

The 10-year swap spread has backed off from the tightest level since October 2017, reached last week. The U.S. Treasury 10-year yield had touched a 15-month low of 2.37 percent on March 27.

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A U.S. homeowner may prepay their mortgage at will, and the duration of a mortgage-backed security can drop dramatically during periods of falling yields due to the potential for faster prepayments. This means MBS investors need to add duration, referred to as “convexity hedging,” as interest rates drop.

A popular method to add duration is by using swaps and “the 10-year is still the most liquid swap for mortgage hedgers,” said Walt Schmidt, head of mortgage strategies at FTN Financial. Now that the 10-year yield has risen again to the 2.50 percent area, swap spreads are back close to where they lay previous to the rally and “the wave of convexity hedging is likely over for now,” he said.

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Duration:  the weighted average maturity of the security’s cash flows, where the present values of the cash flow serve as the weights. The greater the duration of a security, the greater its percentage price volatility.

The Overnight Indexed Swap (OIS) looks like an ARCTANGENT function.

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Slippin’ Jimmy took this photo of Fed Chair Jerome Powell’s chair.

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Trump Announces Fannie And Freddie “Cap And Release” Plan

Fannie Mae and Freddie Mac’s stay in regulatory purgatory may be coming to an end.

President Trump announced his plan to recapitalize the GSEs Fannie Mae and Freddie Mac and release them into the wild.

The memorandum is short, both in length and details.

The President is directing the Secretary of the Treasury and the Secretary of Housing and Urban Development to craft administrative and legislative options for housing finance reform.

  1. Treasury will prepare a reform plan for Fannie Mae and Freddie Mac
  2. HUD will prepare a reform plan for the housing finance agencies it oversees.

What is left out of the memo is … whether Fannie and Freddie will carry a Federal guarantee or not. And where their capital will come from.

So, rather than shutting them down, Trump is “catching and releasing” like undersized lobsters. But these are not undersized (or “chicken” lobsters, but extremely large financial institutions.

For example, Fannie Mae has a loan book of 3.26 trillion …

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while Freddie Mac’s loan book is $1.93 trillion.

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This compares with Bank of America’s loan book of almost a trillion dollars.

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Wells Fargo has a similar loan book to BofA.

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So, how much capital will Fannie and Freddie have to raise to get released given their YUGE book of loans, given their interest rate exposure?

Its almost Supernatural that Fannie and Freddie are escaping purgatory.

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Fed Sees No 2019 Hike, Plans September End to Asset Drawdown (Big, Bad Jay!)

“Big Bad Jay” Powell today announced today that there would be no more rate cuts in 2019 and balance sheet shrinking would halt in September.

Federal Reserve officials scaled back their projected interest-rate increases this year to zero and said they would end the drawdown of central bank bond holdings in September sending benchmark Treasury yields to the lowest level in more than a year and bolstering market bets on a rate cut in 2019.

The median rate projection of Fed officials compared with two hikes in the December forecasts, which spooked investors at the time. In its statement following a two-day meeting in Washington, the Federal Open Market Committee repeated January language that it will be “patient” amid “global economic and financial developments and muted inflation pressures.”

“Patient means that we see no need to rush to judgment,” Fed Chairman Jerome Powell said in a press conference after Wednesday’s decision. “It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”

The Fed’s signal that it will keep interest rates on hold for the full year reflects concerns that economic growth is slowing, lower energy prices are weighing on inflation and risks from abroad are dimming the outlook. The projections go further than the one-hike forecast analysis.

Here is today’s FOMC Dot Plot.

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Here is yesterday’s FOMC Dots Plot.

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On the announcement, 10-year US T-Notes yields dropped 7+ basis points.

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And the 2-year and 5-year Treasury Note yields are BELOW The Fed Funds Target Rate!

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The Fall And Rise Of Subprime Borrowers For Fannie Mae And Freddie Mac

Of course, non-bank lenders were the major participants in the subprime borrower / ALT-A fiasco of the mid 2000s. But both Fannie Mae and Freddie Mac did purchase mortgages to meet affordable housing goals and that included mortgage loans to borrowers with credit scores considered “subprime.” That is, FICO scores of 660 or lower.

In terms of volume, Freddie Mac had more subprime borrowers in 2005, but Fannie Mae has had higher subprime borrower’s mortgages since 2007 with a large peak in 2008.

 

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But as home prices rise and housing is progressively more unaffordable to the average American, the GSEs are under pressure to soften credit standards.

Yes, subprime borrower share of Fannie and Freddie fell, then rose again.

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Did The Federal Reserve Kill Off 10-Year Swaption Volatility? (Lowest Since 2005)

10-year Swaption volatility has sunk to the lowest level since 2005. Did The Federal Reserve provide too much liquidity for too long, effectively drowning bond volatility?

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The Fed’s lingering Target Rate near zero and its three rounds of asset purchases helped kill of bond volatiilty. And with rising Fed Target rate and balance sheet unwind (removing liquidity from markets) has pushed bond volatility to 2006-2007 levels.

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So, the answer is … YES!

(Vol has been) shot through the heart and The Fed’s to blame! The Fed gives central banks a.bad name.

MOVE 3-month Option Volatility Index Hits All-time Low (Bond Market Bernanke’d!)

The  Merrill Lynch Option Volatility Estimate 3-Month has just hit an all-time low.

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The MOVE index is a yield curve weighted index of the normalized implied  volatility on 3-month Treasury options. It is the weighted average of volatilities on the CT2, CT5,  CT10, and CT30.

Even since Fed Chair Ben Bernanke started ZIRP and QE in 2008, continued by Janet Yellen, interest rate volatility has subsided to an all-time low under current Chairman Powell.

Not a great time for volatility traders!

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US New Home Sales Decline 4.1% YoY In January As Median Price Continues To Decline

Has. the US housing market peaked?

In terms of new home sales, perhaps. January new home sales declined 4.1% YoY and the downward trend continues.

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The median prices of one family houses declined once again as one family houses for sales increased.

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The new home sales figures are disturbing given the decline in the 30-year mortgage rate since November 2018.

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Proposed FHFA Director Calabria Plans To Release Fannie Mae And Freddie Mac From Conservatorship With Adequate Capital To Avoid Another 2008 Debacle

The Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie were placed into conservatorship with their regulator back in 2008 after housing prices declined and mortgage defaults spiked.

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But since the catastrophic year of 2008,  Fannie Mae (as an example) generated substantial net revenue after 2008. [This brings into question the wisdom of placing Fannie and Freddie into conservatorship.]

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Fannie and Freddie are not depository financial institutions, of course. And as a consequence, do not have risk-weighted capital requirements. However, once they emerge from conservatorship, they should be required to hold about $200 in risk-weighted capital. But the problem facing Mark Calabria if he is approved as FHFA Director is … WHERE will Fannie and Freddie get the $200 billion in capital.

WASHINGTON — Despite recent speculation that the White House and Federal Housing Finance Agency were planning a dramatic shake-up of Fannie Mae and Freddie Mac, observers say the nominee poised to run the FHFA will have a more targeted agenda on the job.

Some experts expect Mark Calabria, an administration official who could be confirmed as early as this month, to prioritize a plan for letting the government-sponsored enterprises retain more capital once he takes the helm of the agency.

Greater capital retention would most likely be achieved by the Treasury Department and FHFA renegotiating the agreement requiring Fannie and Freddie to hand over profits to pay for their bailouts — to allow the GSEs to retain more of their earnings.

“I support the concept of having significantly more capital at the GSEs,” Mark Calabria said at his FHFA nomination hearing last month.
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“Our expectation would be that there would be capital retention, but that that’s not a day one action and there is probably something collective that will be proposed by the administration, of which capital retention is going to be part of that,” said Bose George, a managing director at Keefe, Bruyette & Woods.

Calabria, currently a top aide to Vice President Mike Pence, is also expected to continue policy initiatives already in process. This includes completing the rollout of an integrated mortgage security for Fannie and Freddie as well as a common securitization platform, and finalizing a rulemaking imposing risk-based capital requirements on the two mortgage companies for whenever they re-enter the private sector.

It is clear that some investors are already anticipating a.freeing of Fannie and Freddie from conservatorship with the FHFA.

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Undun! S&P 500 Index Comes Undone From 10Y Treasury Yield As Term Premium Hits Low

The Treasury market has come undone (or undun as The Guess Who sang).

The S&P 500 index has come undone from the 10-year Treasury Note yield.

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Meanwhile, the 10-year term premium is at a new low, likely due to persistently low inflation.

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No sugar tonight?  Don’t worry! The probability of a Fed rate cut in 2019  is minimal.

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