Tuesday, May 11, 2010

Mortgage update: still no sign of any threat to housing

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. 


John said...

And therin lies opportunity.

John said...

I think this is relavent.

My favorite SHORT SELLER is BUYING the mortgage insurers this afternoon. These are highly levered to the mortgage business and are VERY volatile.

I am NOT participating (too chicken). But this guy is a way better trader than me.

Will be interesting to watch.

Benjamin Cole said...

Get ready for low interest rates for a long, long time.
Gobs of capital seeking safe haven, pushing down all interest rates.

Gold is a haven? Well, the market says so. I say it is risky, but the Chinese have become the world's biggest buyers, and their economy will eclipse ours in 10 years. They will buy more and more.

If you want safety in bonds, get ready for extremely low yields, or maybe slight negative yields.

The Fed can't push on a string, so these low, low rates will mark an entire era of investing.

ronrasch said...

If a central bank peged its currency to the price of gold, would their currency be a target for future market speculators? Would the price of bond's be a better currency gauge because the bond market is larger and not so easily manipulated?

Scott Grannis said...

ronrasch: A central bank has a variety of options for managing its currency, and pegging to gold is one of them. Nothing will work, however, if the central bank lacks credibility. A weak committment to a gold standard would invite speculative attacks. A strong committment, however, should work, but if speculators really mount a challenge to the currency, then the big risk would be whether politicians will step in to disrupt the process. A massive speculative attack against a currency pegged to gold would force the central bank to drastically reduce the amount of currency in circulation, thus raising interest rates sharply and starving the economy for liquidity. Politicians would see this as a major threat to the economy and their livelihoods, and argue that it would be better to accept a devaluation of the currency rather than a deep recession or deflation in the economy.

Politicians are usually the ones who make the big mistakes when it comes to economic policies.