The Big Idea
On the heels of a few out-of-consensus calls
Steven Abrahams | December 9, 2022
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.
Since highlighting a few out-of-consensus market calls the week before Thanksgiving, a pair in particular have attracted attention: a call for the US 10-year Treasury yield to drop below 3.25% next year and for US home prices to actually appreciate. If anything, the prospects for those calls since the holiday have only improved.
A call for US 10-year yields to drop below 3.25% in 2023
The US 10-year Treasury rate hovered around 3.80% the week before the holiday with 1-year forward 10-year rates around the same level. The options market suggested the probability of rates a year later falling below 3.25% was just under 30%. The market has since moved. The 10-year rate now stands around 3.56% with the 1-year forward 10-year rate at 3.47%. And the options market now puts the probability of breaching 3.25% a year out at 43%.
The Fed this month published work that underscores the case for lower government rates over the long run in the US, Canada, the UK and the euro zone. The Fed estimates a neutral nominal rate in the long run at roughly 2.5% for the US and UK, just below 1.5% for the euro zone and just above 3.0% for Canada. These estimates reflect the inflation target of each central bank, the supply of safe government debt, demand for safe assets, productivity, household savings and risk preferences and any spillovers from global developments.
The out-of-consensus case for 10-year rates dropping below 3.25% rests on the assumption that fair value for the 10-year note falls somewhere between 2.50% and 3.00%, consistent with the Fed’s estimates, but that heavy issuance by the Treasury and net tepid demand since August has pushed rates above that range. A few things seem likely to change next year:
- Debt issuance should slow. Net annual Treasury issuance should drop from around $1.9 trillion in the recently completed federal fiscal year 2022, to $1.0 trillion in fiscal 2023, according to the latest Congressional Budget Office estimates, a 46% decline. A divided Congress makes big fiscal change next year unlikely. This cuts the marginal supply of safe assets, pulling down nominal rates.
- Demand from foreign private portfolios should get even stronger. Foreign private portfolios this year have added more than $750 billion in US Treasury notes and bonds through September. The Russia-Ukraine conflict, concern about China-Taiwan, recession and low rates next year in Europe and stress from financial conditions in emerging markets should boost demand for safe, liquid assets. This, again, pulls down rates.
- Inflation, growth and the Fed path should favor lower long rates. Each inflation print next year should make the eventual path to 2% inflation clearer, something that the TIPS market and surveys of consumers and economists all expect. Stephen Stanley expects the Fed to hold target fed funds around 5.125% for five quarters starting in May 2023, keeping financial conditions tight until the path to 2% is clear. Expected growth should return to pre-pandemic levels, if not lower, and the Fed can glide back towards neutral. That sets the stage for 10-year rates to finish 2023 below 3.25%, if not lower.
A call for US home prices to finish December-to-December positive
The rise in home prices since 2020, the rise in mortgage rates in 2022 and the resulting drop in affordability has led to wide expectations that nominal home prices will drop nationally. Estimates vary but commonly range between -5% and -15%. But those expectations miss a unique element of the US housing market: nominal prices tend to be sticky to the downside.
Homeowners that cannot get their target price often stay in the home, take it off the market or even rent it and wait for a buyer. The only circumstance where that does not happen is when the homeowner loses the ability to stay in the home—often due to unemployment, a higher rate on an adjustable-rate mortgage or both sufficient to burn through available cash. But US homeowners, will one notable exception, usually fund with fixed-rate debt. That helps explain why US home prices nationally have run flat or higher in six out of the last seven recessions, through Fed hikes, and through wide swings in affordability. Home prices famously fell starting in 2006 and ending in 2012 after the US adopted a wide range of creative ARMs and recession pushed up unemployment. At the peak, distressed home sales made up 49% of the total.
The latest piece of work to shed light on a call for flat-to-positive home prices came recently from CoreLogic. Analysts there argue that the prevalence of 30-year fixed-rate mortgage debt insulates the US housing market from declining home prices. The piece points out that although US home prices have fallen less than 2% from their recent peak, prices in other countries with a similar rate of pandemic appreciation—Canada, New Zealand and Australia—had seen declines of 5% to 6%. The key difference between the US and these other countries: Canada, New Zealand and Australia finance homes mainly with ARMs. More than half of all homeowners in New Zealand, according to CoreLogic, have seen their mortgage rate reset in 2022. Home prices in markets funded with floating-rate debt remain vulnerable. In most of the US, not so much.
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The view in rates
OIS forward rates continue to price for a peak fed funds rate around 5% in mid-2023 with 50 bp of cuts by the end of year. The cuts run contrary to Fed Chair Powell’s hawkish warnings in recent weeks that the Fed will hold rates high through next year. That sets up the market for volatility next year if Powell sticks to his guns. But forecasting inflation and other elements of the economy has become extremely difficult in the aftermath of pandemic, as the Fed often acknowledges. There is risk next year of repricing the Fed path higher, although there is better likelihood of cuts rather than hikes after a long pause.
Fed RRP balances closed Friday at $2.15 trillion, up nearly $100 billion over the last week. Money market funds may be adding to the RRP ahead of the expected 50 bp jump on December 14. The current and expected RRP rate still beats short Treasury through March.
Settings on 3-month LIBOR have closed Friday at 473 bp, down 3 bp on the week. Setting on 3-month term SOFR closed Friday at 450 bp, up 7 bp on the week. The spread between 3-month SOFR and LIBOR has varied with the higher cost of bank borrowing over yearend.
Further out the curve, the 2-year note closed Friday at 4.34%. The 10-year note closed well above fundamental fair value at 3.56%, so the higher yield has to get chalked up to a market seeing or expecting supply to overwhelm demand. It is shaping up to be a long and volatile winter for the rates market.
The Treasury yield curve has finished its most recent session with 2s10s at -76 bp. The 5s30s finished the most recent session at -21 bp. The 2s10s curve looks likely to invert by around 100 bp shortly before Fed tightening comes to an end. That is a trade for some time next year.
Breakeven 10-year inflation finished the week at 227 bp. The 10-year real rate finished the week at 131 bp.
The view in spreads
Volatility should continue while the Fed’s path stays in flux. But volatility should drop sharply next year as the market sees more on the path of inflation and the impact so far of Fed policy. Both MBS and credit tightened through November but have stayed roughly flat in December. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields has dropped from more than 170 bp at the start of November to close Friday at 148 bp. Par 30-year MBS OAS has dropped from more than 60 bp to close Friday at 21 bp. Investment grade cash credit spreads have dropped from more than 180 bp bp over the SOFR curve to close Friday at 154 bp
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates, and health stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. A recent New York Fed study argues inflation generally helps companies lift gross margins, although airlines and leisure may have an easier time passing through costs than healthcare, retail and restaurants. But in leveraged loans, a higher real cost of funds has already started to eat away at highly leveraged balance sheets with weak or volatile revenues. The leveraged loan market is the bellwether to watch for broader corporate and consumer credit, and stress in leveraged loans looks likely to spill over into CLOs.
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