The 10-year rate has drifted to the low end of fair value as tax reform starts to face opposition, the economy faces stubborn limits on growth, and the Fed faces a leadership shakeup in the next 12 months. Contributions from DB, GS, JPM.
Markets: Fair value on 10-year rates
Fair value on US 10-year rates still looks like it’s in a 25 bp band around 2.50%. With the 10-year closing Friday at 2.31%, we’re at the low end. Chalk that up to potential restrictions on immigration and trade and increasing concern about prospects for fiscal spending and, especially, tax cuts. Opposition is emerging in the Senate to the border adjustment tax, or BAT, that’s central to the tax plan being promoted by House Speaker Paul Ryan. Without the BAT, only a major cut in spending or a hike in personal taxes could fund a corporate tax cut. If only three Senate Republicans defect, it’s back to the drawing board. Nevertheless, recent firming in inflation, strong labor markets and good economic data should keep the Fed on track and rates within the band. See JPMorgan’s Economic Research Note: US: Playing ball without a BAT, 22 Feb 2017, and JPMorgan’s US Fixed Income Markets Weekly: Cross Sector Overview, 24 Feb 2017. (JPM, Milepost).
Markets/economy: Limits on US economic growth
Real economic growth ultimately depends on workforce growth and productivity, and slowdowns on both fronts have hampered US GDP since before the 2008 financial crisis. US labor force participation has dropped three percentage points since then, and some analysts have pinned it on globalization. But Goldman Sachs finds that health and drug-related problems, a high rate of incarceration and limited job retraining and job-search support may have made the US problem worse. Reversing these problems and reinvigorating US growth consequently could take major policy interventions. See Goldman Sach’s US Economics Analyst: The Decline in the US Participation Rate in Global Perspective, 24 Feb 2017. (GS, Milepost).
Markets/economy: The coming shakeup in Fed leadership
The Fed could see a major change in leadership in the next 12 months. As many as five seats could open on the FOMC by then: two empty seats now, Tarullo retiring in April and Yellen and Fischer possibly stepping aside next year when their terms expire. A reconfigured FOMC would see more dissent, more risk premium as potential replacements for Yellen are wide, and a more hawkish and rules-based committee. A Yellen replacement would likely be a market practitioner instead of an academic, more dovish than hawkish and open to Congressional oversight for the Fed. Possible names: Kevin Warsh, Jerome Powell, Randall Kroszner, Lawrence Lindsey, Richard Fisher. John Taylor. Glenn Hubbard, Greg Mankiw. John Cochrane. See Deutsche Bank’s Global Economic Perspectives: The Fed leadership shakeup, 16 Feb 2017. (DB, Milepost).
Markets/economy/banking: Prospects for Fed reform
Legislation proposed in the last Congress and likely to come up again this year could significantly affect the Fed’s independence, transparency and accountability, according to Goldman Sach’s. Proposals include greater Congressional oversight for the Fed, changes in the number and influence of the Reserve Banks, making the Fed budget subject to Congressional appropriations and requiring the Fed to publish and follow policy rules. Although the Fed is widely viewed as independent and transparent, it is more by informal agreement and custom rather than by law. GAO audits and requirements to follow policy rules would reduce Fed independence. The fully implemented legislation would spur the biggest changes to the Fed since 1978. See Goldman Sach’s US Economics Analyst: Fed Reform: Devil in the Details, 17 Feb 2017. (GS, Milepost).
Markets: Investors flock to floaters
The share of corporate debt issued with floating coupons has jumped from 8% last year to more than 16% so far this year. In ABS, the share with floating coupons has jumped from 15% in the same period last year to 23% this year. Investors presumably are listening to the Fed, and this year the market believes the talk. See JPMorgan’s US Fixed Income Markets Weekly, 24 Feb 2017. (JPM, Milepost).
Markets: How slow can MBS go?
With only 20% of outstanding MBS left with real incentives to refinance, thoughts have turned to how slow prepayments might go on the other 80%. JPMorgan thinks the right number is 8-9 CPR for Fannie Mae 30-year MBS backed by loans with 3.50% to 4.00% rates. That drops to around 6-7 CPR for loans with 3.00% rates. Existing home sales as a share of outstanding housing stock backs this up, although the numbers show the Northeast running slow. Borrowers defaulting, paying extra principle or refinancing to take out home equity only a little to basic housing turnover. Smaller loans or loans made to relocating employees can turnover faster. See JPMorgan’s US Fixed Income Markets Weekly: Agency MBS, 24 Feb 2017. (JPM, Milepost).
Markets: The falling share and shifting role of Fannie, Freddie
Fannie Mae and Freddie Mac own the shrinking part of the mortgage lending market with banks taking the higher end and the FHA and VA the low end. That’s the picture painted by the latest data on mortgage originations. The agencies guaranteed 47% of the debt originated last year with banks taking 30% and FHA/VA taking 23%. The agency share is down from a 2009 of 73%. Banks now disproportionately serve jumbo borrowers with the FHA/VA guaranteeing 70% of borrowers with FICO scores below 700. The three channels of mortgage debt are increasingly serving different markets. See Goldman Sach’s The Mortgage Trader: GSE market share below 50% in 2016, 16 Feb 2017. (GS, Milepost).