The Big Idea

A midterm exam on markets

Steven Abrahams | July 14, 2023

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. This material does not constitute research.

The likely level of longer rates, the slope of the yield curve, the path of rate volatility, the arc of home prices and housing, the risks in leveraged loans and CLOs and the fate of Fed sales of MBS. All these areas offered ample room for out-of-consensus views at the start of the year. The midyear scorecard shows two misses, two hits and two undecided. But in each area, there is still room to run up the quality of portfolio returns.

The level of longer rates

My out-of-consensus view last November that 10-year rates would drop this year below 3.25% has come close, but no cigar yet. The 10-year dipped to 3.31% in April but today stands about where it stood on forecast day (Exhibit 1). But do not give up hope, you note and bond bulls.

Exhibit 1: 10-year Treasury rates have roundtripped since November

Source: Bloomberg, Santander US Capital Markets

The 10-year rate still should drop from here. But because a few facts have changed since November, the magnitude of drop looks more shallow than it did last fall. Look for the 10-year at this point to only drop below 3.50% before the year ends. In the long run, it should settle around 3.00%.

Some critical things have changed since November:

• A higher terminal fed funds rate. The likely terminal fed funds rate has moved from the neighborhood of 4.625% last fall to around 5.625% today. This comes from both the Fed and the market. The Fed median dot last September pegged funds to finish 2023 at 4.625% and now has funds peaking at 5.625%. The market has followed the Fed’s lead. Absolute levels aside, the likely terminal rate has moved up, and the fair value for 10-year yields should move up, too.
• A higher neutral 10-year rate. The likely neutral nominal 10-year rate has moved from around 2.50% to around 3.00%. This comes mainly from updated estimates of r-star, the unobserved but often discussed short rate that sets GDP just at its potential with stable inflation. As a recent speech by New York Fed President John C. Williams and recent work by Vanguard economists suggest, r-star has moved higher after Covid. The 0.50% value for r-star implied by the Fed’s longer-term dot reflects orthodoxy before Covid. The latest New York Fed estimates put r-star at 1.14% and Vanguard estimates r-star at 1.50%. Using the New York Fed’s r-star estimate and adding 2.00% to compensate for expected inflation, and that move the neutral 10-year rate from 2.50% to 3.14%.

The likely path of fed funds depends on where the Fed peaks, how long it holds rates there and how the Fed glides back to neutral in the long run. Choose a path for fed funds over the next 10 years, and you have an estimate of fair value in the 10-year note.

The Fed can follow an infinite number of paths, but one simple way to put an envelope around the possibilities is to assume the Fed holds rates at terminal value for somewhere between one and three years and then drops to a neutral rate governed by r-star. Assuming the Fed holds funds at 5.50% for one to two years and that r-star stands at 1.14%–putting the neutral 10-year rate at 3.14%–then fair value for the 10-year falls between 3.38% and 3.61% (Exhibit 2). Split the difference, and fair value ends up in the neighborhood of 3.50%.

Exhibit 2: Breakeven 10-year rate based on terminal fed funds and r-star

Note: Breakeven calculated assuming indicated terminal rate for one, two or three years with immediate drop to neutral rate, which, in turn, assumes 2.00% + r-star. Breakeven for fed funds at 5.50% for one year and an r-star of 0.50% is (5.50%)*(1/10) + (2.00% + 0.50%)*(9/10) = 2.80%. Source: Santander US Capital Markets

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The slope of the yield curve

Count this out-of-consensus view as a hit. The slope between the 2- and 10-year Treasury has breached 100 bp twice since November and should do it again before the end of the year (Exhibit 3). With the slope now at -85 bp, it is a good time to add a 2s10s flattening bias.

Exhibit 3: The 2s10s slope should breach 100 bp again before year end

Note: OoC = out-of-consensus. Source: Bloomberg, Santander US Capital Markets

The rationale here is simple:

• The market currently underestimates how long the Fed will hold policy rates at 5.50% or higher, so 2-year yields should eventually move above 5.00% as the Fed’s hawkishness sinks in.
• When the market finally does price for a sustained high policy rate—and as falling core inflation raises the effective real rate (fed funds – core inflation) and makes policy steadily more restrictive—the back end of the curve should price for lower growth and the 10-year should drop toward 3.50%.

Somewhere along that path, 2s10s should break 100 bp or more.

* * *

The amount of rate volatility

Miss, so far. This view anticipated an increasingly clear consensus on inflation and the Fed, at least compared to 2022. But rate volatility exploded in the aftermath of the Silicon Valley Bank collapse and has continued to range around the relatively high levels of the second half of last year, partly because inflation has proven stubborn (Exhibit 4). But stick with the original thesis and look for rate vol to drop to half of 2022 levels. All risk assets—credit and MBS—should benefit and tighten nominally to the Treasury curve.

Exhibit 4: Implied rate volatility has remained high this year

Note: OoC = out-of-consensus. Source: Bloomberg, Santander US Capital Markets

The thesis that the market would get more clarity on inflation and the Fed has already started to play out. The Philadelphia Fed publishes an index of dispersion among economists’ inflation forecasts, and dispersion has dropped sharply from peak levels in the fourth quarter of last year (Exhibit 5). For example, the difference between the 25th percentile and 75th percentile of economists’ forecasts for core inflation two quarters ahead stood in late 2022 at 137 bp. As of May 12, that dispersion of forecasts for two quarters ahead stood at 60 bp, down by more than half. As inflation data continue to roll in and as the Fed approaches terminal rates, uncertainty should drop and implied volatility with it.

Exhibit 5: Uncertainty about core CPI has broadly dropped from 4Q2022

Note: Dispersion calculated as the difference between the 75^th percentile forecast and the 25^th percentile forecast. Data as of May 12, 2023. Source: Survey of Professional Forecasters, Santander US Capital Markets

Lower volatility should tighten spreads in credit and MBS against the Treasury curve. Because credit is dominated by a more diverse set of private investors and agency MBS is dominated by policy investors—the Fed and banks, specifically—credit looks like the better relative value.

* * *

Home prices and housing

Hit. The idea that home prices would rise this year looked like an out-of-consensus call last fall, but it has slowly become mainstream. Home prices have largely shrugged off the impact of high interest rates and low affordability. But that is something Karl Case, of Case-Shiller fame, put his finger on at least 15 years ago. Home prices should continue accelerating this year and beyond, barring a sharp rise in unemployment. That is good news for a range of assets that rely on homeowner credit.

Since January, every major US home price index shows prices rising. The S&P Case-Shiller national index, which uses pricing on all kinds of homes and both purchase and refi transactions, is up 1.0% with a seasonal adjustment and 2.4% without (Exhibit 6). The Federal Housing Finance Agency index, which only includes purchase transactions on homes financed with Fannie Mae or Freddie Mac loans, is up 2.4% with a seasonal adjustment and 4.7% without.

Exhibit 6: The price of an average home has moved higher since December

Note: Home price indices normalized to Jan 2022 = 100%. Source: Bloomberg, Santander US Capital Markets

Rising prices reflect an extraordinarily low supply of existing homes as the low mortgage rates captured by most homeowners in 2020 and 2021 create disincentives to sell. Karl Case anticipated this. Supply of new homes has picked up to meet the structural demand for housing (Exhibit 7). Home prices should continue rising and homebuilders should continue doing steady business.

Exhibit 7: New home sales have partly offset low existing home supply

Source: Bloomberg, Santander US Capital Markets

The resilience of home prices and homebuilding should make residential credit and homebuilders credit good relative value.

* * *

Leveraged loans and CLOs

This is on track, but the game is not over. The leveraged loan and CLO markets continue to carry a record 30% of loans and 25% of CLO loan collateral in ‘B-‘ exposures. Through June, S&P has downgraded 10.3% of ‘B-‘ loans, an annualized rate of 20.6%. High SOFR and LIBOR index rates and slowing economic growth should keep these ‘B-‘ balance sheets under pressure. Downgrades of ‘B-‘ loans look likely to exceed the 2001-2022 annual median of 18% (Exhibit 8).

Exhibit 8: Downgrades of ‘B-‘ leveraged loans is on pace to hit 21%

Note: Data shows percent of ‘B-‘ loans at the beginning of each year downgraded during the year. Source: S&P, Santander US Capital Markets

Downgrades of ‘B-‘ loans should keep the pressure up on junior classes of CLOs. The average exposure of CLOs to assets rated ‘CCC’ or lower is currently around 6.2%, only slightly below the typical 7.5% limit to ‘CCC’ exposure. Beyond that limit, the risk starts to rise quickly that the CLO structure will divert principal and interest away from junior classes to protect senior. CLO investors should migrate up-in-credit, with ‘AAA’ and ‘AA’ classes the risk-adjusted sweet spot.

* * *

Agency MBS

We still have the balance of the year left, but the likelihood of Fed sales of MBS continues to look vanishingly low. Beyond raising the possibility of MBS sales in the exit principals it outlined at the start of this round of QE, the Fed has been largely silent. Chair Powell has fielded a question or two about MBS sales in the last year, but he has largely dismissed the idea that sales might be imminent. Selling MBS at this point would be a distraction in the Fed’s bigger fight against inflation, and with 30-year mortgage rates above 7% would have limited policy impact.

If the Fed does choose to sell MBS at some distant point in the future, the FDIC’s sales of MBS from the portfolios of Silicon Valley Bank and Signature Bank shows the market can absorb sizable flows with only modest pressure on spreads. But for the foreseeable future, this is one item MBS investors can take off their list of worries.

* * *

The view in rates

OIS forward rates now put fed funds above 5.40% from September through December. The same forwards also anticipate 140 bp of cuts in 2024. This is just the latest version of market pricing for a terminal fed funds rate, the length of the Fed pause and the pace of eventual cuts. The stickiness of core inflation suggests cuts in 2024 look premature, especially cuts of 140 bp. The Fed looks more likely to hold fed funds at a terminal rate well into 2024, something that would actually tighten financial conditions if nominal rates stayed constant and core inflation dropped. Under those circumstances, real rates would rise. That is likely the Fed plan.

Other key rate levels:

• Fed RRP balances closed Friday at $1.77 trillion, the lowest level since April 2022. With the Treasury replenishing its cash balances after the resolution of the debt ceiling, even short T-bills trade above the RRP’s 5.05% rate, drawing cash away from the facility.
• LIBOR officially went away on June 30, so goodbye, old friend. Setting on 3-month term SOFR traded Friday at 530 bp, unchanged over the last week.
• Further out the curve, the 2-year note traded Friday at 4.75%, down 20 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note traded at 3.81%, down 25 bp in the last week. With inflation likely to drift down and growth likely to slow, fair value on the 10-year note is closer to 3.50%.
• The Treasury yield curve traded Friday afternoon with 2s10s at -95, flatter by 7 bp over the last week. Expect 2s10s to flatten beyond -100 bp as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s traded Friday morning at -12 bp, steeper by 19 bp over the last week.
• Breakeven 10-year inflation traded Friday at 225 bp, down by 2 bp over the last. The 10-year real rate finished the week at 157 bp, down by 24 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 148 bp, up 1 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 160 bp, tighter by 12 bp in the last week. Par 30-year MBS TOAS closed Thursday at 49 bp, tighter by 18 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month.

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 on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.