Rates are trading “like death,” one popular strategist wrote, in a Wednesday note.
Other analysts have been kinder. BMO’s US rates team called Tuesday’s belly-led rout “a classic ‘what happened in rates?’ type of session,” for example. But I suppose there’s little utility in being polite or otherwise mincing words.
To that end, I’ll say it’s been a god-awful year for bonds. The figure (below) puts the first quarter in historical context.
That’s pretty rough. And although you could (very) plausibly argue that the bond selloff is overdone and due for a breather (followed, perhaps, by a kind of sideways drift à la Q2/Q3 2021), there’s an equally compelling case to be made that the situation is poised to get worse.
For now, it’s all about repricing the policy path. “Rates and core fixed-income continues to trade like death as they reprice global central banks’ hiking paths and eventual magnitudes,” Nomura’s Charlie McElligott said, noting that the Fed now looks destined to pursue restrictive policy.
He noted “nothing but downside” trading in eurodollars and Euribor options overnight Wednesday. Notably (and this is what I really wanted to highlight), we’re near max short gamma in TLT options positioning (figures below, from Nomura).
That “makes intuitive sense given the way UST futures are trading,” McElligott remarked.
Meanwhile, the buyside is apparently grabbing for downside protection in credit in the wake of Lael Brainard’s emphatically hawkish message delivered Tuesday.
Citing expectations for “rapid” (as Brainard put it) balance sheet runoff (which represents a tightening atop the rate hike tightening), McElligott flagged the “resumption of large demand” for hedges in the junk ETF, where dealers are now back near max short gamma.
What’s the connection? Well, it’s pretty straightforward. Regardless of what the impact of QT ends up being for Treasurys (it’s a tug of war between a bearish read-through from the removal of a price insensitive bid and a potentially bullish read-through from the removal of stimulus at a time when economic momentum is already waning), QT is a widener for spread product.
The risk, McElligott reiterated on Wednesday, is that MBS runoff “seep[s] into credit” as financial conditions tighten. When the Fed offloads its holdings to private investors, price discovery (or a semblance thereof) will reassert itself. That’s a lot of things, but bullish isn’t likely to be one of them after years of administered markets.
Remember: The Fed will lean into MBS when it comes to shrinking the balance sheet. The derisive “housing bubble” chorus is a veritable cacophony now, and there’s a case to be made that if the Committee is looking for places where monetary policy can have a real impact on an inflation problem that’s otherwise beyond their capacity to address (due to the supply-side nature of price pressures), deliberately undercutting home prices is one option.
It’s probably too late, given that shelter inflation responds on a lag (figure above). The pandemic surge in home prices is already “on the books,” so to speak.
But when it comes to MBS, the Fed is keen to shed its holdings in true “better late than never” fashion. Although they’d never admit this, the Committee is probably just fine with the rapid rise in mortgage rates, which topped 5% this week.
As Zoltan Pozsar wrote in February, mortgage rates “need to get higher” and home prices need to be flat or “outright lower.”
The demand for housing is huge.
In various surveys, it turns out that roughly half of Gen Z and Millennials were living with their parents during the covid pandemic.
An unrenovated 1200 sq ft house just sold in my neighborhood.
732k with the buyers having a 4.75% rate. List price was 599 and even that is absurd. My family bought a 2500 sq ft house prepandemic for 500 at 4.25%.
Not long ago I was convinced that higher rates would drop the market. Now I’m wondering if the ubiquity of 3.x% mortgages will drastically shrink the supply of houses as people can’t afford to swap. Unless a recession forces some selling.
This is an excellent point. I have spoken with quite a few friends who live in the Denver area that are recent empty-nesters, who would prefer to sell their house and downsize- but it makes no sense financially. If they have to end up putting all the sales proceeds into the new home- they are deciding to stay where they are.
Recession next year seems fairly likely, unless the war in Ukraine is resolved AND the Fed finds some reason for changing its mind about following through with a rise in rates. The only question is the veracity of the recession. The prospect of massive food shortages as a result of the war, in addition to the war itself, Russia’s insane belligerence, combined with the Fed’s currently hawkish posture should give everyone substantial pause.
I’m in time machine mode today.
I continue to think the Fed will be constrained selling MBS, but apparently, they’ve been successful at the magical art of selling dollar rolls, nonetheless, there are caps that limit the speed of unwinding their avalanche tsunami of balance sheet experiments.
From my time machine:
Fed to linger in agency MBS market after exit
By Julie Haviv – Analysis 2010
“Unloading its holdings would pressure the sector considerably and de-value the rest of its agency MBS holdings. By sending yields higher, it would negate the purpose of the purchase program, which was to bring down mortgage rates and to stimulate the battered housing sector and the overall economy.”
If the following pasted info is too esoteric and weird or too long, possibly out of context or unrelated, you’ll probably really hate my cliff notes on MBS theory that was debated in Fed minutes.
I’m curious about this stuff because I’m concerned about Fed policy errors and attempting to understand how that might impact those of us living in Dystopia, USA.
This has to do with Fed MBS and swaps and dollar rolls related to unwinding their balance sheet, and the relationship to the current explosion in settlement fails, which apparently shuts the Fed desk down in some of these trades.
Here we go:
“The second is failure to deliver at settlement, i.e., the security borrower in a dollar roll
transaction delays the redelivery of MBS to the roll seller in the future-month TBA contract.
In this case, we say the roll is “trading at fail.” Fails could happen if there is a temporary
shortage of MBS that satisfy the TBA delivery requirements due to, for example, a high
volume of CMO deals. In the case of trading at fail, the dollar roll seller benefits by not
having to pay the cash back to the security borrower until the MBS is delivered back. At the
same time, the roll seller is still entitled to the principal and coupon payments of the MBS
that the roll buyer fails to return. That is, while the dollar roll is trading at fail, the roll
seller effectively borrows from the roll buyer at the 0% financing rate. Without a penalty
on failure to deliver, a sufficiently negative implied financing rate in a dollar roll trade can
encourage the MBS borrower in the roll transaction to fail strategically and charge a more
desirable 0% financing rate, instead of the negative financing rate implied by the dollar roll.30
Therefore, we expect the amount of failure to deliver is negatively associated with the IFR.
Though we expect credit risk and failure to deliver to affect the dollar roll financing rates
negatively, we expect neither to affect dollar roll specialness significantly. This is because
GC repo rates should be affected by credit risk and failure to deliver in a similar fashion as
dollar roll financing rates are.
To investigate how credit risk and failure to deliver affect the dollar roll financing rates and
specialness, we obtain the 5-year (senior unsecured) CDS spread on J.P. Morgan from Markit
as a proxy for its credit risk and the amount of delivery fails in agency MBS transactions by
U.S. Primary Dealers from the website of the Federal Reserve Bank of New York.31
Full disclosure, one cup of coffee, one cookie.
OldBird
Don’t know who you are or if you are still doing this stuff but your comments on this site are captivating, largely because even though I taught investments for years and wrote a text on the subject, what you are describing is action way above my pay grade. I’m fascinated by your recent discussions of fails. It seems to me we have created a system that works whether or not people live up to their agreements. That’s a bit scary to Lil old me, anyway (oh yeah and to my advisor as well). Rock on, man.
Thanks Mr Lucky. I’m happy that I haven’t alienated you but I’m always walking on thin eggshells with my ranting.
I always feel like I’m adding too much comment that might not be entirely on topic, but I’m just hoping to add colors to Mr H excellent efforts.
I’ve been looking at monetary velocity a little lately and stumbled across broadly related Fed MBS stuff that is systemically connected to overall market stability. As such, found an educational bunch of ideas from the GFC era. It’s interesting that a large number of Fed voting members were entirely against QE, basically because of credit allocation and then obviously inflation risk.
Here’s the start of that debate:
Bernanke
On item 7, on the guidelines for purchases of agencies, I think this is a useful
clarification. I also support this. But I would like to at least record that, in my own view, I don’t
think that our MBS purchase program is credit allocation in the sense that this guideline was
intended to address—for several reasons. First, to my mind, credit allocation involves a
preference for a certain class of borrowers relative to what normally functioning markets would
throw up. In this case, the issue is not an attempt to distort allocations away from some efficient
outcome; rather, it is our intention to try to make markets work better and to bring us closer to a
normal market outcome. Second, I view the MBS purchase program as being really very close to
monetary policy in spirit and intent in that we are trying to address broad issues of
macroeconomic stability by stimulating an important component of aggregate demand. So we
are using this particular tool not because we have a preference for housing but because we are
trying to stimulate overall aggregate demand. Indeed, as you know, we are in fact looking at
various types of credit in order to achieve that. I think this is similar to the normal use of
monetary policy, which affects different sectors differently, not because we have a preference for
one sector or another but because our tools allow us to address different components of
aggregate demand with different force.
Meeting of the Federal Open Market Committee on
January 27–28, 2009
I’ll toss in another comment here about that exchange.
Perhaps Bernanke philosophy and intentions were honorable and hopefully but the QE push was naive and not as well thought out as it needed to be. The Fed had the technical ability to open Pandora’s box but there was that lingering doubt about moral hazard.
Letting the genie out of the shattered perfume bottle was easy, but cleaning up the mess and getting the smells and stains out was something specifically not talked about during that orgy.
The inability of the Fed to make their MBS evaporate was still a work in progress before the pandemic buying spree. The Fed assumed they could keep swapping out MBS and run down the portfolio and exit that business, but, the pandemic shock was easily solved by sweeping all the Pandora box glass chips under another rug, as if doubling down.
As with Bernanke, I think the current Fed is also naive in thinking they can accelerate cleaning up Schrodinger’s kitty litter box.
I’m not sure how any QT efforts will play out, but I’m confident the mess Will take many years to manage. Unfortunately, in our crazy world, problems unfold, like the pandemic, Ukraine, GFC, Enron and a polarized political world filled with stupidity. The MBS genie isn’t going back in the bottle…
Here’s the next part of Fed minutes related to MBS parameters. One more post will follow this one. I think these discussions help in understanding the intent of the QE framework, but fail to pin down details of unwinding this policy strategy. It’s a chess game that’s still being played and it’s a stalemate.
Meeting of the Federal Open Market Committee on
January 27–28, 2009
Charles Posser, the President of the Philadelphia Federal Reserve
(credit allocation debate):
“… I think this gets back to the accord, Mr. Chairman, in your discussion—for us
to unwind from some of these things if, in fact, we have Treasuries rather than MBS. I think our
credit programs do carry risks. Aside from the moral hazard problems we have created, we face
challenges when we attempt to liquidate particularly non-Treasury assets from our portfolio. We
will get pressure from various interest groups to retain certain assets. We will certainly, in all
likelihood, get calls from consumers, builders, and Congressmen if we start to sell mortgage-
backed securities out of our portfolio in order to reduce its size. We will hear fears that the
mortgage rates may rise. We will have some market participants resisting our desire to pull back
from our credit programs, fearing that markets remain too fragile or the economy’s headwinds
are too strong. I think we will make every effort to resist such pressures, but they could make it
difficult for us to conduct monetary policy in a way that is consistent with our mandate,
particularly our mandate for price stability. Moreover, given that we have crossed the bridge on
credit allocation schemes to specific markets, it will be much easier in the future for special
interest groups to ask us to repeat such actions, especially if they can’t get the answers they want
from the political process.
Next part:
Thus, I think—and I realize this view isn’t shared by all—that the credit allocation
schemes we are pursuing run a real risk of impinging on our independence and our ability to
control our balance sheet and, hence, monetary policy. Again, drawing back from the AMLF
and perhaps the GSE discount window lending facility may help us begin to reassert a bit of that
independence. For that reason, I am not uncomfortable with buying long-term Treasuries, partly
because of their portfolio effect as a substitute for buying MBS. Mr. Chairman, I think that your
comments about moving more of this to the Treasury are exactly right, and it certainly applies to
Maiden Lane. I think it would apply to the CPFF in some respects and perhaps to the TALF, as
President Lacker was suggesting.
I didn’t find the staff’s arguments against purchasing long-
term Treasuries particularly compelling. I guess I share President Lacker’s view that, if we are
blowing up our balance sheet—whether we are blowing it up with MBS or with Treasuries—it is
still expansionary monetary policy as far as I am concerned, and I don’t think it should make that
much difference on inflationary expectations. The staff also raised the problem of interest rate
risks inherent in longer-term Treasuries. Again, I don’t see this as a particular problem distinct
from our purchases of mortgage-backed securities, which also contain interest rate risk at the end
of the day, if we have to sell them.
Both of these programs increase the maturity mismatch on
our balance sheet in very similar ways.
I am a little puzzled—maybe I will save this for the policy go-round—about why we
should leave the door open in the statement. The estimated reduction in longer-term yields, as
the staff suggested, is somewhere between 10 and 30 basis points, which is, at best, quite
uncertain based on the empirical evidence. Putting aside my concern for portfolio composition
and my preferring Treasuries, I don’t find buying long-term Treasuries that compelling, except
for this portfolio reason. Thus, a better reason for leaving the door open may be this portfolio
argument, but I don’t think we could explain that very well. We could simply say that we
continue to weigh the costs and benefits. But I do have some reservations about continuing to
discuss in our statement programs or actions that we might or might not take. I think that there
are certain risks to that in terms of making markets believe that we may do something, and then,
if we don’t do it, we lose some credibility. But we can talk about that in the policy go-round.
Thank you, Mr. Chairman.
I have always feared that some series of events would undermine ongoing maintenance of the policy solution for the MBS fiasco. Along with that fear, I reckoned the need for firm and knowledgeable handling of these special policy tools by Fed governors. But in fact, Fed governors are not clairvoyants or swamis who can actually read tea leaves and see into the future – at least not as well as Ben Bernanke.
Thanks very much, OB, for sharing the records you’ve collected and your thoughts about these large and awful things. You’re helping me to expand my perspective. I’ll probably tend to hold my long positions in stocks, which I repositioned for the longer haul after a recent dip. I’ll probably have my fingers crossed while riding out this storm, and I’ll hope Putin has vanished from the scene too. I have faith that the storm shall pass, but who can know how long it will rage? I hope it will begin to settle in 2024.
Sure nuff, @oldbird curated the good stuff straight from the horse’s mouth(s). Kind of eerie how they are no different than the rest of us mortals, in that they weigh the risks but bravely(?) forge ahead anyway. Like when one crosses a landmine zone on a dark moonless night. No way in hell you are going to turn around and go back the way you came even though you don’t know what the future will hold going forward toward watching enemy lines. I suppose we take our chances with the enemy since landmines don’t take prisoners. The old “it couldn’t be any worse” scenario. Or could it and for how long?
“Stock Market Charts You Never Saw”
54 Pages Posted: 11 Oct 2017 Last revised: 17 Mar 2021
Edward F. McQuarrie
Santa Clara University – Leavey School of Business
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3050736
Clearly there is no want for vertigo inducing charts in “Dystopian, USA”:
https://www.longtermtrends.net/stocks-vs-bonds/
H-Man, our youngest son, age 35, in search of a home was just told by his bank he no longer qualifies for a $600,000 home and will only qualify for a $400,000 home. All this in less than five months.
Sorry to hear this. It seems banks are sniffing out the coming recession and further limiting lending. Liquidity is drying up pretty quickly.