All Things in Moderation

Vital Statistics:

Stocks are flat this morning as bank fears recede. Bonds and MBS are down.

House prices rose 0.2% month-over-month in January and 5.3% year-over-year, according to the FHFA House Price Index. “U.S. house prices changed slightly in January, continuing the trend of the last few months,” said Dr. Nataliya Polkovnichenko, Supervisory Economist, in FHFA’s Division of Research and Statistics. “Many of the January closings, on which this month’s HPI is constructed, reflect rate locks after mortgage rates declined from their peak in early November. Inventories of available homes for sale remained low.”

The West Coast and Mountain states saw the biggest declines, while the East Coast held up better.

Separately, the Case-Shiller Home Price Index rose 3.8% year-over-year in January. Declines were reported in many West Coast markets including San Diego, San Francisco, Portland, and Seattle. The hottest markets were in Florida and Atlanta. “January’s market weakness was broadly based. Before seasonal adjustment, 19 cities registered a decline; the seasonally adjusted picture is a bit brighter, with only 15 cities declining. With or without seasonal adjustment, most cities’ January declines were less severe than their December counterparts. Financial news this month has been dominated by ructions in the commercial banking industry, as some institutions’ risk management functions proved unequal to the rising level of interest rates. Despite this, the Federal Reserve remains focused on its inflation-reduction targets, which suggest that rates may remain elevated in the near-term. Mortgage financing and the prospect of economic weakness are therefore likely to remain a headwind for housing prices for at least the next several months.”

More evidence that the pain in the mortgage space isn’t going away. Mortgage REIT Invesco Mortgage Capital slashed its dividend as MBS spreads remain wide. Invesco continues to put money into the sector as agency MBS remain the cheapest since 2008. “Our investment portfolio continues to generate strong earnings available for distribution despite the sharp increase in short-term interest rates given a high percentage of our funding is hedged with a relatively low-cost legacy swap portfolio. We reduced our common stock dividend to retain capital and enhance book value by continuing to invest in agency residential mortgage-backed securities (“Agency RMBS”) at historically attractive valuations. We believe this represents a compelling environment for longer-term investors.”

Remember that mortgage REITs like Invesco are the ultimate buyers of the loans that mortgage bankers originate. If MBS are “cheap,” that implies that mortgage rates are lousy compared to the 10 year. This means that mortgage rates can fall quite a bit even if the 10 year goes nowhere. Of course the past decade of QE might be an artificial low in MBS spreads. Much will depend on whether some buyer will step up to replace the Fed as the biggest buyer.

The other driver of wide MBS spreads is interest rate volatility. Since a borrower always has the option to refinance, that option is worth something. The value of that option is a function of interest rate movement (i.e. how close current rates are to the note rate on the mortgage) and also interest rate volatility. The more volatile interest rates are, the more valuable the option. Since the borrower owns that optionality, the MBS investor is “short” that optionality. The increased value of that option is recognized in MBS spreads.

You can see the spike in volatility in the ICE / BofAML MOVE Index, which captures interest rate volatility. Think of it as a VIX for bonds.

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