A little offsides
admin | September 13, 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.
Every day the market has to put a level on likely growth and inflation, the path of the Fed, the strength of corporate and household credit, the negative convexity in MBS and any one of a number of other things. It eventually gets a lot of things right. The market has had a lot to absorb lately. On some elements of rates, corporate credit and MBS prepayments, it looks a little offsides.
Growth and inflation
The market since May has struggled to price the right levels of growth but seems to have done a fair job. Trade conflict has complicated things. It has limited direct impact on the US economy, and its indirect impact on business investment is hard to pin down. The market currently implies real GDP over the next decade of between 1.74% and 2.09%, and that part of the yield equation seems plausible. The spread between real rates and GDP over the last decade has averaged 1.54% with a median of 1.89%. And with the current 10-year real rate on TIPS at 0.20%, the numbers add up to a plausible implied range of growth. The Congressional Budget Office, which weighted the impact of trade in its latest forecast, estimates growth over the next 10 years at 1.8%, so the market roughly agrees.
Pricing inflation has been more challenging, and the market seems too pessimistic about the Fed’s ability to get inflation back to 2%. The rate of inflation implied by the spread between 10-year notes and TIPS dropped to a low in early September of 152 bp before rebounding most recently to 166 bp. That still seems low. The Fed has fed funds, forward guidance and QE in its arsenal. The ECB’s recent resort to those same tools may have reminded the market of what the Fed still has in reserve. Fundamental fair value on 10-year notes is above 2% with a reasonable case for 2.5%.
Fundamental fair value for long rates could change substantially, of course, if trade frictions get worse or go away. The US-China frictions look far more difficult to unwind today than they did six months ago. Rate volatility should stay high.
The market has done a far better job of pricing a Fed inclined to create easy financial conditions. And financial conditions have eased since early August, according to most benchmarks, with lower rates and recent stock market gains contributing. A cut in September is baked in, with a 70% chance of another cut in December. Even if longer yields rise, the short end of the Treasury curve should stay below 2%.
The credit markets also have struggled to price risks to growth, but rather than price average growth the way rates markets might, credit has had to price for the tail event—recession. Recession seems unlikely in large part due to the readiness of the Fed, the ECB and other central banks to backstop growth. The Fed’s linking of policy to trade risk is among the more explicit examples. The drop in rates broadly and the likely continuing drop in short rates have helped both corporate and consumer balance sheets. Heavy corporate new issuance largely reflects refinancing of existing debt, and lower rates translate directly into relief for borrowers in the leveraged loan market since almost all of that debt floats over LIBOR. Recession always looked unlikely, and lower policy rates have helped ensure another buffer for corporations. Adjusting for the impact of rate volatility, corporate spreads should tighten.
The household balance also has taken advantage of lower rates to refinance outstanding mortgages, only adding to already clear strength.
The MBS market has had to price for materially faster prepayments for the first time since mid-2016, and that has put pressure on spreads. Refinancing forces a return of cash to investors and creates a rising supply of new MBS. So far, most prepayments have been broadly in line with the pace projected by models fit to historic data. The surprises have concentrated in the newest vintages, or, in Ginnie Mae, vintages with unfettered access to refinancing for the first time. Although price premiums for specified pools have jumped as rates have fallen, speeds have accelerated and implied volatility has moved higher, there are some opportunities to trade on these surprises in both seasoned conventional pools and newer custom Ginnie Mae.
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