Thursday, June 20, 2013

More on stocks and bonds


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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