Bond Market Commentary by Brad Tottle
Bond Market Update
by Brad Tottle
The Lampshade Had to Come Off Eventually
January 5th, 2009
The Treasury market had quite a holiday season with yields dropping precipitously into year-end with back-end rates leading the charge. In December alone, the yields on the 10-year and 30-year Treasury sank by 71 and 75 basis points, respectively. That in itself is astounding until you think back to November during which the 10 & 30 year yields fell by 104 and 93 basis points, respectively. So in the last two months of the year we had roughly 175 bps shave off of 10s and 168 bps off of 30s. No wonder then that everyone is starting to rumble about a potential bubble in Treasuries. It is no surprise then that when trading resumed stateside on the 2nd, Treasuries were suffering from a hangover from the party that was the 4th quarter of 2008, a quarter that in involved so much destruction in terms of capital and the functionality of the capital markets that it truly was one that we will look back on forever as one of the most notable periods in the history of our economy. Regardless of the fact that none of the problems had changed, merely the picture on our wall calendar, stocks rallied and Treasuries swooned popping yields back up across the curve. Again it was the long-end that led the sell-off albeit on below average volume. Over the weekend I think I must have read a dozen different news articles proclaiming a bubble in Treasuries and how we might here the pop amid a second-half recovery. Barron’s ran the Treasury bubble as their cover story with an inset headline above the main text of “Get Out Now!” warning investors of the dangers of buying into such low yields. The message has merit but I wonder how many average investors actually were buying long-dated Treasuries over the last two months in the first place? Portfolio managers, forced in arbitrage players, and proprietary trading desks paring down before year-end did most of this buying and as such will be doing most of the selling in the future.
While I will be the first to agree that Treasuries are well over bought by most metrics and have stated so in the last several commentaries (see Dec 22/Dec 8th BMU) I am also fully aware that we remain in the midst of a deleveraging on a scale of which there are few historical precedents. If deflation rears its head in the first quarter (and judging by the trends in inflation gauges it will) yields could flutter around these historic low levels for a while. That doesn’t mean there won’t be a high amount of volatility, or that most investors won’t find better bargains elsewhere in the debt markets. In fact, the richness of Treasuries only stands to amplify the relative attractiveness of other bond sectors. Just know that the Fed has a big balance sheet and it’s only getting bigger. The Fed has stated its intentions to implement quantitative easing while targeting virtually 0% overnight rates, meaning they will be buying assets. Even if the majority of those assets are not Treasuries, rather mortgages and agencies form the large institutions holding them those receiving the proceeds from the Fed are likely to dump a meaningful amount back into Treasuries, specifically longer-dated ones even as yields stay unattractive. The point to all of this is that by now, everyone should know that the road to recovery goes directly through the housing market. The Fed sees that the economy needs a refinance wave in order for depleted household capital to replenish before any talk of a sustained recovery can be considered rational. If long-end rates rise too quickly then there goes the cost effectiveness of refinancing. Rates can rise from here but it’s more important that spreads come down due to a lessening in perceived risk. A perfect example is mortgage spreads. The following chart shows the yield on the 10-year Treasury and the average rate recorded on Freddie Mac’s Primary Mortgage Market Survey, along with a hart showing the spread between them. The mean average spread over the life of the data (Freddie began publishing in 1972) is 171 basis points. The spread currently is 273 basis points, a marked improvement from the 306 basis points wide from the week ending December 19th, but still over 100 basis points off the historical average. As mentioned above, in the last two months of 2008 10-year yields fell by 175 basis points while the rate on Freddie’s weekly survey fell from 6.46% to 5.10% for a change of 136 bps. Over the same time period the spread has gone from 250 bps, up to 306 bps, and now resides at 273 bps. Even after announcements of up to $500 billion purchase of agencies and agency-backed mortgage paper (scheduled to begin in January) as well as potential purchases of Treasuries, the spread is wider than where it was at the beginning of November. It certainly is improving in meaningful terms but it is a far cry from an all-clear signal. Several weeks back before the Fed announced it was targeting the long-end of the curve I hypothesized that maybe a 4-4.5% refinance rate would be in the realm of possibilities and that it would most likely take rates in this range to make any kind of improvement via refinancing a viable option (for those lucky enough to qualify anyway!) If we assume a modest correction in 10s up to 2.5% and add the historical average spread of 170 bps we get within that range. However, to do so the spread must come in another 100 basis points from current levels. With the 10-year currently yielding roughly 2.40%, the remaining 90 bps in spread tightening would have to be driven by the demand side which is still only nibbling. If 10s were to rise to 3% we would need mortgage rates to tighten below 200 bps to get anything in the 4% arena. Ideally the spreads would tighten as Treasuries adjust due to a risk rotation out of Treasuries and into mortgages. By being the buyer of first resort the Fed is attempting to “lead the horses to water” but will that induce them (investors) to drink once again? It will if the Fed keeps duration starved portfolio managers staring at 2-3% long bonds long enough.
Freddie Mac PMMS vs 10-Year Treasury Yield
Saved By Zero... Perhaps
December 22nd, 2008
Mark last week as yet another one for the record books as yields in the long end of the curve hit new all-time lows and the Federal Open Markets Committee opted for a range rather than a target for the overnight rate. The buying seen in long Treasuries is one for the ages as multiple factors have combined to exacerbate the downward thrust in yield. 10-year yields hit 2.05% last week and 30-year yields tickled 2.50% before pulling back a bit into Friday’s close. Both levels are record lows since the mid-50s when the Fed began publishing historical data on the rates. What started off as a classic flight to quality quickly morphed into a convexity-hedging/derivative unwinding trade, both technical-based buying which tend to feed on themselves and induce more buying. Renewed disinflation fears gave the low nominal yields new sparkle on a real basis, which brought in more buyers. As if that weren’t enough one-way momentum, the street got wind two weeks ago that the Fed might be embarking on a “quantitative easing” campaign whereby they purchase debt obligations in the open markets. In fact, the Fed did begin purchasing front-end agency paper in addition to the purchases it was already making as the counterparty of last resort in markets for commercial paper, asset-backed securities, and front-end collateralized loans. But in last week’s statement the FOMC made clear that they would “employ all available tools” to right the ship, including expanding the amount of direct agency debt and agency-backed mortgage paper they would be willing to buy as well as the possibility of purchasing longer-term Treasury securities.
This kicked buying in the long-end into overdrive even though many on the street question exactly what Fed officials mean when they say “longer-dated”. Does that mean 10s and 30s or is “longer-dated” in the Fed’s eyes 3-5 year paper since they are both considerably longer in duration than the Fed’s usual overnight open market activities. We’ll find out soon but for now all one can do is marvel at the absolute nosedive in the long-bond’s yield (see first chart). It seems like the short of the century and it probably will be someday but for now the bulls are in charge, standing ready at every slight pullback to buy more. Watch mortgage rates for signs that the rally is abating. If the Fed gets what it wants which is a refi/new buying sweep to clean up household balance sheets and home supply then eventually growth should return and inflation along with it. Given the magnitude of extension risk that the market may be presented with in such a scenario the upward correction in long-end yields is likely to be just as voracious as it has been on the way down.
The Fed also established a range of 0-.25% for the overnight rate which was in no doubt a response
to the glaring fact that the target has been somewhat meaningless for a while now given where the effective fed funds rate has actually traded in the open market over the last 3 months. The second chart shows the Fed’s target for the overnight rate graphed with where funds actually traded. It’s easy to see that the market has been operating at close to zero rates so it isn’t a surprise that the Fed finally cut rates down to the level. What surprised most people was that the fact that the Fed did it all at once taking all the guesswork out and even announcing that, due to the bleak economic backdrop, it is likely that they will have to keep the funds rate at “exceptionally low levels” for the foreseeable future.
The fresh low nominal yields in Treasuries and the overly accommodative tone of the Fed did seem to spawn some light risk-taking in spread product, but volume was choppy during the last full week before the holidays making it hard to tell if it was just some end of the year prepping or a renewed sense of value investing. Despite larger than anticipated writedowns from several banks the financials seemed to be slightly favored, as spreads, which have tightened considerably, remain elevated to historical norms. The FDIC-backed paper issued through their TLGP program continued to outperform agencies with most issues trading at or below 2%. Retail investors will likely find more yield in CDs but institutional demand for these explicitly guaranteed bonds over their agency counterparts, which still only carry an implicit backing while in conservatorship, has been strong and will likely continue. As I mentioned at the onset of this program, the rally in this paper will likely accelerate if the risk weighting for bank capital is reduced (currently at 20%) which should push the sector to trade between Treasuries and agencies. This brings me back to the question of why won’t the government just explicitly guarantee the agency debt? The Fed and the Treasury have been trying to buy paper from the GSEs to help narrow the spreads on their front-end borrowing costs as well as their primary mortgage rates. Mortgage rates have begun to fall but the Fed cannot completely replace the loss of private capital flows into the arena. Sure the buying we have seen so far has been an attempt to front-run the Fed but it does little to bring in the historically largest purchasers of debt (read foreign central banks) who have subsequently dumped agencies in exchange for Treasuries. They are certainly not doing it for the yield. They are doing it for the explicit guarantee of the U.S. government in the midst of a global recession.
Chart of the Week: LIBOR/OIS Spread: The LIBOR/OIS continues to improve yet it remains elevated due to ongoing funding pressure in the banking system. We have come in considerably from the 365 basis point reading post-Lehman filing for Chapter 11 but still remain well above the peaks seen after the takeover of Bear Stearns and the placing of the GSEs under conservatorship. The Fed has expanded its balance sheet immensely in an attempt to make up for lost private investment in various sectors of the credit markets. However the real challenge is bringing traditional investors back from the sidelines and safety of Treasuries.
Yield? We Don’t Need No Stinking Yield!
December 8th, 2008
It was yet another week of fresh record-setting levels in the bond markets last week as Treasury yields hit 50+ year lows and corporate spreads widened to record highs. The heavy dose of downbeat economic data served as a fresh log thrown atop a market still smoldering from October. After the abysmal payrolls report on Friday, front-end yields dove lower with the yield on the 3-month T-bill only 2 basis points from zero while the yield on the 2-year sank as low as 77 basis points before a little profit taking ensued toward Friday’s close. The back-end of the Treasury curve, especially the 30-year Treasury bond, maintained a steady and unyielding bid throughout the week even as many market observers (myself included) opined about the bubble-like characteristics of the movement. The yield dipped to 3% before some profit taking and repositioning ahead of this week’s 3-year and 10-year supply, finishing the week at 3.13%. The reason it seems so obvious that back-end rates are due for an upward adjustment is because of the low nominal levels but that alone doesn’t mean that rates can’t stay low for an extended period of time. As discussed in the last two postings of the Bond Market Update, the Fed is implementing quantitative easing, a practice used in Japan during its “lost decade” of deflation. This tactic can keep a soft ceiling on rates regardless of the richness implied by fundamental or technical factors. Yes, shorting this rigged market is akin to being tied to the tracks, seeing the train, and hearing the airbrakes…you can only hope that the brakes stop the train before it reaches you. Unfortunately, when the correction does come I fear it will be as fierce as the rally. Just ask an oil futures trader what that looks like. The price movements in the long-end differ somewhat from a true bubble in the fact that only some of the buying has been speculative with traders scrambling to front run the Fed’s purchases. The rest of it has been driven by large technical factors such as forced in derivative buyers, convexity hedging, a squeeze in deliverable securities available to settle futures, and plenty of real money buyers flocking to safe liquid assets. As long as demand continues, the Treasury can keep coming with the supply without exerting upward pressure on rates. Japan issued loads of paper amid deflation and yields continued to fall. The modus operandi of the street has very little to do with competitive returns at this juncture, especially given fears of a deepening recession.
The volatility that the government via that Fed, Treasury, and FDIC are causing due to the open-ended nature of their proposals seems counteractive to their main goal of getting things back to normal. Take for example their announcement about purchasing $100 billion in agency debt from primary dealers though competitive auction. The entire market shifted in anticipation of the Fed’s purchase, unaware of what duration would be targeted. It became clear this week that, at least initially, the Fed would target the front-end of the agency curve in order to keep front-end funding costs for the agencies low. As for the $500 billion that the Federal Reserve will begin purchasing of agency-backed mortgage debt, the main question remains what yield are they targeting? As I mentioned in last week’s commentary, the Fed appears to be looking for a clearing level for the market. My initial impulse was that they were attempting to get mortgage spreads down in the 4% range in order to spur a refinancing wave. However, this will not clear the market as much as it will aid households in cleaning up their personal balance sheets during the current deleveraging phase. The Fed most likely wants to bring in new homebuyers and to do so it must target an attractive rate in order to stem the drop in prices.
This is key because the Fed is actually starting to address the housing market directly, albeit in a different fashion than was initially proposed under the TARP. Instead of trying to clean up bad assets on the banks’ balance sheets the government seems to have shifted its focus on righting the ship from the top of the credit quality spectrum as opposed to dwelling in the cellar. With approximately 10 months supply of single-family homes and 14 months supply in condos/co-ops the Fed has to help lower the supply side and increase the demand side by being the demand for a while. This (hopefully) helps bring in mortgage spreads while also freeing up capital for the primary dealers to (hopefully) reinvest in new issuance. The other big hope is that foreign central banks who have long been the biggest buyers of agency debt (both direct and mortgage-backed) move some of their Treasury holdings back into the asset class as well. The second chart shows foreign holdings held by the Fed for both Treasuries and Agencies. The recent movement out of agency paper and into Treasuries is abrupt and telling; the demand right now has nothing to do with yield and everything to do with safety and liquidity. This trend will likely continue into year-end.
Also pulling money away from agency paper is the new issuance from certain banks and financials via the Fed’s Temporary Liquidity Guarantee Program, or TLGP. Nearly $40 billion of TLGP paper has been issued and absorbed easily in the last three weeks with more supply slated before year-end. Since the debt carries the full faith and credit of the U.S. government along with the promise of timely payments in the event of default rather than bankruptcy, typical agency buyers have been diverting funds toward the issuance. And why shouldn’t they? This issuance carries the aforementioned guarantees while the GSE paper remains “implicitly” backed while in conservatorship. Did I mention you could also potentially pick up roughly 10-30 basis points in yield compared to agency paper? There are differences in funding costs that still make agencies more cost competitive for institutional investors but for portfolio managers and retail investors who typically allocate a portion of investable assets to agency debt it sure looks like an attractive alternative. Supply should remain robust and I would be willing to bet all issuance will remain within the June 2012 guarantee window so it is also a nice alternative for front-end buyers. Of course, if you want to take a leap of faith and assume that the companies who are issuing this debt will utilize the program to refund as much of their existing front-end debt as they can under their respective caps then you can pick up significant yield to these issues. Take for example (and this is only an example not a specific recommendation) the new issue Goldman Sachs issued under the program. The 3.25% notes due June 15th, 2012 (within the guarantee window) were priced just below par at a spread to the 3-Year Treasury of +200 basis points for a yield of 3.367%. They are currently trading around +170/3s for a yield of 2.90%. That is a pickup of 10 basis points to the Fannie Mae 4.875% notes due 5/15/12 that are trading at +160/3S for a 2.80%. Fannie is under conservatorship and the bonds still remain for all intents and purposes senior unsecured notes of the GSE. Now look at Goldman’s 6.6% notes due 1/15/12, which are currently trading at over +700/3s for an 8.25% yield. They only carry the company’s promise to pay rather than the TLGP Goldman issue, which carries the government’s promise. So do you want to be able to sleep at night or do you want high yield? If you like your rest, choose the TLGP issues and if you like yield look at the senior unsecured debt and buy some Nytol. The risk/reward tradeoff is every bit compelling as it is unnerving.
Chart of the Week: Long-end Yields Fall, Mortgage rates follow. As mentioned before, the Fed is implementing quantitative measures to ease pressures in the credit markets while specifically targeting the long-end and mortgage rates. This chart shows the weekly results for Freddie Mac’s market survey for 30-year fixed conventional, 15-year fixed, and 5/1 adjustable mortgage rates along with the 10-year Treasury yield. While 10-year yields have plummeted mortgage rates have reacted meaningfully, but as mentioned in last week’s Chart of the Week, the spreads between the benchmark Treasury and mortgage rates remain wide. The Fed is trying to change the widening bias by offering to purchase up to $500 billion in mortgage paper. The Treasury can issue more supply without exerting too much upward pressure so long as the fear/liquidity bid remains intact. Even if rates started to drift higher there is room as long as the mortgage/Treasury spreads are tightening in since nominal rates are so low.
The author of this material is a Proprietary Trader/Desk Strategist in the Fixed Income Division of Raymond James & Associates, not a Research Analyst. Any opinions expressed may differ from opinions expressed by other divisions of Raymond James including our Equity Research Department and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but Raymond James does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitutes a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities, and/or derivatives that Raymond James may have positions, long or short, held proprietarily. Raymond James may have also performed investment-banking services for the issuers of such securities. Investors should discuss the risks inherent in bond with their Raymond James Financial advisor. Risks include, but are not limited to, changes in interest rates, credit quality, volatility, and duration. Past performance is no assurance of future performance.
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