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Pricing for recession in Treasury debt and MBS

| January 4, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The rates markets have priced for recession, but the odds of ending up there look low. That begins to make the case for higher yields on the long end of the Treasury curve. And as recession concerns have built up, MBS spreads have done surprisingly well, signaling a premium for the possibility that the Fed could stop MBS runoff and begin reinvesting principal much sooner than the market expected.

A case for higher yields in Treasury debt

As Mary Beth Fisher points out this week in A premature pessimism, the rates markets have priced for a recession, and that seems unlikely for now. Slower growth seems likely, but recession does not. Fair value for 10-year yields still looks like it sits above 2.75% and, in the long run, closer to 3.00%.

It’s not just the mid-2020 cut in fed funds implied in the futures market that signals concern about recession. It’s not just the steady drop in short yields over the next two years implied by forward curves. More strikingly, it’s the roughly 40 bp drop in inflation over the next decade implied by the spread between 10-year notes and TIPS. The implied 1.70% inflation would sit well below the Fed’s 2.00% target.

The primary way inflation would run that far below Fed target for a decade would be a sustained recession that proved hard to manage with the Fed’s monetary toolbox. The market has good reason to doubt the Fed’s toolbox since the Fed has rarely pushed core PCE above 2.00% since 2008. The Fed in 2018 seemed well on its way to putting the problem of low inflation behind it, but now the market is in doubt. The market also has reason to believe that the next recession might be a long one since the Fed has only 250 bp between today’s fed funds target rate and the zero lower bound. When the Fed eased in 2007, it only stopped after pushing rates 500 bp lower. When it eased in 2000, it stopped with rates 550 bp lower. Today’s there’s much less room to maneuver. But the argument for recession seems premature.

The argument for slower growth, however, seems strong. Many economists project slowing growth through 2019 as a surge in federal spending that started last year begins to fade. That’s the most likely outcome for now, and that solidly supports fair value for longer Treasury rates at levels closer to 3.00%.

A case for a policy premium in MBS

The risk of recession has also added a policy premium to the price of agency MBS, and MBS should continue to tighten to Treasury debt and do well relative to credit if recession fears persist. Fed Chairman Powell at a conference Friday said the Fed “wouldn’t hesitate to make a change” to the pace of Fed portfolio runoff if the Fed thought it was adding to a policy problem. In the addendum to its game plan for shrinking the Fed portfolio, released June 14, 2017, the Fed noted (here) that it could start to reinvest Treasury and MBS principal “if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.” As the economy likely slows this year, the MBS policy premium should rise.

* * *

The view in financing

Secured lending came under signficant pressure over the turn of the year, and has finally started to normalize in the last several trading sessions. On the last day of 2018, secured funding for UST and MBS pass-throughs averaged more than 4% and saw a high of 7%. Only by the first Friday of 2019 did secured funding start to resemble something normal. Repo shouldl continue to trade under pressure over the next several weeks despite Treasury bill pay downs and net money market fund inflows. Clients remain skewed toward leveraged long positions that require funding, primary dealer balance sheets are swollen and supply in CP and CD is likely to ramp up, crowding out existing investments. Treasury notes and bills are trading lately at 2.55% overnight, about the same to the end of March and mid-July, and MBS GCF trades 2.62%. Banks may want to move out of IOER into agency MBS repo at IOER + 5 bp. Portfolios that know investment grade credit also can invest in repo against corporate names at LIBOR + 20 bp with a 5% to 7% haircut.

The view in rates

Rates on 10-year notes should rise above 2.75% as signs of slower but still reasonable economic growth start to appear. The slope of the curve will depend heavily on signals from the Fed. If the Fed signals more hikes in 2019, the curve should flatten with shorter yields rising while longer yields fall as investors worry that the Fed could tip the economy into recession. If the Fed signals no more hikes, that could steepen the curve as concerns about recession ease.

The view in spreads

Credit spreads should continue widening until they have priced fully for decelerating growth next. Slower growth poses risk to the nearly $3 trillion in ‘BBB’ credit, especially the most highly leveraged names. Names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Wider spreads in corporate credit should put pressure on other spread assets, although consumer debt should show less volatility. Agency MBS should perform the best as concern about recession increases the chances the Fed might start reinvesting portfolio principal.

The view in credit

Although corporate balance sheets have to deal with higher leverage, household balance sheets looks strong. The weakest pockets on the household balance sheet look like subprime auto credit and student loan debt.

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