Top of the Street: Shifting views on rates, an FOMC preview, MBS risk, GSE reform, retail CRE and bank CLOs

Some rate expectations rocket, others reverse. The FOMC stars this week. Risk rises in MBS. GSE reform resurfaces. Retail CRE looks weak, bank CLOs look strong. Contributions from DB, the NY Fed, GS, JPM and Milepost.

 Markets: A sudden call for 10-year rates at 3.60%
The rate on US 10-year notes could finish the year at 2.75% and reach 3.60% by mid-2017, according to Deutsche Bank, just one week after the firm argued that it was “hard to justify on fundamental ground 10-year yields above 2.50% in the short run.” The bank now argues that the market will not know the actual amount and impact of fiscal stimulus until late 2017 or early 2018 but will likely trade in advance as if the new administration will deliver on all promises. That would set the market up for a rally to lower rates late next year, assuming modest growth and low inflation persists. At the very least, the bank’s sudden change highlights the risk as the market adjusts to the emerging US political landscape. See Deutsche Bank’s US Fixed Income Weekly, 10 Dec 2016. (DB, Milepost).

Markets: Short 10s
Speculators these days have almost never been as bearish on US 10-year rates. The CFTC Commitment of Traders Report indicates that speculators have run up their largest short position in ED and Treasury futures since at least 1997 and are short by nearly three standard deviations based on the 1-year average, according to JPMorgan. In contrast to Deutsche Bank, JPMorgan reads the numbers as bullish for Treasury debt since speculators arguably have little room to short the market further. That’s what makes markets. See JPMorgan’s US Fixed Income Markets Weekly, 9 Dec 2016. (JPM, Milepost).

Markets: Fed preview
Unlike the markets, the FOMC is likely to put aside prospects for fiscal stimulus at its meeting this week and anticipate only two hikes in 2017. A higher US dollar could prompt projections of marginally lower inflation and GDP for next year. The FOMC’s long-term dots, which signal where the Fed might stop hiking, should come in low or lower than September. Markets have matched the FOMC’s dots for 2017 but fall 40 bp below Fed expectations for 2018 and 80 bp below 2019. See JPMorgan’s US Fixed Income Markets Weekly, 9 Dec 2016. (JPM, Milepost).

Markets: Rising rate risk in mortgages and MBS
Banks and other holders of mortgage risk need to keep their eye on interest rate exposure, which goes up, of course, as rates rise. The duration of outstanding MBS has more than doubled since July – 2.2 years then, 4.6 years now, according to Goldman Sachs. Around 70% of agency mortgage borrowers had clear incentives to refinance in July, but only 35% now. The likely decline in origination of ARMs and 15-year loans should extend duration further if rates stay here or go higher. Every portfolio needs to watch the impact on capital. See Goldman Sachs, The Mortgage Trader, 9 Dec 2016.

Markets: New life for GSE reform
Treasury Secretary-designate Steve Mnuchin gave new life to GSE reformers when he told Fox News on November 30 that getting Fannie Mae and Freddie Mac off the government balance sheet was a Top 10 priority for the incoming administration. Exactly what that means, however, is anyone’s guess. Two reform proposals with heavyweight backing wait in the wings in Washington. One comes from former aide to Sen. Bob Corker (R-TN), Michael Bright, and former FHFA Director Ed DeMarco, both now at the Milken Institute. The Milken proposal would use the architecture of Ginnie Mae to rebuild the system. Another proposal comes from Jim Parrott, Lewis Ranieri, Gene Sperling, Mark Zandi and Barry Zigas, who work for various policy advisers. Their proposal would build on the current direction of Fannie and Freddie. Both proposals have broad areas of overlap but differ in governance and control. The Bipartisan Policy Center convened a December 2 meeting in Washington of senior mortgage finance policy analysts from government and industry to discuss the possibilities. The Milken proposal is here. The Parrott proposal is here. (Milepost).

Markets: Retail CRE
Retail commercial property prices have lagged other sectors for much of the last five years, but the trend has worsened recently. Retail prices dropped 1% over the last two months as apartment and office prices rose 2% to 3%, according to Goldman Sachs. CMBS loans backed by retail have had the highest cumulative losses compared to other property types for the 2005-2007 vintages. The stress in retail reflects continuing pressure from ecommerce but also a consumer shift away from the department stores that anchor many malls and shopping centers – urbanization taking suburban shoppers away and income disparity splitting the market in to the very high and very low ends. Credit Suisse estimate that 78 million square feet of retail space has closed this year, the highest since 2008. Retail constitutes 30% of 4Q16 CMBS collateral. There is some hope. The best malls in major markets have the best prospects, according to Credit Suisse. There’s also promise from attracting new anchor tenants that offer experience rather than goods – entertainment, exercise, sports, restaurants and more. See See Goldman Sachs, The Mortgage Trader, 9 Dec 2016, and Credit Suisse, 2017 CMBS Year Ahead Outlook, 9 Dec 2016. (GS, CS, Milepost).

Markets: CLOs managed by banks may have the upper hand
CLOs managed by groups from the same bank that arranged some of the underlying leveraged loans seem to lower their exposures to distressed loans sooner and faster than unaffiliated managers, according to the NY Fed. “While this behavior may suggest that these CLOs have an informational advantage,” the NY Fed writes, “the fact that they continue to sell off their investments in distressed loans even after default may instead indicate that they are actively seeking to mitigate reputational risk. Thus, CLOs affiliated with banks appear to be different from the other CLOs in that they adjust their trading strategies and risk appetite in order to be compatible with the generally more conservative goals of their bank organization.” The NY Fed post is here. (Milepost).