Top of the Street: Holiday rates, MBS tapering (or not) and tax reform

Rates roll forward while the Fed waits to see. Proposals for tax reform start to take shape. A small twist in investor lending. Contributions from JPM, GS, Corelogic.

Markets: Rates
The Fed, tax reform and fiscal spending all continue to get priced in the rates markets. The Fed last week laid out its expectations for a tighter labor market and three rate hikes next year while the market continued to price a little closer to two. The FOMC’s expectations for long-run fed funds edged up from 2.9% to 3.0%. Little else changed. JPMorgan meanwhile joined Deutsche Bank in expecting rates to reflect high expectations for tax reform and new fiscal stimulus at least until the new administration hits the ground. JP revised its forecast for 10-year rates at the end of 2017 to 2.85%, which is roughly where the implied forward rate stands. But with Fed expectations for equilibrium funds at 3.0%, it’s hard to see rates running much higher. See JPMorgan’s US Fixed Income Markets Weekly, 16 Dec 2016. (JPM, Milepost).

Markets: No tapering in MBS, yet
The Fed has said it before and said it again last week: it will consider letting its $4.2 trillion portfolio run off only “once normalization of the federal funds rate is well under way.” The Fed currently reinvests $40 billion a month in MBS, although JPMorgan expects recent higher rates to trim that volume back to $15-$20 billion. Tapering will likely have to wait until the Fed feels it has ample room to reduce rates if the economy softens. Mortgage spreads would likely widen and rate volatility pick up as more prepayment risk flows back onto private balance sheets. Of course, there’s a twist. Tapering will likely reduce the supply of excess reserves in the banking system, which banks need to meet current liquidity rules. They could reach for MBS, offsetting the impact of tapering on spreads. See JPMorgan’s US Fixed Income Markets Weekly, 16 Dec 2016. (JPM, Milepost).

Markets/banking: New interest in interest expense
The latest passion for tax reform has raised a potentially big issue for banks and other financial concerns: elimination of the deduction for interest expense. Reformers argue that this would fix the current bias for companies to issue debt instead of equity.  For markets, this would likely take a big chunk out of corporate debt issuance. Banks and other financials, however, could get an exemption and pay taxes only on net interest income. The proposal is tied to others that would allow immediate full deduction of capital expenses and ones that would tax goods and services based on where they are consumed rather than produced. In a deep dive on the subject, Goldman Sachs puts the odds of passage next year at 30%. Tax reform in general could have a big impact on growth in late 2017 and early 2018. See Goldman Sachs, Q&A on Tax Reform, 16 Dec 2016. (GS, Milepost).

Markets/banking: A strange new twist in investor lending
A surprising though still small share of new homebuyers are misrepresenting their properties as investments just so expected rental income can count as an asset when the lender calculates debt-to-income ratios, according to CoreLogic. Of 2016 mortgage applications for investor properties in New York, for instance, CoreLogic found that 13% showed signs of this approach. The unusual borrowers tended to have relatively low income and ask for relatively large loans. The CoreLogic post is here.