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.

Goin’ Down! US GDP Nosedives To 0.5% On Bubbles And Bottlenecks

Goin’ down! GDP, that is.

The Atlanta Fed’s GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2021 is 0.5 percent on October 19, down from 1.2 percent on October 15. After recent releases from the US Census Bureau and the Federal Reserve Board of Governors, the nowcasts of third-quarter real personal consumption expenditures growth and third-quarter real gross private domestic investment growth decreased from 0.9 percent and 10.6 percent, respectively, to 0.4 percent and 8.4 percent, respectively.

US real GDP nosedived to 0.5% according to the Atlanta Fed GDPNow real-time tracker.

Again, The Fed and Federal government pumped trillions of stimulus into an unprepared economy resulting in massive bottlenecks. So, we are getting declining GDP and rising inflation.

Yesterday’s industrial production dove leading to the 0.5% GDP figure. Today’s housing starts didn’t impact GDP in a meaningful way.

And she was.

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!)

Victory? US Real Average Hourly Earnings “Rise” To -0.8% YoY (Too Bad Real Home Prices Are Rising At 14.34% YoY Clip)

Good news on the wage front. Sort of .

US REAL average hourly earnings rose in September to -0.8% YoY.

Too bad that REAL home prices are growing at a 14.4% YoY clip.

The Federal Reserve’s new motto: making home unaffordable! With help from the US Treasury.

Just 194K Jobs Added In September Versus 500K Expected, Unemployment Rate Falls, Wages Rise (Mighty Biden Strikes Out)


Like the poem, Casey At The Bat, the US economy struck out with a shockingly bad jobs report for September.

Oh, somewhere in this favored land the sun is shining bright;
The band is playing somewhere, and somewhere hearts are light,
And somewhere men are laughing, and somewhere children shout;
But there is no joy in Mudville USA—mighty Casey Biden has struck out.

The U.S. economy added fewer jobs than forecast for a second straight month in September. Nonfarm payrolls increased by just 194,000 last month after an upwardly revised 366,000 gain in August, Labor Department figures showed Friday. 500K was expected.

The U-3 unemployment rate declined to 4.8% (meaning that the labor force shrank due to people dropping out of the labor force). In fact, 338,000 people dropped out of the labor force.

Average hourly earnings YoY rose to 4.6%. While that is an improvement, but it is lower than the inflation rate of 5.25% YoY and house price inflation of 20% YoY.

This miserable jobs report is a victory for Fed doves that don’t want to raise rates or slow down the balance sheet growth.

Where were the jobs created? Leisure and hospitality, as usual, leads in job gains.

Mighty Biden’s economic policies have struck out. Good night, Irene.

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.

Consumer Sentiment For Housing Falls Due To Skyrocketing Home Prices (Consumers Get Powell’d!)

I have a new term for consumers that get beaten-up by The Fed’s massive distortion of markets. I call this being “Powell’d”.

The latest example of consumers getting Powell’d is in the University of Michigan consumer survey. Buying conditions for housing just fell to the lowest level since 1982.

Foul Powell on the prowl.

Dracula’s enemy Harker says that he sees rate hike in late 2022 or early 2023.

“I am in the camp that believes it will soon be time to begin slowly and methodically — frankly, boringly — tapering our $120 billion in monthly purchases of Treasury bills and mortgage-backed securities.”

Here is a photo of Harker with Fed Chair Powell.

Mortgage Lender Offering 105% LTV Loan With $500 Down And Downpayment Assistance, FICO Down From 660 To 620 (Into The Storm!)

I call this “lending into the storm.”

A national mortgage lender has just introduced a 105 Loan-to-value (LTV) ratio loan and a lowering of FICO scores from 660 to 620.

Now, the loan still requires 97% LTV with downpayment assistance and gift funds permitted to boost CLTV to 105%.

With The Fed helping to raise home prices at a whopping 20% YoY, …

lenders are trying to find loan products for lower-income households so they can get in on the bubble! Hence, a 105% CLTV mortgage product with reduced credit requirements and increased Debt-to-income requirement rising from 43% to 45%. Also, borrowers can avoid the 3% downpayment requirement and put down only $500.

This is lending into the storm: softening of underwriting requirements as the house price bubble surges. Sound like 2005. This was not supposed to happen. After the housing bubble burst and the financial crisis, The Fed was supposed to encourage counter-cyclical lending (tighten credit standards as a housing bubble worsens). Instead, lenders are lowering credit standards, feeding the house price bubble.

If this was just one lender, I would have barely noticed. But this mortgage is being offered by most banks. And then sold to our GSEs: Fannie Mae and Freddie Mac.

Government mortgage giant Fannie Mae purchases these mortgages in their 3% down programs.

Eligibility and Terms

  • Desktop Underwriter® (DU®) underwriting required
  • 1-unit principal residence, including eligible condos, co-ops, PUDs, and MH Advantage® (Standard manufactured housing: max. 95% LTV/CLTV)
  • Fixed-rate mortgages with a maximum term of 30 years and ARMs are eligible (restrictions apply)
  • Reserves (if required per DU) may be gifted
  • Combined LTV up to 105% provided subordinate lien is an eligible Community Seconds® loan
  • Downpayment assistance found here.

Speaking of lending into a storm, as part of the raft of new legislation designed to spur first-time homeownership in America, a remarkable bill has joined the fray: its sponsors propose creating a new subsdizied 20-year-fixed-rate mortgage program through Ginnie Mae, HousingWire reports.

According to the bill, Ginnie Mae in tandem with the Department of the Treasury would subsidize the interest rate and origination fees associated with these 20-year mortgages, so that the monthly payment would be in line with a new 30-year FHA-insured mortgage. The move – which is an explicit subsidy of one share of the population by another – could, in theory, “allow qualified homebuyers to build equity-and wealth- at twice the rate of a conventional 30-year mortgage.” Instead, what it will do is lead to is an even bigger housing bubble.

As I said, lending into a storm.

US Home Price Growth Hits 20%! While Fed’s Inflation Target Is 2% (Phoenix AZ Growing At Whopping 32.4% YoY!)

The Federal Reserve is dominating the news today as two Fed regional Presidents have resigned (Rosengren [Boston] and Kaplan [Dallas]) for trading irregularities.

Speaking of The Fed, their target rate for inflation is 2%. Yet the Case-Shiller 20 metro home price index just rose to 20% YoY for July. Yes, house price growth is 10 times The Fed’s target rate!!

Now, it is September 28, so this is a report of happenings two months ago. Well, now you know why The Fed ignores housing despite being the largest asset is most household’s portfolio.

A measure of prices in 20 U.S. cities gained 19.9% in July. Phoenix led the way with a 32.4% surge. New York (17.8%), Boston (18.7%), Dallas (23.7%), Seattle (25.5%) and Denver (21.3%) were among the cities that posted record year-over-year increases.

The housing market is over, under, sideways, down thanks to The Fed pumping trillions into a market with limited available inventory.

The Fed is not talking about housing. Or the fact that home prices are growing at 10 times the rate of The Fed’s inflation target.