Top of the Street: Reading the Fed's mind, rising mortgage refi risk

GS on the Fed’s flirtation with the idea of secular stagnation, CS, JPM and MS on rising MBS refi risk and contributions from the NY Fed on fed funds markets and consumer expectations. 

Markets: The Fed’s falling view of rates in the long run
The market has priced the Fed to a long and low path with the probability of a hike before the end of 2017 barely above 50% for now, and the Fed may be seeing the world the same way. Signals of a changing Fed view comes wrapped in the vapors of academic debate about the neutral rate of interest, the one that keeps growth and inflation at just the right levels. The Fed view of that rate, captured in the Fed’s dots, has dropped 125 bp in recent years to a nominal 3.0% or just 1.0% in real terms. That may drop further. “Recently, Fed officials appear to have become increasingly sympathetic to the secular stagnation view,” writes Goldman Sachs. That could bias the Fed against higher rates, according to Goldman, since tightening too soon could push the economy into recession. Tightening too slowly, on the other hand, could easily be reversed. Rather than watch inflation, which Goldman argues would still remain low even if the Fed held rates down for too long, the labor market may offer the Fed a better signal about when to tighten. A summary of the case for secular stagnation by Larry Summers is here. See Goldman’s US Economics Analyst: The Fed’s New Take on Neutral, 08 Jul 2016. (GS, Milepost).

Markets: Rising MBS prepayment risk
The recent dip in mortgage rates to historic lows has sent the Street scrambling to map changes in MBS prepayment risk. The average rate on a new 30-year mortgage touched 3.35% last week, according to Credit Suisse, within basis points of the historic lows of 2012 and 2013. That gives good refinancing incentives to 78% of the loans backing outstanding agency MBS, by CS calculations, and by August or September should spur a 25% to 30% surge in gross MBS issuance. Ginnie Mae MBS backed by loans to US veterans may be especially at risk since those loans often refinance quickly for reasons revisited by Morgan Stanley. Pricing in specified pools, which usually prepay more slowly than average, has also jumped sharply. Lower rates, a flatter yield curve and more prepayment risk in TBA pass-throughs, according to JP Morgan, have all helped the specified pool rally. See Credit Suisse’s MBS Quick Notes, 05 Jul 2016, JPMorgan’s US Fixed Income Weekly, 08 Jul 2016, and Morgan Stanley’s Agency MBS Weekly, 08 Jul 2016. (CS, JPM, MS, Milepost).

Markets: The changing market for fed funds
The structure of the fed funds market has changed dramatically since the 2008 financial crisis, according to analysis posted Monday by the NY Fed. Borrowing in the fed funds markets has tumbled from more than $250 billion before the crisis to roughly $50 billion lately as bank reserves have climbed. Foreign banking organizations have become the biggest borrowers with a 65% share followed by bank holding companies at roughly 30%. Since US banks pay FDIC deposit fees when they borrow and FBOs don’t, that may explain part of the shift. And the biggest lender has become the FHLBanks, with their market share going from 52% before the crisis to 80% lately. It seems like the fed funds market has become something of a side show in monetary policy. (Milepost). 

Market: Shrinking CMBS, steady spreads
Private CMBS issuance this year is on track for around $60 billion, according to Credit Suisse, after $110 billion last year. Dealer inventory of private CMBS also has dropped to roughly half of last year’s. The capital markets are likely loosing share to aggressive underwriting by banks and insurers. The light supply is helping CMBS spreads, CS notes, including recent tightening in spreads from wider post-Brexit levels. Low rates should help CRE credit since valuations improve and refinancing becomes easier. The new risk in the London real estate markets also could also draw a few more international real estate investors into the market. See Credit Suisse’s CMBS Market Watch, 07 Jul 2016. (CS, Milepost).

Economy: Mixed consumer expectations for inflation
Consumer expectations for inflation a year from now dropped by 8 bp to 2.54% from May to June while expectations three years out rose by 13 bp, according to the NY Fed’s latest Survey of Consumer Expectations released Monday. Expectations a year ahead have been drifting down since the survey started in mid-2013, something the Fed has noted in its efforts to get inflation back up to target levels. (Milepost).