Yesterday was a great example of a common
misconception out there: that bond and stock markets always move in opposite
directions - they don't. Not only did was the U.S. 10-yr T-note down by a
point, closing at 2.30%, but the S&P was down about 23 and the Dow down
over 200. "I guarantee it!" If there was any good news, it was that
agency "MBS held up well in sell-off with two-way flows in lower
coupons." More on this a couple paragraphs down - it is not the end of the
world.
As
if the compliance and regulatory environment isn't enough, now non-depository
mortgage banks and banks with large lending operations are looking at interest
rates that noticeably higher than a week ago, certainly more than two months
ago. Make sure those extension policies are bullet-proof! Did the Fed say
anything really surprising yesterday? Not really. Do many feel rates and
stocks over-reacted? You bet. Does that mean it is going to come roaring back?
Probably not, but who can foresee the future? So let's discuss the cold hard
facts, and you can draw your own conclusions.
First, the Fed Funds target remains at
0-.25%, the Prime Rate is unchanged at 3.25%, and the Discount Rate is
unchanged at .75%. The policy bias points toward maintaining the Fed's risk bias to growth and unemployment but indicated there had been some
improvement. The Fed was expected to make a few changes in its statement, which
it did, defend QE3, which it did, re-iterate specific economic thresholds
(unemployment below 6.5%, inflation above 2.5%) to the timing of rate increases
rather than calendar projections, which it did. The Fed repeated the pace of
bond purchases.
The Fed did not make major policy changes at
the 2-day standard format meeting. Did anyone out there think the purchase
of $85 billion a month was going to continue forever? I hope not, nor do I hope
that no one is basing their business model on it. And any loan officer who
convinced their boss that his or her business will really take off if rates go
down in order to keep their job - well, good luck with that one. But on a
global scale, the Fed continues to purchase a significant percentage of agency
MBS and CMOs, but yields have moved to a much more attractive level over the
past month. It is believed that the effect of Fed tapering of purchases is
mostly already priced into yields. Depository banks have been active in 15 year
and 20 year pass-through MBS and callable agencies as the recent volatility of
interest rates has presented opportunities. For most community banks, as any
commercial loan officer will tell you, loan growth remains difficult and margin
compression is a primary concern. As Pacific Coast Bankers Bank noted,
"Banks should continue to address the extension of the low rate
environment for some time to come in their ALCO and planning sessions, but also
cover the possibility of a steepening yield curve and how it could impact
the bank's balance sheet, both on the asset and on the liability
side."
The Fed news yesterday brought the focus back
to the economy. When the recession hit, state and local government tax revenue
plummeted. Those governments responded by cutting spending and employment,
which have still not recovered. On a per-person basis, production of goods and
services is about 1% below its pre-recession peak. More recently, higher taxes
have come into the picture. Income tax rates were raised on upper-income
Americans, and the Social Security payroll tax cut was allowed to expire. And,
on top of that, we have sequestration. The United States is not the only
country going through a period of budgetary restraint. In Europe, government
spending has grown much slower than in other recent recoveries. Among countries
that use the Euro, recessions have caused tax revenue to tank, which widens
budget deficits. In the face of those enormous deficits, governments have
slammed the brakes on spending. However, not all the news from overseas is bad.
In Japan, the central bank has adopted a much more aggressive policy to promote
growth. If the Bank of Japan succeeds in jump-starting growth, that should
offset some of the economic drag coming from Europe. There is so much criticism
towards our financial system for not making credit more readily available,
especially for mortgages. Banks are in business to lend, and today unlike
troubled counterparts in Europe, they have good balance sheets and plenty of
money available. In today's world of low interest rates and a flat yield
curve a bank has less than a 3 percent net interest margin. The very best
possible outcome on a loan for our forever criticized bank is to get paid back
all its principal and make a small spread on the interest. Get paid back 95 %
of every loan and it goes broke. Careful scrutiny of any type of loan is
judicious business practice and necessary to remain solvent. A top quality
financial lending institution can be lucky to earn is 1 to 1.4 percent on total
assets.
So again, what happened yesterday? Basically,
Ben Bernanke affirmed what the market was thinking anyway - that QE3 will
eventually go away if the economy is doing better. Certainly housing is
doing better, but the job market - not so much. As for the FOMC statement,
there were some upgrades. Labor market conditions were said to have shown
"further" improvement versus "some" in the previous one.
Also, the Committee saw downside risks to the outlook for the economy and labor
market as "having diminished" from last fall versus that it continued
to see downside risks.
The analogy is that the Fed, if driving a
car, is merely taking its foot off the gas but not putting on the brakes. Bernanke indicated that the Committee's preference is for holding MBS to
maturity, and to reinvesting the pay-downs (homeowners paying off their
mortgage early). The yield curve has steepened - good news for banks IF rates
are increasing due to the economy doing better.
United States 10-year notes worsened by a point in price, closing at 2.30%. But on a relative basis, what is going to happen to agency MBS? Prices could continue to do well if supply drops - how much mortgage volume will be produced at these rates? In research from Deutsche Bank, mortgage-backed securities analysts said "if the Fed rewrites its playbook and delivers on the promise of holding MBS rather than selling, that could provide major support for MBS spreads for the first time this year." Yesterday mortgage banker supply was "uneventful" at under $2 billion.
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