Top of the Street: Farewell to the Fed chair, a foreign bid for US credit, a Ginnie Mae fix and more

Chair Yellen bows out after this week, US corporate credit gets a lift from foreign demand, Ginnie Mae fixes a prepayment problem, the loan mix shifts in CMBS and lessons from the financial crisis. Contributions from DB, GS, JPM, NY Fed and Milepost.

 Markets: The Fed says farewell to the Chair
The FOMC will hold Janet Yellen’s valedictory meeting this week with likely few substantive changes to language and the Fed on track to hike in March. Markets have priced an 86% chance of a March hike. Growth has been steady, labor markets tight and inflation still below target. Core PCE for December should come in next week year-over-year at 1.5%. The Fed has signaled three hikes this year. Street economists lean toward four. See Deutsche Bank, What to expect from the January FOMC statement, 26 Jan 2018. (DB, Milepost).

Markets: Foreign investors reach for US credit
Net foreign purchases of US corporate debt in 2017 tallied $133 billion through November and could go on to top the post-crisis record set in 2015 of $143 billion. European investors have been the strongest source of foreign demand. The European Central Bank has absorbed a significant share of EU corporate debt through its QE program, and that has likely pushed private EU investors into the US market. As the EU throttles back on QE, spreads in the US could widen. See Goldman Sachs, The Credit Trader, 19 Jan 2018. (GS, Milepost).

Markets: Ginnie Mae comes up with a fix
Ginnie Mae last week moved to fix a problem with fast prepayments in its MBS that it has battled for more than a year. The agency announced new rules giving it power to rein in or shut down issuers with high rates of loan default, little retained prepayment risk, limited loan diversification or abnormally high prepayments.  JPMorgan estimates that the rules would have cut 2017 prepayments in the most vulnerable 30-year Ginnie Mae II 3.5% MBS by 3 CPR, 4.0%s by 11 CPR and 4.5%s by 21 CPR. Ginnie Mae MBS prices jumped higher on the announcement. See JPMorgan, US Fixed Income Markets Weekly, 26 Jan 2018. (JPM, Milepost).

Markets: The CMBS market adds office space
The share of CMBS loans backed by office space has jumped in the last five years from 20% to more than 30%, according to Goldman Sachs. The rise partly reflects the drop in loans backed by retail property. Retail has fallen from nearly 35% of underlying CMBS loans to less than 15%. Office loans face some headwinds, however. Office rents grew by 6.0% in 2015 but only 1.6% last year. And all commercial real estate should come under pressure if rising interest rates cut into market prices. See Goldman Sachs, The Mortgage Trader, 21 Jan 2018. (GS, Milepost).

Economy: Lessons from the financial crisis
The boom in mortgage debt before the 2008 financial crisis has become both history and Hollywood, but now the NY Fed has added a wrinkle to the story. Import competition, the NY Fed argues, explains an important part of the rise in mortgage debt. The NY Fed calculated exposure to import competition in local economies across the US in the 2000s and correlated it with subsequent rise in mortgage debt. The stronger the competition, the higher the debt. Borrowers generally increased their household leverage by taking equity out of their homes. The Fed speculates that borrowers used the debt to smooth household finances as new import competition put pressure on employment and wage growth. The NY Fed post is here. (NY Fed, Milepost).

Top of the Street: The Fed rethinks inflation, DC rethinks its favorite P&L, the muni market worries about bank selling and more

The Fed has started rethinking inflation in ways that could reshape the yield curve, Fed remittances to Treasury look set to drop, banks could become sellers of munis, Puerto Rico avoids the worst and tax reform bites high-priced housing. Contributions from Barclays, DB, GS, NY Fed and Milepost.

Markets/economy: The Fed rethinks inflation
The Fed may take a dovish tilt in the years ahead and tolerate a bit more inflation, according to Deutsche Bank Chief Economist Peter Hooper. He attended the Brookings Institute’s Jan 8 conference on inflation targeting along with former Fed chair Ben Bernanke, economists Larry Summers, Olivier Blanchard, Rick Mishkin, John Taylor and others. The debate focused on ways to give the Fed enough room to ease in the next recession. Bernanke and San Fran Fed President John Williams argued for targeting 2% inflation on average. Shortfalls during recessions would have to be followed by higher inflation during expansions. That would produce much more volatility in the shape of the yield curve than the market has seen historically, but it would help the Fed in markets where fed funds were floored at zero. Materials from the conference are here. See Deutsche Bank, Fed Note: Brookings Fed policy framework discussion, 10 Jan 2018. See also Goldman Sachs, Price Level and Nominal GDP Targeting: New Frameworks for the Fed?, 14 Jan 2018. (DB, GS, Milepost).

Markets: DC rethinks its favorite P&L
The Fed’s $4.5 trillion portfolio has sent hundreds of billions of dollars to the US Treasury in the last decade and helped trim US deficits, and now the NY Fed has projected how those remittances will change as the Fed lets its portfolio run down. Expected annual remittances should drop from more than $70 billion currently to around $40 billion by 2020 as the Fed pays banks higher interest on excess reserves and as securities run off. But as IOER plateaus and the Fed begins reinvesting run-off again, remittances start to climb as new purchases come into the portfolio at higher yields. By 2030, the Fed could be putting more than $100 billion a year in the Treasury. The NY Fed looks at the risk that IOER could rise so quickly that the Fed pays out more than it takes in, something that could create political problems for the central bank. Most plausible scenarios in the NY Fed analysis show the risk of Fed shortfalls at less than 5%. The NY Fed post is here. (NY Fed, Milepost).

Markets/banking: The muni market faces possible bank selling
Tax reform has almost certainly changed the way that banks evaluate municipal bonds, according to Barclays, putting more than $200 billion potentially in play if rates and spreads make other investments more attractive. The drop in the top corporate tax rate from 35% to 21% has revived memories of 1986 tax reform, when the top rate dropped from 46% to 34% and bank holdings of muni debt dropped from $235 billion to $100 billion. Banks currently hold more than $300 billion of muni debt with $220 billion readily salable. Of course, it will take compelling alternatives, but Treasuries and MBS could create competition. See Barclays, Bank Appetite for Munis Under the New Tax Regime, 11 Jan 2018. (Barclays, Milepost).

Economy: Puerto Rico dodges the worst case – so far
Despite continued power outages, water shortages and travel and telecommunications problems since Hurricane Maria hit on Sep 20, Puerto Rico so far has escaped a worst-case hit to economic output, according to the NY Fed. Employment in Puerto Rico in October and November plunged with tourist sectors hit hardest and wholesale trade, health and education also showing steep losses. However, initial losses look consistent with those from other major hurricanes, which saw employment and output rebound over 12 to 18 months. The employment data may not be reliable, but other economic data show a similar pattern. The huge impact of the hurricane on general quality of life could accelerate emigration from Puerto Rico, which could push the island into a downward spiral. But initial signs look far from catastrophic. The NY Fed post is here. (NY Fed, Milepost). 

Markets/economy: Tax reform to bite high-priced housing
Most of the impact on housing from recent tax reform should fall around New York City, New Jersey, southern Florida, coastal California, Chicago and parts of Texas, according to Morgan Stanley. The cap on state and local tax deductions should take the biggest bite while limits on the mortgage interest deduction and a doubling of the standard deduction should have small effects. The latest work continues analysis done years ago by the Cleveland Fed and PwC that suggest home prices in some markets could drop by 10% or more. See Morgan Stanley, A Tax on Both Your Houses, 12 Jan 2018. (MS, Milepost).

Top of the Street: On towards flatter yields, upcoming in politics and a $400 billion sale to start the year

A flatter yield curve, contentious politics, a $400 billion corporate sale, a tax gift for REITs and more bad news for retail. And that’s only the first week of the year. Contributions from CoreLogic, CS, GS, JPM and Milepost).

Markets: On towards flatter yields
Flatter. And maybe a little higher. That should be the direction for US rates. Tax reform should give a small lift to growth this year and, possibly, inflation. The bump in deficit spending from tax cuts should also help lift 5-year and shorter yields. The December FOMC minutes signaled a Fed on track to tighten between two and four times this year. The spread between 2- and 10-year yields since December 20 has dropped by 14 bp. Look for it to go to zero this year and for 10-year rates to range between 2.25% and 2.75%. See JPMorgan, US Fixed Income Markets Weekly, 5 Jan 2018. (JPM, Milepost).

Markets/economy: Upcoming in politics
On the political agenda for the foreseeable future: First, federal spending authority, which expires January 19 and has become tangled up in the debate over deferred action for childhood arrivals (DACA) and an $18 billion administration request for a border wall. Second, the US debt limit, which will need to be raised by March. Third, US deficits, which should rise with tax cuts and likely new fiscal spending and approach 3.7% of GDP this year and 5.5% by 2021. Fourth, infrastructure. Fifth, technical corrections to tax reform. And beyond these items come tweaks to Obamacare, financial regulations, GSE reform, international trade, and the looming 2018 midterm elections. See Goldman Sachs, US Economics Analyst: The 2018 Political Outlook: More Stimulus and New Trade Risks Ahead of the Midterms, 6 Jan 2018. (GS, Milepost).

Markets: A $400 billion sale to start the year
The first week of the year brought more than $400 billion in selling of longer corporate debt likely by Taiwan insurers, according to JPMorgan. Taiwanese investors had a 1-time opportunity to reclassify investments from old to a new accounting categories starting Jan 1, 2018, and apparently decided to take some gains before reinvesting. The new categories give Taiwan investors a little more flexibility to trade their accounts, but the selling doesn’t necessarily signal a material change in investment strategy. Taiwan insurers invest heavily in US corporate debt, callable agency debt and agency MBS. See JPMorgan, US Fixed Income Markets Weekly, 5 Jan 2018. (JPM, Milepost).

Markets: A tax gift for MBS REITs
December’s tax reform includes a gift for REIT investors, including those that invest in MBS. Investors will be able to deduct 20% of qualified REIT dividends. An investor with a 37% marginal tax rate, for example, consequently pays only 29.6%. For a REIT paying a 10% dividend, that’s a 74 bp gain in after-tax income. The REIT provision hasn’t had a clear effect on REIT stocks so far, but a lift to the sector could help REITs raise equity as they did in 2017 and become better buyers of MBS. The new benefit now makes REITs much more efficient than mutual funds as a way to hold MBS risk. See JPMorgan, US Fixed Income Markets Weekly: Agency MBS, 5 Jan 2018. (JPM, Milepost).

Markets: Retail rolls over CMBS again
Sears and Macy’s announcement that week that they would close more stores has put a range of CMBS deals at risk. Sears announced it would close 39 Sears stores and 64 K-Mart stores sometime between early March and April. Macy’s announced 11 closings. The Sears closings affect nine loans backing CMBS deals, including one loan that makes up 41% of the loan pool behind a 2006 CMBS deal. The Macy’s closings affect three CMBS deals. This is the latest round of bad news to hit CMBS as e-commerce continues to hurt bricks-and-mortar retail shopping, with loans to mall operators most at risk. Credit Suisse expects retail closings and bankruptcies to continue, weighing on rents and vacancy rates. See Credit Suisse, CMBS Retail Outlook: transformation accelerating, 4 Jan 2018, and Credit Suisse, CMBS Loans in the News: Another 64 Kmart and 39 Sears are closing, 4 Jan 2018. See also JPMorgan, US Fixed Income Markets Weekly: CMBS, 5 Jan 2018. (CS, JPM, Milepost).

Markets: Single-family rents slow
Rents on single-family houses rose 2.7% year-over-year through October, according to CoreLogic, down from a peak pace of 4.4% in February 2016. The most pronounced slowing came in the most expensive rentals. Trends in rents also varied widely across different markets. Las Vegas saw single-family rents rise 4.6% year-over-year through October, while rents in Miami dropped 1.3%. The CoreLogic post is here. (CoreLogic, Milepost).