All Things in Moderation

Vital Statistics:

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

We have a decent amount of data this week, with home prices (Case Shiller and FHFA), the third revision to first quarter GDP, and the jobs report on Friday.

The first quarter of 2022 has been a record bad year for bonds, going back to 1973. The Bloomberg US Treasury Index has lost 6.5% this year. The move has intensified since the March meeting as investors re-calibrate expectations for further rate hikes this year. The Fed Funds futures are looking at end-of-year Fed Funds rates between 2.5% and 2.75%.

The big question is whether this sort of tightening will trigger a recession. The data is mixed on tightenings and recessions. That said, if the yield curve inverts then that is a very strong recessionary indicator. We are already seeing some flattening – the 5 year and 30 year spread is zero. If we see a 2.5% Fed Funds rate by the end of the year, and the 10 year is sitting below that, watch out. FWIW, the Fed is about to embark on a tremendous amount of tightening, and it is an open question whether the economy is strong enough to take it.

As bonds sell off, mortgage rates are moving inexorably higher. Below is a chart of just how far they have moved over the past few months.

The name of the game going forward will be purchases and cash-out debt consolidation refi. The beautiful thing about cash-out debt consolidation refis is that if you are paying 18% on credit card debt, it doesn’t matter whether your mortgage rate is 4% or 4.75% – it is still a smart transaction.

As rates rise, profits fall for independent mortgage banks. In the fourth quarter of 2021, mortgage banks earned an average pre-tax margin of 38 basis points, down from 89 basis points in the third quarter, according to the MBA. Believe it or not, that is still a decent number – in 2018 independent mortgage bankers earned almost nothing.

We are seeing more an more layoffs, with Maxex cutting about a third of their staff. PennyMac is making cuts as well.

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Vital Statistics:

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

We have a lot of Fed-speak today, with 4 different speeches.

Consumer sentiment slipped in March, according to the University of Michigan Consumer Sentiment Survey. Rising gasoline prices are weighing on sentiment.

Mortgage delinquencies ticked up in February, according to Black Knight. Overall, mortgage delinquencies remain close to pre-pandemic levels however. Foreclosures starts fell 25% YOY to 25,000. Prepays hit a 3 year low, falling another 11%. This should boost servicing values, although MSRs are already pretty elevated, pricing – wise.

As the Fed raises interest rates, the fear is that it might tip the economy into recession. This is a valid fear, and sometimes that is necessary to beat inflation. The Fed managed to raise rates without triggering a recession in 1994 and 1984, however the situation now is different. Inflation is much higher and rates are much lower. On the plus side, the economy is pretty resilient, and just-in-time concepts of inventory management didn’t really exist in the early 80s, and were just coming into practice in the early 90s. The biggest driver of recessions is inventory build, and today’s inflation is being driven by a lack of inventory. So that probably won’t be an issue.

If we are heading into a recession, we should see a couple of things. First, an inversion of the yield curve. This happens when long-term rates are lower than short term rates. For example, if the Fed hiked the Fed Funds rate to 2.5% and the 10 year yield stayed at 2.35%, that would be an inverted yield curve. The other thing to watch is credit spreads. Credit spreads are the incremental return investors demand for taking credit risk. Rising credit spreads usually portend pain in the financial sector.

As of now, high yield credit spreads are behaving well.

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Vital Statistics:

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

Neel Kashkari said that he sees 7 quarter point hikes this year, which would put the ending Fed Funds rate at 1.75%. Kashkari is a prominent dove on the Fed, and his forecast is below the other members.

Fed Governor Chris Waller said that the Fed should be paying attention to housing prices. “With housing costs gaining an ever-larger weight in the inflation Americans experience, I will be looking even more closely at real estate to judge the appropriate stance of monetary policy,” Waller said in prepared remarks for a webinar on housing organized by Tel Aviv University and Rutgers University.

Meanwhile James Bullard said that inflation is “way over” where it ought to be and policy makers need to think bigger and act faster. Waller said last week the Fed should increase by 50 basis points in May and June, and that seems to be the consensus.

He estimated that the Fed’s purchases of mortgage backed securities lowered mortgage rates by 40 basis points. He doesn’t think that home price appreciation is being driven by excess leverage or easy lending, however it does have implications for monetary policy since rent is a big component of inflation. Increasing home prices are a function of a massive supply / demand imbalance and I don’t know what the Fed can do about that.

Durable goods orders fell 2.2% in February, according to Census. Ex-transportation they fell 0.6% and core capital goods orders (a proxy for business capital expenditures) fell 0.3%. These numbers came in below Street expectations.

The labor market remains strong as initial jobless claims fell to 187,000 last week. We are back at levels not seen since the 1960s.

The national median mortgage payment for applications rose 8.3% in February to $1.653, according to the MBA. “Low unemployment has spurred strong income growth in early 2022, but homebuyer affordability has decreased due to the quick rise in mortgage rates amidst steep home-price growth,” said Edward Seiler, MBA Associate Vice President of Housing Economics and Executive Director of the MBA Research Institute for Housing America. “The 30-year fixed-rate mortgage spiked 73 basis points from December 2021 through February 2022. Together with increased loan application amounts, a mortgage applicant’s median principal and interest payment in February jumped $127 from January and $337 from one year ago.”

The MBA’s Purchase Applications Payment Index has been shooting upward as rates have risen.

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Vital Statistics:

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

Jerome Powell is speaking on a panel this morning regarding digital currencies. It shouldn’t be market-moving, but bonds are on a hair trigger after the rout over the past couple of weeks, so be aware.

New Home Sales fell 2% MOM and 6% on a YOY basis according to the Census Bureau. This was well below expectations. Rising labor and materials cost have added something like 20% to the cost of building a house. In high cost areas like California, extra regulations have increased the cost even more. This has led to an issue where it is so expensive to build starter homes that people with a starter home income cannot afford them. It is easier to build luxury homes than it is to build starter homes. Note the average sales price rose 25% YOY to $511,000.

Mortgage applications fell 8% last week as purchases fell 2% and refis fell 14%. “Rates on 30-year conforming mortgages jumped by 23 basis points last week, the largest weekly increase since March 2020. The jump in rates comes as markets moved to price in a much faster pace of rate hikes, as well as expectations of fewer MBS purchases from the Federal Reserve. With mortgage rates now at 4.5 percent, compared to rates at or below 3 percent not that long ago, it is no surprise that refinance volume has dropped by more than 50 percent compared to this time last year. MBA’s new March forecast expects mortgage rates to continue to trend higher through the course of 2022,” said Mike Fratantoni, MBA’s Senior Vice President and Chief Economist. “Purchase application volume was down slightly for the week, with a larger drop in FHA and VA purchase volume, and a small decline in conventional purchase loans. First-time homebuyers, who rely on these government programs, are increasingly challenged by both the rapid increase in home prices and higher mortgage rates. Repeat homebuyers, who are more likely to use conventional loans, benefit from the gains in home equity realized on a sale which can be used to fuel their next purchase, even with rates moving higher.”  

The Fed Funds futures continue to move into a more hawkish direction. Just one week ago, the central tendency was for the December fed funds rate to be something like 1.75% – 2.25%. Today, it is looking more like 2.25% to 2.5%. This is a massive change in sentiment.

Given that the markets are predicting such a huge increase in the Fed Funds rate, investors have to be concerned that the Fed might tip the economy into a recession, probably next year. I think with such a dramatic move, that could be a possibility. While the economy grew at a healthy clip last year, much of that was the rebound from COVID and also stimulus money.

The recession of 80-81 and 81-82 were an example of a Fed-driven recession, and at that time was the deepest slowdown since the Great Depression. Paul Volcker took the Fed funds rate from 10% to 20% in the span of a year (twice) to break the back of 1970s inflation. Below is a chart of the Fed Funds rate from 1979 – 1983. The shaded areas on the chart represent recessions. The 81-82 recession was particularly brutal for the Farm Belt and the Rust Belt.

These actions caused the economy to go into a deep recession, and really set the stage for a lot of the 1980s economic issues with farmers and oil drillers. Commodities like oil and food had a massive rally in the 1970s, which triggered plenty of losses in the banking sector, especially in the Midwest and Texas. In a case of art imitating life the bookends for the 1970s center around Texas and oil, which begins with the series Dallas and ends with pop artist Robert Rauschenberg’s glut.

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Vital Statistics:

Stocks are higher this morning after Fed Chairman Jerome Powell said the Fed was prepared to move in half point increments to beat inflation. Bonds and MBS are down.

Goldman is out with a call saying that the Fed will raise the Fed Funds rate by 50 basis points at both the May and June meetings. They are basing this on the change in language from Powell last night, where he said the Fed must move “expeditiously” and “more aggressively” to prevent an upward spiral from occurring. Overall, Goldman is forecasting 50 bps in May and June, and then 25 bps at every meeting for the rest of 2022 and the first 3 meetings in 2023.

It is interesting to see stocks rallying on Powell’s comments. The general playbook is that stocks generally struggle when the Fed is tightening. At a panel last night, Powell said: “If we think it’s appropriate to raise [by a half point] at a meeting or meetings, we will do so,” Mr. Powell said during a moderated discussion after a speech on Monday before the National Association for Business Economics in Washington, D.C. He acknowledged that inflation is no longer “transitory:” “That story has already fallen apart,” Mr. Powell said Monday. “To the extent it continues to fall apart, my colleagues and I may well reach the conclusion we’ll need to move more quickly. And if so, we’ll do so.”

If the Fed follows Goldman’s forecast, the Fed Funds rate will be be in a range of 2.25% – 2.5% by the end of the year. This is more or less where rates were in 2019 before the pandemic. The bond market bottomed in late 1980, when the Fed Funds rate topped out at 22%. While stock bull markets generally last a few years, and bear markets last under a year, bond market cycles are long.

The number of loans in forbearance slipped by 12 basis points to 1.18% of servicer’s portfolios in February. “There were many positive results in overall mortgage performance in February,” said Marina Walsh, CMB, MBA Vice President of Industry Analysis. “The percentage of borrowers in forbearance declined for the 21st consecutive month, and the percentage of borrowers current on their mortgage payments increased to almost 95 percent – 350 basis points higher than one year ago. Finally, the percentage of borrowers with existing loan workouts who were current on their mortgage payments improved for the first time since June 2021. These three results – the lower forbearance rates and higher performance rates for both total borrowers and borrowers in workouts – are especially favorable, given that there is typically a dip in mortgage performance in February because of the shortened number of days to make a payment.” 

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Vital Statistics:

Stocks are flattish this morning as commodities continue to rally. Bonds and MBS are flat.

The upcoming week is relatively data-light, with new home sales and durable goods as the only data points.

The Chicago Fed National Activity Index declined in February from .59 to .51. This means the economy is still growing above trend, although that outperformance is declining. Note the Atlanta Fed’s GDP Now index shows growth in the first quarter to be just above 1%, which would be considered below trend in my book.

The collapse of the Champlain Towers in Surfside Florida has Fannie and Freddie asking condo boards questions regarding deferred maintenance and for the Boards to attest that they will not be the the target of building code violations in the future. Some condo boards are refusing to answer them, or to add a addendum that they are answering the questions to the best of their ability, with no guarantee” for fear of liability. “They understand the intent,” the CAI’s Dawn Bauman told me. “But some questions are not yes-or-no questions, and condo boards usually don’t have that kind of expertise. They are willing to provide the documentation, but they say lenders should make the decisions.”

If these condo boards choose to not answer the questions regarding maintenance, then it basically makes the units in the building ineligible for Fannie and Freddie financing. The bottom line is that the number of unwarrantable condos is probably going up.

St. Louis Fed President James Bullard said he would like to see the Fed Funds rate raised to 3% this year. Bullard was one of the dissenters from last week’s Fed decision, preferring to increase the Fed Funds rate by 50 basis points instead of 25.

The combination of strong real economic performance and unexpectedly high inflation means that the Committee’s policy rate is currently far too low to prudently manage the U.S. macroeconomic situation. Moreover, U.S. monetary policy has been unwittingly easing further because inflation has risen sharply while the policy rate has remained very low, pushing short-term real interest rates lower. The Committee will have to move quickly to address this situation or risk losing credibility on its inflation target.

The point about inflation acting as an easy monetary policy is important and one that is rarely addressed. While the Fed controls the Fed Funds rate, this is a nominal interest rate, which means it doesn’t take into account inflation. Economists generally agree that real interest rates (in other words, inflation adjusted rates) are really what drive behavior. So, even if the Fed doesn’t do anything with interest rates, changes in inflationary expectations are moving real interest rates.

So, if the Fed funds rate is stuck at zero, but inflation increases real interest rates are falling, and that is stimulating the economy more. Japan had the mirror image of this problem over the past several decades. Rates were set at the zero bound, but Japan was experiencing deflation, which made had the effect of tightening an already moribund economy.

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Vital Statistics:

Stocks are lower this morning as March options expire. Bonds and MBS are flat.

Existing home sales fell 7.2% MOM and 2.4% YOY to a seasonally adjusted annual pace of 6 million. Inventory improved ever so slightly to 870,000 units, and the median housing price increased 15% to $357,300.

“Housing affordability continues to be a major challenge, as buyers are getting a double whammy: rising mortgage rates and sustained price increases,” said Lawrence Yun, NAR’s chief economist. “Some who had previously qualified at a 3% mortgage rate are no longer able to buy at the 4% rate. Monthly payments have risen by 28% from one year ago – which interestingly is not a part of the consumer price index – and the market remains swift with multiple offers still being recorded on most properties”

Despite all the cheerleading in the press about yesterday’s housing starts number (highest since 2006!!!), the overall inventory problem is being driven by the fact we have underbuilt since 2012. Take a look at the chart below:

Chart: Housing starts:

The chart doesn’t really tell the whole story however since population has increased, and as population increases you need more housing. Here are housing starts divided by population:

Chart: Housing starts divided by population:

This chart gives a more accurate (IMO) picture of what is going on. We have underbuilt for probably a decade, and that explains why we have such an abject shortage of homes for sale.

Despite the increase in housing starts yesterday, builder applications are down 1% MOM and 4% YOY. “New home purchase activity slowed in February, as for-sale inventories remained tight and mortgage rates increased to their highest levels since 2019,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “February is typically the start of the spring home buying season, but applications to purchase a new home were down on a monthly and annual basis.”

The economy may strengthen in the future, at least if you look at the latest Index of Leading Economic Indicators out of the Conference Board. The US LEI index rose slightly in February, following a decline in January. That said, they don’t reflect the Russian invasion of Ukraine either, which will probably act as a brake for economic growth as commodity prices spiral.

“The US LEI rose slightly in February, partially reversing January’s decline,” said Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board. “However, the latest results do not reflect the full impact of the Russian invasion of Ukraine, which could lower the trajectory for the US LEI and signal slower-than-anticipated economic growth in the first half of the year. The global economic impact of the war on supply chains and soaring energy, food, and metals prices—coupled with rising interest rates, existing labor shortages, and high inflation—all pose headwinds to US economic growth. While the Omicron wave and its economic impact waned in recent months, the potential for new COVID-19 variants remains. Amid these risks, The Conference Board revised its growth projection for the US economy down to 3.0 percent year-over-year GDP growth in 2022— still well above the pre-pandemic growth rate, which averaged around 2 percent.”

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Vital Statistics:

Stocks are lower this morning after the Fed raised rates yesterday. Bonds and MBS are up.

The Fed hiked the Fed funds rate 25 basis points, and announced that it would begin shrinking its balance sheet “at a coming meeting.” The dot plot was moved up markedly, and pretty much caught up with the Fed Funds futures. The comparison between December and March is below:

Chart: Dot Plot Comparison

Two thinks to note here. First, the consensus is that the Fed Funds rate will be between 1.75% and 2.25% by the end of the year, and second the Fed expects to have rates above the long-term expected rate for 2023 and 2024. Much of this will be determined by the path of inflation going forward.

The economic forecasts were tweaked, with the 2022 GDP growth forecast trimmed to 2.8% from 4% in December and the inflation rate increased from 2.6% to 4.3%. The Fed Funds estimate for 2023 and 2024 were bumped up as well.

The press conference wasn’t that interesting, however Powell stressed that the effects of the war in Ukraine were highly uncertain and were likely to both push up inflation and dampen economic growth. That said, 2.8% GDP growth is normally a pretty solid number, so it isn’t like the Fed sees that much of a recession risk. The questions largely centered around whether the Fed was behind the curve, and also around the fact that real (i.e. inflation-adjusted) interest rates are still highly negative.

Mortgage backed securities and Treasuries were sold off in the aftermath of the announcement, although Treasuries clawed their way back. Mortgage backed securities were under pressure as the market ponders what will happen to prices when the Fed begins to unload its holdings of MBS. On the plus side, refi volume is drying up, so there will be less supply from mortgage banks, but the Fed has a lot of paper to go.

Treasuries and MBS are clawing their way back this morning, with yields falling marginally. Probably a case of buy the rumor, sell the fact.

Housing starts came in at 1.77 million, which was a touch above expectations, and building permits rose to 1.86 million. Housing starts are up 22% compared to a year ago. Housing construction has been the missing element from the economy ever since the 2006 housing bubble, and there is tremendous pent-up demand for construction. This is this sort of thing that could feed the economy for years. The problem, of course is affordability, and shortages of materials and skilled labor.

Separately, builder confidence is slipping, according to the NAHB / Wells Fargo Housing Market Index. “Builders are reporting growing concerns that increasing construction costs—up 20% over the last 12 months—and expected higher interest rates connected to tightening monetary policy will price prospective home buyers out of the market,” said NAHB Chief Economist Robert Dietz. “While low existing inventory and favorable demographics are supporting demand, the impact of elevated inflation and expected higher interest rates suggests caution for the second half of 2022.”

Industrial production rose 0.5% MOM and manufacturing production increased 1.2%. Capacity Utilization rose to 77.3%. This is another long-term trend to watch. Companies are bringing back manufacturing to the United States as the wage gap between the developing nations and the US is shrinking, and companies have realized the vulnerabilities of extended supply chains. This will take years to play out, but the offshoring / outsourcing megatrend of the last 40 years might be played out.

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Vital Statistics:

Stocks are higher this morning as Chinese markets rallied in the wake of the government’s decision to support markets. Bonds and MBS are down again.

The Fed’s decision will come out at 2:00 pm, and the press conference will start at 2:30. This decision will carry more weight than the usual Fed decision, as market participants will be looking closely at the dot plot and the updated economic forecasts.

Import and export prices rose in February, with import prices rising 10.9% YOY and export prices rising 16.6%. Keep in mind that these numbers predate the Ukraine situation.

February retail sales disappointed, rising only 0.3% MOM. Ex-vehicles and gasoline, they fell 0.4%. On a year-over-year basis, retail sales rose 17%, however it is clear that rising gasoline prices are beginning to depress other categories of spending.

Does it seem like mortgage rates are rising faster than the 10-year bond yield? Your gut is correct. MBS spreads (which are basically the difference between the yield on mortgage backed securities and Treasuries are indeed increasing. The Fed’s re-introduction of QE in response to COVID pushed them down, but now that QE is over, they are returning to normal, albeit we are wider than normal. The green bars below represent the MBS spread, which sits at 114 basis points. Note the spike up to 175 in the early days of COVID, when the mortgage market froze and everyone in mortgage-land was getting margin calls.

Chart: MBS Spreads

Some of this widening is due to volatility in the bond market. The CBOE has a volatility index for Treasuries, and that index has been pushing up since the pandemic began. The Fed’s purchases of MBS kind of papered over the effect of increasing volatility, but now the impact is being felt in widening spreads.

Chart: Treasury volatility

The punch line for non-bond geeks: Mortgage rates are rising easily when the 10-year yield increases. They are moving down grudgingly (if at all) when the 10 year yield falls. Note that this doesn’t take into account competitive activity between mortgage bankers. This only represents what MBS investors are willing to pay for generic mortgage backed securities. Mortgage rates have a “Wall Street” component and a “mortgage banker” component. MBS spreads represent the Wall Street component.

Mortgage applications fell by 1.2% last week as purchases increased 1% and refis fell 3%. “Mortgage rates continue to be volatile due to the significant uncertainty regarding Federal Reserve policy and the situation in Ukraine,” said Joel Kan, MBA Associate Vice President of Economic and Industry Forecasting. “Investors are weighing the impacts of rapidly increasing inflation in the U.S. and many other parts of the world against the potential for a slowdown in economic growth due to a renewed bout of supply-chain constraints.”

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Vital Statistics:

Stocks are higher this morning as we begin the FOMC meeting. Bonds and MBS are down.

Inflation at the wholesale rose at a 10% clip in February, according to the Producer Price Index. Ex-food and energy it rose 8.4%. Rising energy costs were the big driver of the increase and we are seeing increased diesel prices push up transportation costs, which is now flowing into intermediate goods. The Fed will almost assuredly raise rates this week, however all eyes will be on the dot plot and the new economic forecasts.

The Nasdaq officially closed in bear market territory as many high flyers are getting some air taken out of their multiples. Leaders like Netflix and Tesla have been smacked down hard so far this year. The mortgage bankers have been wrecked as well.

Sarah Bloom Raskin, Biden’s nominee just had a blow dealt to her nomination after West Virginia Senator Joe Manchin expressed opposition to her nomination. Without Manchin’s support, she will need a Republican to vote for her, and that chance is remote.

What is the issue here? Well, she wanted the Fed to take into account climate in banking regulation. In practice this would mean restricting credit to the energy industry. For example, the Fed could decide that excessive energy exposure would cause a bank to flunk its stress test, which would limit dividends and buybacks.

Note that ethical, social governance (ESG) investors are pushing energy companies to shut down production, along with a group of banks and money managers which control $60 trillion in assets via Climate Action 100+ which have refused to lend to natural resource companies. The Arizona AG is investigating this group for antitrust violations under the theory that colluding to raise prices is illegal regardless of whether it is done for profits or ideology.

The bottom line is that increasing production to counter higher prices is going to be more difficult than it was in the early 00s, the last time energy prices spiked. In normal times, the cure for high prices is high prices. That might not be the case this time around. Which means the Fed has its work cut out for it.

Mortgage delinquencies fell to 3.4% from 5.8% a year ago. “Nonfarm employment grew by 6.7 million workers during 2021, the largest one-year increase, supporting income growth and keeping more families current on their loans. Nonetheless, places hit hard by natural disasters have experienced a spike in missed payments. Serious delinquency rates for December in the Houma-Thibodaux metro area were nearly two percentage points higher than immediately before Hurricane Ida. ”

Back to the issue with energy companies. ESG investors and the big passive investors are driving corporate decision making in a way that didn’t exist even 5 years ago. To grasp the implications of this, it is important to understand the way index fund managers are paid: They are paid to mimic the index, not to pick good stocks. In other words, if XYZ corp is a dog with fleas, but the index they are matching has 2.4542% of XYZ corp, the manager will have to hold 2.452% of his or her fund in XYZ corp.

This creates something similar to what business school professors would call an agency cost. The incentives of the manager and the shareholder are not aligned. The manager of your index fund doesn’t have to care how the stock performs. Since they have no skin in the game with corporate performance they can costlessly push for things that might not be investor’s best interest. Ain’t their money. And that, folks is the “cost” of that rock bottom management fee. . At a minimum, it certainly raises fiduciary responsibility questions. If you support the ESG ideology, great, but if you don’t chances are your retirement fund does.

I have a feeling that the era of outperformance by passive fund managers is about to come to an end as the big index names get tied down with ideological institutional investors. It will become what people used to call “a stock picker’s market.”

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