All Things in Moderation

Vital Statistics:

Stocks are higher this morning after a positive retail sales number. Bonds and MBS are flat.

The yield curve continues to invert, with the 2s / 10s spread at -20 basis points and the 2s / 30s spread at -5 basis points. The yield curve’s shape isn’t dispositive – there is an old joke that an inverted yield curve has predicted 12 of the last 5 recessions, but it flashing warning signs and we are getting confirmation elsewhere.

Retail Sales rose 1% MOM and 8.4% YOY. Note this number is not adjusted for inflation, which is running right about the same level. Ex-vehicles and gasoline sales rose 0.7%, which was much better that -0.2% Street expectation.

Wells Fargo reported earnings this morning. Earnings per share declined 47% on a YOY basis. Revenues were down 16% YOY, and earnings were mainly affected by provisions for credit losses. The credit losses should really have an asterisk nest to it. Most of the banks over-reserved for losses in the early days of COVID and when the losses never materialized, they reversed them in 2021. Now that we are back to normalcy, they are reserving for credit losses again. So you get a strange YOY comparison, which will be pretty common for all the banks, IMO.

The mortgage banking numbers were pretty lousy, as expected. Home lending earnings were down about 50% (as they telegraphed a month ago), as falling origination income was offset somewhat by increased servicing income. Originations fell 11% QOQ and 36% YOY to $34.1 billion.

Consumer sentiment improved in the preliminary July reading of the University of Michigan Consumer Sentiment Index. More importantly, the inflationary expectations of consumers began to moderate. As we learned from the FOMC minutes from the June meeting, the Fed pays close attention to this number.

Consumer sentiment indices are often nothing more than gasoline price indices – in other words high gas prices depress sentiment. Gas prices are off the highs from a month ago, so I guess it makes sense that inflationary expectations would fall. Regardless, this number is welcome news for everyone.

This highlights one of the big risks at the fed: by adjusting policy to inflationary expectations, the Fed risks chasing oil prices which is the wrong metric to use.

That said, consumers’ financial situation isn’t in the best of places. One of the metrics for this survey asks consumers about their current financial situation. You can see from the chart below, they are in a bad place:

A recent article in the New York Post shows the difficulty in measuring inflation. BMW is now requiring subscriptions to use heated seats or automatically adjusted high-beams. Access to CarPlay requires an up-front fee. It is the Spirit Airlines model – advertise a low price and then charge for the oxygen the passenger breathes.

Now, according to the government, the only relevant number is the price of the car, however if automakers are lowering prices by introducing a slew of add-on charges, then the price growth is understated. It is a different play on shrinkflation, which is evident again to anyone who eats a bagged salad for lunch.

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Vital Statistics:

Stocks are lower this morning as the banks kick off earning season. Bonds and MBS are flat.

JP Morgan reported earnings that missed Street expectations. Earnings per share fell 27% YOY as provisions for loan losses and noninterest expense increased. Mortgage banking revenue fell 14% QOQ and 27% YOY as lower production revenue was offset somewhat by higher servicing income. Origination volumes fell 11% QOQ and 45% YOY to $21.9 billion. The stock is down about 3% pre-open.

The producer price index came in hotter than expected, rising 1.1% on a MOM basis and 11.3% on a YOY basis. The PPI focuses on inflation at the wholesale level, which will translate into higher prices at the consumer level down the road. About half of the increase was attributable to gasoline prices, which thankfully are beginning to fall. Final demand when you strip out food and energy rose 0.4% MOM and 8.2% YOY.

The strength of the dollar is beginning to help in the fight against inflation as commodities generally trade in US dollars. Note that the US dollar just went below parity versus the Euro. The downside will be lower corporate earnings for companies with overseas operations.

The Fed’s Beige Book reported that economic activity expanded at a “modest” pace (“modest” is Fed-speak for “meh”), but several districts reported that they are seeing a decrease in demand and many noted an increased risk for a recession.

The increase in the CPI and PPI has changed the outlook for the July FOMC meeting. The markets are now predicting a 83% chance for a 100 basis point hike in the Fed Funds rate. For the end of the year, the central tendency is a rate of 3.75% – 4%, which would indicate another 125 basis points of increases in September, October and December.

The fact that we are talking about recessionary conditions now, with this much tightening ahead of us and a 9 – 12 month lag for the economic effects to matter bodes ill for the economy by the end of the year and into 2023.

The spread between the 2 year and the 10 year bond has become even more negative, falling to -23 basis points. This recessionary indicator is flashing red.

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Vital Statistics:

Stocks are lower this morning after the consumer price index came in hotter than expected. Bonds and MBS are down.

The consumer price index rose 1.3% month-over-month and 9.1% year-over-year. This is the highest rate in over 4 decades. Energy prices (particularly gasoline) was a big driver of rising prices. Ex-food and energy the index rose 0.7% MOM and 5.9% YOY. On both indices, the monthly rates are rising, which means that inflation is accelerating, not decelerating. This will almost certainly raise alarm bells at the Fed and keep them on a path for increasing rates.

And just like that, the Fed Funds futures for July have a coin flip between a 75 basis point hike and a 100 basis point hike:

On the bright side, we are seeing some commodity prices fall. Oil and natural gas prices are falling, and we are seeing recent weakness in food such as corn, wheat and cattle. Finally, retailers are reporting that they are stuck with inventory they need to liquidate. This means falling prices for lots of finished goods. This has largely been a June phenomenon, so you won’t see it reflected in the the June CPI. It will filter through to the producer price index first, and then will be reflected in final goods.

The shoe that has yet to drop is the price of shelter. Rising home prices affect the CPI with a 12-18 month lag. So the torrid home price appreciation of the past two years is only beginning to impact the numbers. Shelter rose 5.6% YOY, and the monthly numbers are increasing. Given that all the home price indices show high teens increases, more inflationary pressure is coming there. Rents are only beginning to reset to higher levels.

The rapid increase in the Fed Funds rate is almost certainly going to cause a recession, and if the Atlanta Fed’s GDP Now index is correct, you could argue that we are in one already, though that determination is subjective and made by the NBER. The spread between the 2-year and the 10 year Treasury is now negative by 14 basis points, and this indicator is flashing red.

If we hit a recession, you know what is going to take a hit? Servicing values. The first shoe to drop will be rising delinquency rates, and then the second will be falling long-term rates as markets anticipate the Fed taking its foot off the brakes. I suspect this was the issue with First Guarantee and its backer PIMCO. While FGMC dabbled in the jumbo and NQM space, it was known primarily for being the home for low quality FHA loans. Since there are no LLPAs in GNMA securitization, the gain on sale margins for a low FICO FHA can be huge. But, there is a catch.

GNMA servicing rules are exceptionally harsh regarding advances and modifications. I suspect PIMCO pulled the plug on FG because they could see what was coming for that servicing book if the economy rolls over. For them, it was an unbounded liability given that lenders never fully recover servicing advances on GNMA loans. Also, I am hearing rumblings that loan mods are going to be problematic this time around due to the various CFPB rules that never anticipated a rapid increase in rates.

Mortgage Applications fell 1.7% last week as purchases fell 4% and refis fell 2%. The index includes an adjustment for the 4th of July holiday. “Mortgage rates were mostly unchanged, but applications declined for the second straight week,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “Purchase applications for both conventional and government loans continue to be weaker due to the combination of much higher mortgage rates and the worsening economic outlook. After reaching a record $460,000 in March 2022, the average purchase loan size was $415,000 last week, pulled lower by the potential moderation of home-price growth and weaker purchase activity at the upper end of the market.”

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Vital Statistics:

Stocks are up this morning as oil prices fall. Bonds and MBS are up.

Small Business Optimism declined again, according to the National Federation of Independent Businesses. “As inflation continues to dominate business decisions, small business owners’ expectations for better business conditions have reached a new low,” said NFIB Chief Economist Bill Dunkelberg. “On top of the immediate challenges facing small business owners including inflation and worker shortages, the outlook for economic policy is not encouraging either as policy talks have shifted to tax increases and more regulations.”

The report is interesting in that it captures the divergence in the economy right now. If you look at things like sales, profits and economic sentiment, the situation is pretty negative. If you look at the employment picture, it is the exact opposite.

That said, the chart for economic optimism is getting pretty dire and approaching Great Recession levels.

The Atlanta Fed GDP Now Index has improved somewhat, but we are looking at negative growth still with the index showing a -1.2% estimate. This would make two consecutive quarters of negative GDP growth, however the media / government is pushing back against calling this a recession. Ultimately, the official recession call is ultimately subjective and the administration / media will be working the refs pretty hard.

Loan Depot is doing a massive restructuring to get its costs in line. Headcount is going to decline 43% between the end of 2021 and 2022. Their outlook is quite dire. We are executing our Vision 2025 plan on a foundation of a strong balance sheet and ample liquidity, with a current cash position of approximately $1 billion. We anticipate continued challenging market conditions, with mortgage originations projected to decline by roughly half in 2022 from 2021, including an accelerated decline in the second half of 2022, followed by a further decline in 2023. We continued to reduce our costs significantly in the second quarter. Over the next two quarters, we expect to accelerate these efforts and aggressively drive down our costs in line with our previously stated goal of exiting this year with a profitable operating run rate. After two years of substantial headcount and expense growth that was necessary to support unprecedented origination volumes we are returning to previous levels of staffing and expense.”

Loan Depot stock has been a disaster this year, falling 70% year-to-date. The current dividend of $0.08 a share clearly ain’t happening – that 19% yield is not real. Surprised they didn’t just rip the band aid off and cut the dividend to $0.02 a quarter.

Mortgage credit availability fell in June, according to the MBA. “Mortgage credit availability decreased slightly in June, as significantly higher mortgage rates compared to a year ago slowed refinance activity and impacted the overall mortgage credit landscape,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “While there was reduced supply of lower credit score, high LTV rate-term refinance programs, the decline was offset by increased offerings for conventional ARM and high balance loans. With higher rates and elevated home prices, more prospective buyers are applying for ARMs, but activity remains below historical averages.”

I am guessing this doesn’t take into account the NQM market, which will be affected by the exit of Sprout and FGMC. Mortgage credit is getting close to the levels seen in the aftermath of the Great Recession.

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Vital Statistics:

Stocks are lower this morning as we begin an important week for data. Bonds and MBS are up.

Ordinarily, the week after the jobs report is data-light. This week that is not the case. This week kicks off earnings season, with a lot of the big banks reporting. Second, we will get the Consumer Price Index on Wednesday, which is now one of the most important economic reports out there. Finally, we will have the University of Michigan Consumer Sentiment Survey. Historically, these consumer sentiment surveys have generally been non-events as far as markets go, but the Fed is focusing on the inflationary expectations embedded in the report. In fact, that report loomed large in the Fed’s decision to move from 50 basis points to 75.

The stock market is down pretty big from its heights of earlier this year. Do we bottom here? IMO the stock market’s behavior is the classic bear market before a recession playbook. Going forward, earnings season will matter a lot. While I don’t generally talk too much about currencies (they generally aren’t relevant to mortgage banking) the US dollar has been quite strong this year.

This is factoring into earnings for companies with big overseas operations. As a general rule, as the dollar rises, corporate earnings fall. So this increase in USD will be a big factor this earnings season. Microsoft has already warned that the US dollar will take a bite out of profits. Chip shortages and currencies will definitely affect the automakers. The fear in stock market investors is that earnings estimates are still too high and need to drop further.

The profit outlook for banks will be dented by mortgage banking. Wells indicated at a conference that Q2 mortgage banking profits will be down about 50% from Q1. Companies are aggressively cutting staff, and it looks like there probably will be more to come: “Over the next month or two we’ll see the bulk of layoffs,” said Doug Duncan, chief economist at Fannie Mae, which, along with Freddie Mac, backs many U.S. mortgages. “There is usually about a six-month lag between a turn in the market and layoffs.” While Wells and JPM are struggling in mortgage banking, apparently Bank of America has not cut staff. They saw mortgage banking revenue increase in Q1, unlike most of their compatriots.

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Vital Statistics:

Stocks are lower this morning after the employment report came in stronger than expected. Bonds and MBS are down.

The economy added 372,000 jobs in June, which was well above the Street estimate of 270k. The unemployment rate remained at 3.6%, and average hourly earnings rose 0.3% MOM and 5.3% YOY. There are 5.7 million long-term unemployed who want a job but were unable to find one, which is still higher than the 5 million pre-pandemic.

Leisure and hospitality, health care and professional / business services added the most jobs. Overall, this report will give the Fed the leeway to raise interest rates 75 basis points at the end of the month as expected.

The demise of First Guaranty and Sprout has people asking if this is the harbinger for another 2008. Given that real estate prices have risen so dramatically over the past two years it is hard to deny the similarities are there. That said, there are big differences. The most important difference is that the products that don’t fit the Fannie / Freddie credit box are still high quality loans. We don’t have the negative amortization (i.e. pick-a-pay) loans that were given to anyone who could fog a mirror. The non-QM loans are often based on rental income, which has been rising at a rapid clip.

Second, the home supply situation is much different today than it was in 2006. In 2006 we were coming off years of overbuilding. For the 10 years prior to the 2006 peak, the US built about 16.8 million units. Over the past 10 years, we have built about 10.5 million. The supply overhang doesn’t exist this time around, homeowners have much more equity and the mortgages that were done since the crisis have been much higher quality than during the bubble years.

Others have pointed out that perhaps the non-QM issue is something more reminiscent of the Russian debt crisis of the late 90s, which blew up hedge fund Long-Term Capital Management. FWIW, I don’t see it – the non-QM market simply isn’t that big. Non-QM issuance is around $20 billion per year, give or take. To put that number in perspective, $20 billion is about half the average daily traded volume of US corporate debt. Year-to-date, corporate bond issuance is about $836 billion. A blow up in the non-QM market won’t even register outside of the mortgage banking space.

My guess is that these firms got stuck with inventory that was depreciating in value as rates rose so rapidly over the past few months. Most of these places hold loans on a sort of warehouse line, and they were being hit with curtailments they couldn’t pay. Don’t forget, there are no products which can hedge the interest rates risk on non-QM. Selling TBAs against non-QM paper is subject to basis risk, which means TBAs and non-QM don’t really correlate all that well. In other words, non-QM paper is basically unhedgeable. This is probably not an issue for lenders who simply buy non-QM for their portfolio, but it is an issue for those who rely on securitization as an exit. Note that this issue doesn’t affect the underlying credit quality at all – NQM securities were falling price due to interest rates, not defaults. This is a huge difference from 2006.

The punch line here is that the non-QM issue is something that isn’t big enough to cause any sort of crisis in the overall economy.

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Vital Statistics:

Stocks are higher this morning on no real news. Bonds and MBS are down.

The FOMC minutes were released yesterday at noon. The takeaway is that the Fed is worried most about inflationary expectations becoming entrenched in the economy and is willing to cause a recession to defeat inflation. The time period between the May and June meeting had two big data points: the consumer price index which showed headline inflation at 8.7% and the University of Michigan Consumer Sentiment Index which showed inflationary expectations rising.

Inflationary expectations are critical because they have a self-fulfilling aspect to them. Vendors begin to build them into contracts, employees (especially those that are represented by collective bargaining) negotiate raises into contracts, and consumers / businesses begin to hoard materials in anticipation of future price increases.

The Fed has two vehicles to measure inflationary expectations. The first is consumer sentiment surveys like the University of Michigan and the second is the differential between Treasury Inflation Protected Securities (TIPS) and Treasuries. These market-based measures of inflation so far are still behaving, which gives the Fed some comfort. That said, the University of Michigan report along with the super-tight labor market gives the Fed the leeway to act aggressively. The self-reinforcing aspect of inflationary expectations means that the cost of bringing down inflation now (in terms of growth) are much lower than it will be when these expectations become entrenched. Don’t forget the 1981-1982 recession was the worst since the Great Depression and the Fed took up the Fed Funds rate into the mid-teens to defeat inflation. This is what the Fed is trying to avoid.

In terms of rate hikes, the view that 75 basis points was necessary was almost unanimous, with one participant wanting to hike 50 at this meeting and then 75 in July.

Sprout Mortgage is shutting down, the latest casualty in the mortgage business. So far, the company hasn’t publicly commented, but this was apparently announced on a conference call. There is no word on what Sprout will do with loans in the pipeline and the company isn’t responding to media requests for comment. Separately, Wells announced more layoffs. It will be interesting to hear from the banks next week when they announce earnings. Wells had telegraphed that origination income will be down 50% compared to Q1.

In other economic data, initial jobless claims rose to 235k last week. Meanwhile, outplacement firm Challenger Gray and Christmas reported that announced job cuts rose to 32,517 from 20,712 during the same month last year. The automotive sector bore the brunt of most of the changes, as shortages and high prices are depressing business. Health care / products is also laying off workers as the COVID-19 pandemic hiring spree reverses.

So far the labor market remains tight, but cracks are beginning to show in the foundation. I keep saying this, but it bears repeating: the rate hikes from earlier this year won’t begin to impact the economy until late this year.

Finally, there is no ADP report this month as they are retooling their methodology. There has been too much of a difference between the ADP report and the BLS’s Employment Situation Report so they are reworking their models.

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Vital Statistics:

Stocks are flat this morning on no real news. Bonds and MBS are up.

The yield curve inverted yesterday afternoon and remains so this morning, with the 2s-10s spread at -2 basis points. An inverted yield curve is usually an early warning sign for a recession. Given the Fed’s aggressive path for rates, we are probably headed for one. The big question lies around the labor market. So far we aren’t seeing any major uptick in initial jobless claims. If that holds, then we might manage to avoid one.

As I discussed yesterday, the unofficial definition of a recession – two consecutive quarters of negative GDP growth – is not used by the government. The NBER basically has discretion to declare one is occurring. Since the labor market is so strong, they probably will avoid declaring one.

Note that the German Bund yielded 1.52% at the end of June and is now trading at 1.1%. This is a big decline in just a week as investors are fearing a recession in Europe. The Euro – dollar spot rate is almost back to parity, something we haven’t seen in over 20 years. Not all sovereign yields are down – the Japanese government bond yield is up to 25 basis points, however British Gilts are down about 30 bps over the past week. While the economies of Europe, the US and Japan are in different phases, sovereign debt markets do generally correlate. This is part of what is pushing down yields in the US.

The Fed Funds futures are becoming a touch less hawkish. Compared to a week ago, the central tendency for the end of the year has decreased by 25 basis points to a range of 3.25% – 3.5%. This is still much higher than a month ago, when the central tendency was 2.75% – 3.0%.

The current handicapping is another 75 basis points at the end of July meeting, 50 basis points in September, then 25 in November and December. That is still a lot of tightening to go, and since the Fed Funds rate tends to impact the economy with a 9 month lag or so we haven’t even begun to feel the impact of the rate hikes we have already seen.

Mortgage applications fell by 5.4% last week as purchases fell 4% and refis fell 8%. There was an adjustment for the early close on July 1, so that is probably affecting the numbers somewhat. The refi index is down 78% from a year ago, and the share of refis has fallen below 30%.

“Mortgage rates decreased for the second week in a row, as growing concerns over an economic slowdown and increased recessionary risks kept Treasury yields lower,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “Mortgage rates have increased sharply thus far in 2022 but have fallen 24 basis points over the past two weeks, with the 30-year fixed rate at 5.74 percent. Rates are still significantly higher than they were a year ago, which is why applications for home purchases and refinances remain depressed. Purchase activity is hamstrung by ongoing affordability challenges and low inventory, and homeowners still have reduced incentive to apply for a refinance.”

The service economy rose in June, according to the ISM Services Index. This reading was above expectations, but lower than May’s numbers. It looks like the prices index fell for the second straight month, which is welcome news on inflation. Here is what one retailer had to say: “Consumers are shifting purchases away from our discretionary products to essentials. Inflation is definitely taking a bite from our sales, and mall traffic is far below the norm, potentially due to inflation, a need for more disposable income on essentials and less willingness to drive to malls. E-commerce sales will be going up again.” [Retail Trade]

Another indication the economy is slowing: job openings are decreasing. Job opening fell by 427k to 11.3 million. The quits rate inched down to 2.8% from 2.9%. The quits rate tends to be a leading indicator for wage gains.

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Vital Statistics:

Stocks are lower this morning as investors fret about growth going forward. Bonds and MBS are up again.

The big event this week will be the jobs report on Friday. The Street is looking for 270,000 jobs and for unemployment to remain at 3.6%. We will also get the ISM Services Report which will be a bellwether for the state of the economy.

The data last week has pushed the Atlanta Fed’s GDP Now forecast to -2.1%. This would mean negative GDP growth for the first half of 2022.

This would typically mean we are in a recession. That said, the government and the chattering classes are pushing back against that definition. The government changed the definition of a recession from 2 consecutive quarters of negative GDP growth to something more subjective: “In general usage, the word recession connotes a marked slippage in economic activity. While gross domestic product (GDP) is the broadest measure of economic activity, the often-cited identification of a recession with two consecutive quarters of negative GDP growth is not an official designation. The designation of a recession is the province of a committee of experts at the National Bureau of Economic Research (NBER), a private non-profit research organization that focuses on understanding the U.S. economy.” 

What this means is that even if we get a negative GDP print in the second quarter, the government and the business press will insist we are not in a recession. They will use the low unemployment rate as the reason. That said, the National Bureau of Economic Research generally gets around to calling something a recession after it is over.

Regardless of whether the government determines we are in a recession or not, the yield curve is definitely giving clues that we are headed towards one. The slope of the yield curve (i.e. the difference between short term rates and long term rates) is often a pretty solid indicator of an impending recession. Here is a chart of 2s-10s going back to the 1970s:

The shaded lines indicate an official NBER recession. You could make the argument that this indicator has lost value in a QE world, and you would be 100% correct. That said, the indicator is flashing a warning sign for growth.

The problem for the Fed is that interest rates are still highly negative on an inflation-adjusted basis. The Consumer Price index is running over 8% and the PCE Index is running at a 4.7% rate ex-food and energy. So, even though the Fed is being aggressive in hiking rates, overall monetary policy remains highly accommodative.

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We lasted another year. I can’t say the prospects look good for the long term, but I am marginally more optimistic than I was last year, so let’s celebrate while we still can. Hope you all have a good 4th!

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