Morning Report: Sell-off is “technical fear,” not “real fear” 2/6/18

Vital Statistics:

Last Change
S&P Futures 2593.8 -14.0
Eurostoxx Index 373.2 -8.8
Oil (WTI) 63.4 -0.8
US dollar index 84.0 0.0
10 Year Govt Bond Yield 2.74%
Current Coupon Fannie Mae TBA 103.591
Current Coupon Ginnie Mae TBA 103.688
30 Year Fixed Rate Mortgage 4.33

Stocks are lower after yesterday’s bloodbath. Bonds and MBS are down.

There was no real catalyst for yesterday’s sell-off. The economic data has been great, earnings have been good, and nothing has really changed fundamentally. The canary in the coal mine economically is credit spread behavior, and we have not seen any major movement there. To put things in perspective: We are 8.5% off the record highs set last week. That doesn’t even meet the threshold for a correction, which is defined as a 10% drop. Don’t forget that a lot of money has been hiding in the stock market because bonds have paid nothing for so long. As the Fed hikes rates, short-term money instruments begin to come back on the radar screen for many investors. Investors have been spoiled over the past few years. Low volatility made people a lot of money in some trades, and it also made investors complacent.

In fact, THE trade of 2017 was short volatility, and it blew up yesterday. Retail investors can trade volatility via VIX futures, and there are exchange traded funds that mimic movements in the volatility indices. VIX is a “fear index” and it is generally associated with major downward moves in stocks. The “short vol” trade made something like 100% last year, and the mechanics of exiting it can cause all sorts of technical trading issues that can affect stocks. If all the speculators are short volatility, then their exit from the market can add to the destabilization. It is tough to explain, but think of a marble in a bowl. That is “normalcy.” If the marble is off-center, it is attracted to the center. That is what typical buy low / sell-high stock market behavior is like. Too many sellers come in, and the buyers emerge which stabilizes things. But, when the crowd is generally short volatility, it is like the bowl is flipped over and the marble is on top. So when the marble is off-center, it is more likely to move away from equilibrium, and the further away it gets, the more the momentum builds. That is what a short squeeze in volatility feels like, and that is what happened yesterday. I am hearing that the mechanical covering in the exchange traded notes is largely done. However, the real money resides in the over-the-counter market and there is simply no visibility there.

You can see the correlation between high VIX and market-moving events below. There is an old market saw: “VIX is high, time to buy. VIX is low, time to go.” You can see the volatility spikes which generally correspond with major events, like the end of the dot-com bubble or the financial crisis. There is no catalyst to speak of here, so I have to imagine this will be short. Yesterday was technically-driven “fear” not “real fear.”


By the way, whenever you hear the term “convexity-related buying or selling” that describes sort of the same phenomenon in bonds, although the magnitude is much less than it is with stocks and VIX. Convexity buying and selling generally refers to the behavior of mortgage backed securities and interest rate hedging. We did not see much activity in credit spreads yesterday, and that is a good sign. If credit spreads are increasing, that means investors are becoming worried about the economy going forward. While spreads moved a little, it wasn’t much.

Bonds rallied hard on the flight-to-quality trade, which gives LOs a chance to retrieve some loans that may have gotten away from them last week. Take advantage of the drop in rates to review your pipelines and see if any borrowers might want to lock and / or consider a refi. Given the massive home price appreciation we have seen lately, the switch out of a FHA into a conforming loan with no MI still makes a lot of sense. You might only have a short window here.

As an aside, Jerome Powell took over as Fed Chairman yesterday as Janet Yellen heads to Brookings. Welcome to the party, Jerome!

Interestingly, the move in markets yesterday caused the Fed Funds futures to take down their estimate of a March hike from 78% to 69%. While it is a low-probability event, the Fed could ease up on rate hikes if the sell-off continues, provided that inflation remains below target. If inflation passes the target and hits the upper 2% range, then they will probably stick to script regardless of what happens in the markets, barring a crash of some sort.

Home prices rose 0.5% MOM and 6.6% YOY in December, according to CoreLogic.

As an aside, I will be on a panel at IMN’s MSR conference in NYC March 26 and 27. Should be a good event.

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