Tuesday, May 11, 2010
It's been six weeks since the Fed stopped buying MBS, and still there is no sign that Fed purchases kept mortgage rates artificially low, or that the end of the purchase program has caused mortgage rates to rise by any meaningful amount. 10-yr Treasury yields are in fact lower today by about 30 bps than they were at the end of March, and MBS spreads to the 10-yr are only about 9 bps wider. Jumbo fixed rate mortgages can be had today for the lowest rate in history, and conforming rates are only marginally higher than their all-time lows of early last year.
A few months ago it was widely believed that the Fed's massive expansion of its balance sheet (achieved largely by buying $1.25 trillion worth of MBS) was keeping long-term interest rates artificially low in order to stimulate the economy. I've always been skeptical of the Fed's ability to control long-term rates. I think the market is the main driver of long-term rates, and the market drives rates based on its growth and inflation expectations. I've argued quite a few times in the past few years that the low level of Treasury bond yields is primarily a reflection of the market's deep pessimism. I think the market is priced to the expectation that economic growth will be 3% at best (i.e., the "new normal" that is in vogue), and inflation will be 2-3% for as far as the eye can see. These are the assumptions that keep bond yields so low. The next chart is my graphical interpretation of this: today's 3.53% 10-yr T-bond yield is the market's way of expressing a very pessmistic view of the economy's long-term growth prospects.
This all circles back to my long-held assertion that the capital markets have a negative valuation bias (i.e., there is little if any evidence of optimism in the prices of bonds and stocks). Market participants are content to buy Treasuries at yields of 3-4% because investors don't expect nominal GDP (which is a good proxy for the growth in corporate profits over the long run) to be more than about 5% (2.5% real growth and 2.5% inflation). Although this is only slightly lower than the 5.7% average nominal GDP growth rate from 1984-2007, it assumes that the economy will never recover all that it lost in the last recession; that the economy will never return to trend growth, and it will therefore suffer with a permanently higher level of unemployment.
Posted by Scott Grannis at 11:34 AM