The Yield Curve Is Back to Being Interesting Again (More Interesting If Powell & The Gang Take Their Foot Off The Monetary Accelerator Pedal)

I remember my academic colleague at The Ohio State University (now at Notre Dame), Paul Schultz saying “Why do you find fixed-income and the yield curve interesting?” I have always found the yield curve to be interesting … at least until The Federal Reserve hammered down the short-end with it zero-interest rate policy (ZIRP) and tried manipulating the 10-year Treasury Note yield through Quantitative Easing (QE) meaning The Fed’s purchase of Treasuries and Agency Mortgage-backed Securities (MBS). No, I still think the manipulated yield curve is interesting.

Here is today’s Treasury actives curve (green) versus the yield curve at the peak of the previous housing bubble in 2005 yellow). That is a 300 basis point shift as the short-end. And a 243 basis point shift for the 10-year Treasury Note.

(Bloomberg) — The yield curve is one of the most-powerful forces in the observable financial universe. While much of the price action that we see on a day-to-day basis may be driven by some sort of dark energy, the curve provides a highly visible lodestone indicating the state of policy settings and the likely trajectory of the economy. That being said, the curve is often misunderstood — a bear flattening often produces plenty of hand-wringing, when it’s the bull steepening that you should really worry about. In fact, referring to “the curve” itself is something of a misnomer — while different iterations of the yield curve often travel in tandem, sometimes their paths diverge. That has been the case recently, though perhaps not for much longer. The recent rise in two-year yields looks more than justified, as various fixed income models demonstrate in a roundabout way.

For the past year and a half or so, most of the focus on the yield curve in this column has been on the 5s-30s iteration. The rationale for this has been relatively straightforward: With the Fed funds rate locked in near zero for the foreseeable future, the two-year note has been moribund. As such, 2s-10s has really just been another articulation of the 10-year yield. And much like recent price action vis-a-vis my 10-year model, the curve briefly traded where it “ought” to in March before once again becoming too flat in recent months.


 
At least 5s-30s has had the benefit of containing a useful forward-looking component on both legs of the spread. Yet even as I type that, it is interesting to note that 2s-10s and 5s-30s exhibited virtually identical price action at virtually identical levels earlier this year. While they remain positively correlated, of course, a clear wedge has emerged between the two curves as five-year yields have broken decisively through 1%, pricing greater conviction that a monetary tightening cycle will fully emerge over the next half-decade.


 
Yet I am left to wonder about the two-year note. The eurodollar strip is pricing that the bulk of monetary tightening will come by the end of 2023, a period that’s now largely captured by the shortest-maturity coupon security. To be sure, the appropriate level for 2s is a function not only of the ultimate magnitude of monetary tightening, but when it begins. After all, a 150 bp hike in Q4 of 2023 carries very different implications for the current two-year note than a 25 bp rate rise every three months from Q3 of next year onwards.

It occurred to me that I could back out a model for two-year yields by simply subtracting the output of my yield curve model from that of the 10-year model. I had no real idea of what to expect from this exercise, but even with the proviso that short-end yields rarely stray too far from the policy rate, I was pleasantly surprised at how close the fit is from this “derivative” model for the two-year.


 
The question then arose, naturally, of what actually went into the calculation of this “model.” After all, knowing the formulae of the two constituent models — for the 10-year and the yield curve– should allow for the distillation of a separate equation for the two-year note. Because that sort of thing is more fun than unpacking more boxes, that’s how I spent a few minutes on Wednesday night. The outcome isn’t necessarily an optimal model for the two-year, but more of an accidental one.

A bit of high school algebra

For what it’s worth, the resultant formula is 2y = 1.24 * FDTR + 1.3 * (ED2 – ED6) -0.015  PCE CYOY + 0.08 * USURTOT – 0.25 * (10y average of FDTR) + 0.12 * (10y average of USURTOT) – 1.27. I am pretty sure that one could get similar results with a simpler framework; the notion that a 2% rise in core inflation is worth just 3 bps on the two-year yield, all else being equal, leaves me simultaneously amused and bemused.

What does seem evident, however, is that henceforth there is going to be considerably more signal generated from two-year yields than has been the case in recent quarters. As such, 2s-10s are going to be worth following again, just as much if not more than 5s-30s. Both nominal yields and the curves are clearly constrained by the notion that all of this inflation kerfuffle really is transitory at its heart, and that, with r* remaining in the gutter, the long-run lid on nominal policy rates is going to be extraordinarily low.

That’s probably as good a null hypothesis as any, and possibly better than most. That being said, if we’re still having a lot of the same inflation conversations a year from now, we’re gonna need a long hard think about whether some of the post-GFC lessons need to be unlearned. In the meantime, at least fixed income is interesting again. I wonder where the yield curve and the model will eventually meet up to shake hands again… -Cameron Crise

The yield curve will become more interesting if Powell and The Gang take their foot off the monetary accelerator pedal.

September US Existing Home Sales Surprise! 6.29M Home Sold SAAR, Median Price Drops Like A Rock, Inventory Still MIA

It was a surprise to see 6.29 million home sold SAAR in September. That is a 7% MoM growth rate.

The median price of existing home sales GROWTH slowed to 15.85% YoY (it was over 24% for the last two months).

And INVENTORY of existing homes for sale remains MIA.

Perhaps President Biden can issue an executive order forcing households to place their homes up for sale if they refuse to get vaccinated for Covid. /sarc

Other than insanely high prices for existing homes and the utter lack of available inventory, the September EHS report is a shining star.

Fed Inferno? Mortgage Purchase Applications Rise 1.87% From Previous Week, But Down 10% From Same Week Last Year

Yes, the super-heated housing market is showing signs of slowing down.

According to the Mortgage Bankers Association (MBA), mortgage purchase applications rose 1.87% from the previous week. However, purchase applications are down 10% from the same week last year.

Refinancing applications dropped -.48% from the previous week as the 30-year mortgage contract rate rose from 3.14% to 3.18%. Refi apps are up 6% from the same week last year.

As rates begin to rise, mortgage refi applications will decline.

With the Atlanta Fed GDP tracker showing GDP growth slowing to 0.5%, we are starting to see the beginning of a Fed inferno.

Here is Biden’s Press Secretary Jen Psaki!

705742? Bitcoin Hits 63983 As US Treasury Curve Steepens (As Mortgage Rates Rise?)

I have no idea why Jack Dorsey tweeted “705742.” But I do know that Bitcoin hit 63,982.92 this morning as the US 10Y-3M curve has been steepening.

Since the 3-month Treasury yield has been repressed to near zero, the 10Y-3M curve is pointing to rising 10-year yields. Which likely means that 30-year mortgage rates will be rising too.

UPDATE! Bitcoin hits 66,615 as Proshares Bitcoin Strategy E rises as well.

US Housing Starts Drop 1.58% In September (Permits Drop 7.67%) As Interest Rate Increases And Inflation Loom

US housing starts slowed in September to at a -1.58% MoM rate. Permits dropped 7.67% MoM.

Now that interest rates are expected to rise … in late 2022, we may be a slowing in the housing market.

Here are the numbers.

The US Treasury 10Y-3M slope is rising as inflation rises (that inflation curve looks like the ARCTAN function from prepayment modeling!)

Secret Warning? Zillow Pauses Home Purchases as Snags Hit Tech-Powered Flipping (Fed Flippers??)

They call them flippers, faster than lightning. At least until now.

Zillow Group Inc. shares fell as much as 6.8% in premarket trading Monday after the online real estate firm said it would stop buying new homes and work to clear a backlog of properties it already has.

The Seattle-based company, which acquired more than 3,800 homes during the second quarter, has seen its stock price tumble about 27% this year after it nearly tripled in 2020 amid the pandemic-fueled housing market boom.


The shares have come under additional pressure in recent weeks after a viral TikTok video from a real estate agent in Las Vegas said an unnamed company was pulling off a convoluted scheme to manipulate housing prices in his home market. Zillow is also facing increased competition from firms like Opendoor Technologies Inc., which announced in August that it bought about 8,500 homes during the second quarter.

Zillow, which acquired more than 3,800 homes in the second quarter, will stop pursuing new home purchases as it works through a backlog of properties already in its pipeline.  

“We are beyond operational capacity in our Zillow Offers business and are not taking on additional contracts to purchase homes at this time,” a spokesperson for Zillow said in an email. “We continue to process the purchase of homes from sellers who are already under contract, as quickly as possible.”

Zillow is best known for publishing real estate listings online and calculating estimated home values – called Zestimates – that let users keep track of how much their home is worth. The popularity of the company’s apps and websites fuels profits in Zillow’s online marketing business. 

Of course, The Fed dumping in trillions into a bottlenecked housing market is helping to fuel the flipper fire.

Is this a secret warning about a possible slowdown in the housing market?

Time To Buy? Real 30Y Mortgage Rate At -2.21% As Real Home Price Growth At 14.34% YoY (UMich Home Buying Sentiment Improves To 75)

Wake up. Time to buy?

This is a time even unlike the disastrous housing bubble of the 2000s that led to the financial crisis and Great Recession. Even during the housing bubble years, we still had positive REAL mortgage rates: Bankrate 30Y Fixed rate – CPI YoY. But today we have even FASTER REAL home price growth and NEGATIVE mortgage rates!

And yes, REAL home price growth is 14.34% YoY while REAL hourly earnings growth is -0.79%.

The University of Michigan consumer survey came out today and buying conditions for housing improved to 75. Which means that more people were negative than positive due to skyrocketing home prices.

With negative 30Y mortgage rates and rising apartment rents, is it time to buy? Just remember what happened to Leon in Blade Runner.

Bank of Japan Stops Printing Money, Will The Fed Follow? (US Misery Index Above 10%, Housing Misery Rate At All-time High)

My Kuroda!

金融政策に限界があるとは考えておりません 
(I do not believe that there is a limit to the effect of monetary policy.)

Haruhiko Kuroda, Bank of Japan, 13 April 2016

The Bank of Japan is one of the top three Quantitative Easing (QE) Monsters in terms of the absolute amount of assets it purchased. The Fed and the ECB round out the trio. The BoJ started QE over 20 years ago, and went hog wild under Abenomics, which became the economic religion of Japan in 2013. But the era of Prime Minister Shinzo Abe ended in September 2020, and Abenomics is now finished.

What’s left of it is that the BoJ (and Bank of Japan Governor Haruhiko Kuroda) now holds about half of the huge pile of the central government’s debt. With their target rate at -0.10% and a gargantuan balance sheet, what could go wrong?

But BOJ’s QE has ended. The BoJ’s overall assets stopped growing, and its holdings of government bonds have started to decline.

As of the BoJ’s balance sheet dated September 30, released on Thursday, total assets declined to a still monstrous ¥724 trillion ($6.4 trillion), below where it had been in May 2021.

But look at Japanese home prices with the growth of the BOJ’s balance sheet and general decline in mortgage rates. Like the USA, there was a balance sheet spike associated with Covid and a resulting spike in home prices.

The USA? We also saw a surge in home prices following The Fed’s monetary “stimulypto.”

But will The Fed follow BOJ’s lead and stop asset purchases? Not yet, anyway. It seems that The Fed can’t turn market forces loose and let interest rates rise.

Bear in my that the US Misery Index is above 10% (U-3 unemployment + inflation).

And if I define the US Misery Index as U-3 unemployment + home price growth, we can see we are at record misery rates. Miserable for households that don’t own a home or are trying to move to a higher housing price area).

What I like about The Fed’s monetary policies?? Nada.

Alarm! Big Short Resurfaces in U.S. Bonds, Wary of ‘Convexity Trigger’

Alarm!

It was great to be a “Master of the Universe” (Treasury and MBS trader) since October 1981 when the US 10Y Treasury yield peaked at 15.84% and mortgage rates peaked at 18.63%. Treasury and mortgage rates have generally fallen ever since. But what happens if Treasury and mortgage rates rise?

Bond investors are piling back into short positions, motivated not only by the specter of inflation but also by the risk that yields are approaching levels that will unleash a wave of new selling by convexity hedgers. 

That level is around 1.60% in the U.S. 10-year Treasury yield, less than 10 basis points from its current mark, according to Brean Capital’s head of fixed income strategy, Scott Buchta. It’s the mid-point of “a key threshold” between 1.40% to 1.80%, an area “most critical from a convexity hedging point of view.”

Convexity hedging involves shedding U.S. interest-rate risk to protect the value of mortgage-backed securities as yields rise, slowing expected prepayment rates.

It’s already begun to pick up as yields stretched past the 1.40% level. Another wave is expected at around 1.6% — a point of “maximum negative convexity” in agency MBS, “where 25bp rallies and sell-offs should have an equal effect on convexity-related buying and selling,” Buchta says. 

Signs that short positions are accumulating include Societe Generale’s “Trend Indicator.” Among its 10 newest trades are short positions in Japanese 10-year debt, German 5-year debt futures, U.K. 10-year gilts, U.K. short sterling and U.S. 2- and 5-year notes. Meanwhile, CFTC positioning data for U.S. Treasury futures show asset managers flipped to net short in 10-year note contracts in the process of dumping the equivalent of $23 million per basis point of cash Treasuries over the past week. Hedge-fund shorts also remain elevated in the long-end of the curve, as measured by net positions in Bond and Ultra Bond futures. 

“Bond-bearish impulses remain in place,” says Citigroup Inc. strategist Bill O’Donnell in a note, citing tactical and medium-term set-ups. Traders should be aware of short-covering rallies in the meantime, however, he says. 

“Potentially extreme short-term positioning and sentiment set-ups could easily allow for a counter-trend correction under the right conditions,” he said.

U.S. 10-year yields topped at 1.57% this week, the cheapest level since June, spurring the breakeven inflation rate for 10-year TIPS to 2.51%, the highest since May. Friday’s September jobs report could add fuel to this inflationary fire, rewarding bond shorts. 

Here is a chart of the rising 10Y Treasury yield against The Fed’s 5Y forward breakeven rate.

Here is a Fannie Mae 3% coupon MBS. Note the rise in Modified Duration with an increase in interest rates.

Convexity for the FNMA 3% MBS?

There is something on the wing. Some-thing.

Stimulypto! US GDP Q3 Tracker Slumps To 2.3% Despite Massive Monetary Stimulus (Down From 13.7% On May 5th, 2021 Despite MORE Stimulus)

Can you say “All the king’s horses and all the king’s men ..” Or “All The Fed’s stimulus and all of Biden’s jobs bills ..”

Yes, the Atlanta Fed’s GDPNow Q3 tracker slumped to 2.3% despite the massive stimulus coming from The Federal Reserve and the Biden Administration. Down from 13.7% GDP growth as of 5/5/2021.