Top of the Street: Reasons for short rates to rise this week, banks stockpile liquid assets, Ginnie Mae disappoints

The Fed gets its last hurrah for 2017. Banks look liquid. Ginnie Mae looks weak. Contributions from JPM, MS and Milepost.

Markets: Lots of reasons this week for short rates to rise
The Fed should hike this week, and it has a 50% chance of using its dots to signal four hikes in 2018 instead of three. Also look for the Constitution Avenue crew to announce a drop in it’s portfolio by as much as $20 billion a month starting in January, up from $10 billion currently. The US debt ceiling, which Treasury hit last Friday, may also nudge up short rates. Treasury can use $286 billion in extraordinary measures to fund the government through March. But it also will need to issue a steady supply of bills. The curve should almost fully flatten by the end of next year. See JPMorgan, US Fixed Income Markets Weekly: Treasuries, 8 Dec 2017. (JPM, Milepost).

Markets/banking: Banks stockpile liquid assets
The biggest US banks hold more than enough liquid assets to meet current bank liquidity rules, according to recent filings, which should help them weather Fed tightening. The eight largest hold $2.37 trillion in high quality liquid assets or 124% of the amount needed to cover the cash expected to leave the bank in regulators’ stress scenario. Nearly 85% of the liquidity portfolio sits in reserves held at the Fed, US Treasury debt or Ginnie Mae MBS. Another 15% is held in Fannie Mae or Freddie Mac MBS and less than 1% in other assets. As the Fed let’s its portfolio run off and starts to draw down reserves, the banks seem to have a sizable cushion for meeting liquidity rules. See JPMorgan, US Fixed Income Markets Weekly: Agency MBS, 8 Dec 2017. (JPM, Milepost).

Markets: Ginnie Mae disappoints
MBS investors hoping that Ginnie Mae would solve its recent prepayment problems were disappointed last week, and prices on the most sensitive Ginnie MBS dropped 8/32s to 16/32s below Fannie Mae. The agency announced new measures to dampen speeds in new pools, but the measures looked light. Speeds in new Ginnie Mae pools have been rising quickly in recent years, and the agency in December 2016 stopped originators from pooling loans that went through a streamline refinance within their first six months. That only delayed the prepayments. Last week Ginnie Mae extended that rule to cashout refis starting April 1. The agency also will add prepayment performance to a scorecard it calculates for each issuer, but there’s no clear enforcement mechanism for poor scores. It will also limit the pooling of loans with rates well above average. Much of the problem seems to be coming from VA loans, but Ginnie Mae has left it to the VA to apply a tangible benefit or fee recoupment test to refinanced loans, and VA has provided no public guidance. See Morgan Stanley, Agency MBS Weekly, 8 Dec 2017. See also JPMorgan, US Fixed Income Markets Weekly: Agency MBS, 8 Dec 2017. (JPM, MS, Milepost).

Markets: Eight things you need to know to trade fixed income in 2018
If you missed last week’s summary of key themes in the Street’s annual 2018 outlook gaze into the future, see our post for Mon, 4 Dec 2017. It’s there, hundreds of pages reduced to a few bullets. Brought to you by Milepost.

Top of the Street: The eight things you need to know to trade fixed income in 2018

The Street has started delivering its annual gaze into the future, with some running more than 400 pages. Although much of it seems like a forced march through every possible topic in every possible market, there are nuggets of insight. Here is what you need to know, with contributions from Barclays, DB, GS, JPM, MS and Milepost.

1. The economy: growth, but rising risk of recession
The Street is looking for real GDP to run between 2.0% to 2.5%. Strong consumer spending and business investment lead the way with modest growth in housing and government spending and little from trade. Tax reform and post-hurricane rebuilding edge the numbers up slightly. Unemployment drops toward 3.5% and wage pressure helps push inflation toward the Fed’s 2.0% target. Of course, no one seems to have a good explanation for the low inflation of 2017, so that should temper any confidence in inflation predictions for 2018.

Beyond 2018, the risks of recession start to rise if the labor market keeps heating up and the Fed needs to cool things off with more tightening. Both the Fed and fiscal policymakers could find their options limited. The Fed could push funds a few percentage points above zero, but that’s not much room to ease by historical standards. And both the House and Senate tax bills would add a net $1 trillion to deficits over the next 10 years, taking national debt as a share of GDP from 80% currently toward 100% by 2030. Rising debt could limit any new fiscal stimulus. Constraints on monetary and fiscal policy could make it harder to climb out of the next recession.

2. The Fed: up in rates, and out of QE
The Fed hikes once a quarter next year or possibly more, according to consensus, although that seems to depend on a credible rebound in inflation. The Street’s economists seem to expect that rebound, but a little humility might serve well here. Inflation for now is a puzzle, and the market is pricing in less than two hikes. The truth is probably somewhere between the economists and the market. Uncertainty around inflation is a clear risk. The Fed’s exit from QE also picks up steam until as much as $50 billion a month is rolling off in the fourth quarter.

3. Rates: flat and stable
The yield curve flattens significantly in 2018, with 2-year rates rising as much as 85 bp and 10-year rates going up by only half that amount, according to JPMorgan. The Fed and heavy new Treasury supply help push up short rates while expectations of modest inflation and low real growth keep longer rates stable. Implied forward rates have the 2-year up a more modest 30 bp and 10-year up 15 bp. But Morgan Stanley expects inflation to continue running below the Fed target by 30 bp to 60 bp and the 10-year rate to finish around 2.00%.

The outstanding balance of Treasury debt rises by more than $1 trillion, mainly in 5-year and shorter maturities. The spread between the swap and Treasury curves narrows inside the 5-year mark. The outstanding balance of Fannie Mae debt drops by $15 billion and Freddie Mac by $30 billion while outstanding Federal Home Loan Bank debt rises by $65 billion.

Volatility, after sinking to historic lows in 2017, stays low or drops further. Limited economic surprise, reasonable liquidity and programmatic selling of options by portfolios that need income suppress any bounce to higher volatility.

4. Credit: stronger and tighter
Another year of tighter spreads on US corporate debt will owe thanks to rising GDP, rising corporate earnings and higher yields on US than on Euro corporate credit. Rising earnings should help credit quality by trimming leverage and lifting interest coverage. Buying of investment grade Euro credit by the European Central Bank into mid-2018 should help, too. But spreads are already tight, so opportunity is limited. Investment grade, high yield, leveraged loan and CLO markets all grow. A surge in supply from M&A or slowing growth, however, could sting.

5. MBS: replacing the Fed
Nothing matters more in this market than the Fed’s shrinking agency MBS portfolio. More than $150 billion should flow out of the Fed next year. Combined with natural growth of around $250 billion in outstanding MBS, conventional wisdom calls for wider mortgage spreads. But conventional wisdom has been wrong so far, with tighter spreads since the Fed officially announced its exit. Banks and REITs have taken up the Fed’s slack. That could continue, with mutual funds joining the parade if spreads on corporate debt continue to narrow. The best predictor of risk-adjusted MBS spreads in 2018: exactly where they are now.

Fannie Mae and Freddie Mac credit-risk transfers should continue feeding demand for fresh RMBS credit exposure, with securitization of non- and re-performing loans complementing the risk transfers. Home prices look reasonable, up from their 2009 low by 40% while commercial real estate has jumped 85%. Rising prices have generally tracked rising income. However, studies by the Cleveland Fed and PwC estimate that reductions in the mortgage interest deduction could cut home prices in some metro areas by as much as 10%. Recent tax legislation, which cuts the deduction, could soften the resi credit markets next year and beyond.

6. CMBS: adjusting to the new retail
Changes in the retailing business should matter to CMBS in 2018 since loans to malls season many of the private deals. Brick-and-mortar malls are under attack. Loans secured by retail properties hurt private CMBS performance in 2017. Expect more pain in 2018.

More broadly, prices on office, industrial, retail and apartment properties stand 20% or more above pre-crisis peaks. Property income has been strong and growing, interest rates low and most alternative investments expensive, so higher prices are not unreasonable. But, with many assets, the margin for error is small.

The CMBS backed by Fannie Mae, Freddie Mac and Ginnie Mae now have $500 billion outstanding, well above the $350 billion in outstanding private CMBS. Agency CMBS includes more affordable apartment building than the private market, and agency occupancy rates are near 95%. Agency CMBS issuance should keep outpacing private. Agency CMBS outperform private.

7. ABS: the strong consumer
Spreads in credit card, auto and student loan deals last year reached the tightest levels since the 2008 financial crisis, and the Street expects stable or possibly even tighter spreads in 2018. Household debt-to-income has dropped since the 2008 financial. Home prices are up, unemployment down. Steady economic growth and even lower unemployment next year should support stable-to-tighter spreads on consumer debt. The risks to the consumer rise as the risks of recession pick up beyond 2018.

8. Municipal debt: tested by tax reform
Tax reform reshuffles the muni debt market in 2018. Elimination of advance refunding of muni bonds drives issuance down by 10% to 20%, and spreads tighten. Elimination of deductions for state and local taxes raises concerns about the credit of high-tax issuers as those areas face a higher local cost of living, less disposable income and cloudy prospects for population growth. Local demand from wealth investors for the debt from high-tax issuers nevertheless surges. Lower corporate taxes cut demand for muni debt from banks and insurers, which currently hold 23% of the market.

For more detail on these and other themes, please see the following: Barclays, 2018 Municipal Outlook: Opportunity Knocks, 1 Dec 2017; Deutsche Bank, The Outlook: MBS and Securitized Products, 21 Nov, 2017; Goldman Sachs, US Economic Analyst: 2018 Outlook: Too Much of a Good Thing, 17 Nov 2017; Goldman Sachs, 2018 US Housing and Mortgage Outlook, 21 Nov 2017; JPMorgan, US Fixed Income Markets 2018 Outlook, 22 Nov 2017; Morgan Stanley, 2018 Global Rates Outlook: Toward the First Flat Curve, 1 Dec 2017; Morgan Stanley, 2018 Global Securitized Products Outlook: Cherry Picking, 27 Nov 2017.

Top of the Street: The biggest drag on inflation, the shift that could slash muni issuance, the new mortgage lender of last resort, a Nobelist’s view of volatility and more

Healthcare may be behind the global slowdown in inflation. Tax reform could slash muni issuance by 33% next year. FHA mortgage defaults rise. Shiller makes a case for low volatility. Contributions from Barclays, GS, JPM, MS, NY Fed and Milepost.

Markets/economy: The biggest drag on global inflation: healthcare
Healthcare has been a clear and persistent drag on inflation worldwide, according to Goldman Sachs. The cost of US healthcare rose 2% to 3% annually from 2002 to 2011 before slowing to 1% since, and other major economies have seen comparable declines. The reasons aren’t clear. But nothing else seems to explain the persistent run of inflation below most central bank targets. Globalization, technology and inflation expectations all come up short, according to Goldman, and overheated labor markets will eventually push inflation up. Goldman’s read seems to line up with the Fed. See Goldman Sachs, US Economics Analyst: What Can We Learns from Lower Inflation Abroad?, 12 Nov 2017. (GS, Milepost).

Markets: The shift that could slash 2018 muni issuance
Issuance of muni debt could fall sharply next year if current proposals for tax reform become law. Both House and Senate proposals end several forms of muni issuance including advance muni refundings, used to retire callable debt before the call date. Advance refundings constituted 25% of total 2016 muni supply. According to Barclays, total muni supply could drop nearly 33% from $400 billion this year to $270 billion next. Tax-exempt supply could drop 50% from $360 billion to $180 billion. The potential drop in issuance has led to a surge of recent buying and tighter muni spreads. See Barclays, Municipal Weekly: Fading the Rally…For Now, 10 Nov 2017. (Barclays, Milepost).

Markets: The new lender of last resort: FHA
Homeowners that have used finance companies in recent years to get mortgage loans guaranteed by the Federal Housing Administration are defaulting at 2- to 3-times the rate of similar borrowers from banks. FHA loans originated in 2014-2015 by finance companies from borrowers with FICO scores below 650, for instance, have cumulative 90-day or longer delinquencies of 11% while similar borrowers from banks come in around 3%.  Finance company borrowers with scores between 726 to 750 show cumulative delinquencies of nearly 2% while bank borrowers show less than 1%. Finance companies seem to be lending to riskier FHA borrowers, and with finance companies now originating nearly 75% of all FHA loans, credit risk at FHA is rising. That is one important reason that FHA may have little or now room to lower borrower mortgage insurance premiums and may have reason to raise them. See Morgan Stanley, Agency MBS Weekly, 10 Nov 2017. (MS, Milepost).

Markets: A Nobelist’s view of low volatility
Whether it’s the daily volatility of S&P returns, the VIX or other measures, stock market volatility is near its lowest levels in decades. But Nobel Laureate Robert Shiller might not be worried. The VIX lately is running around 9-10% while its average since 1990 is 20%. The Fed and other analysts have worried that a sharp reversion to the mean could slash S&P valuation by 5-10%. But Shiller, winner of the 2013 Nobel Price in economics, might argue that volatility is fine right where it is. Shiller has pointed out that a stock’s value is nothing more than the discounted value of its expected dividends, and the volatility of dividends since the 1950s has been about 7%. Other ecoomists argue that low volatility, investor complacency and higher leverage could pose risks to financial stability. The NY Fed digs into Shiller’s case and others’ in this recent post. (NY Fed, Milepost).

Markets: The quiet buyer of MBS: REITs
The top real estate investment trusts added $26 billion in agency MBS from July to September, the biggest REIT buy of MBS since 2012. The top 15 REITs raised $3.5 billion in equity and boosted their overall leverage ratio to 7.6x, with agency MBS often leveraged more. The REITs raised capital as price-to-book ratios climbed over 1.0, although the ratio for the largest has fallen below 1.0 lately. Interest rate exposure dropped slightly while option exposure rose. See JPMorgan, US Fixed Income Markets Weekly: Interest Rate Derivatives, 10 Nov 2017. (JPM, Milepost).

We’ll be back the week of November 27. Happy Thanksgiving!