Top of the Street: Volatility, debt ceilings, budget brinksmanship and hurricanes

August never seems to be dull. Rate volatility has edged up, and debate over debt ceilings and budgets along with Fed action should tip it up further in September. Harvey should shape prepayments and defaults in MBS. Contributions from GS, JPM, S&P and Milepost.

Markets: Volatility edges up from a 30-year low
The US yield curve has flattened this month with 2-year Treasury rates dropping 2 bp and 10-year rates down 17 bp.  Yields at the short end have been held up by the risk of hitting a debt ceiling in October and by the Fed’s potential hikes. The long end has rallied on rising political risk, including the fading prospects of US tax reform. Despite the drop in longer rates, the future rate volatility implied by options is up only slightly after hitting a 30-year low on Aug 7. Volatility stands to edge up further in Sep as the debt ceiling, debate over the federal budget and the Fed’s first steps to trim its securities portfolio all come into play. (Milepost).

Markets: The market prices for a debt ceiling
Treasury bills maturing just after the US could hit it’s debt ceiling in early to mid-Oct now trade 10 bp to 15 bp wider than debt maturing before or after – the pricing on maturities beyond Oct implying that Washington would eventually fix the problem. Congress has only 12 working days between returning from recess on September 5 and the Oct 1 start of FY18 to pass a new budget and raise the debt ceiling. Most analysts expect both to happen after some brinksmanship; a debt ceiling debate has never led to a default before. But a default on repaying principal would affect not just Treasury yields but would trap cash and make the defaulted issue ineligible as collateral in the repo markets. That’s undoubtedly part of the best explanation for the weaker pricing in the Oct issues. Beyond default, the market could see other effects of debt ceiling brinksmanship: a delay in the scheduled Sep 29 reopening of 2-year FRNs and 10-year TIPSs, a rise in repo rates and haircuts for some Treasury issues, See JPMorgan, Q&A on US Treasury Technical Default, 21 Aug 2017. (JPM, Milepost).

Markets: Budget brinksmanship could delay government data
Although House Speaker Paul Ryan has argued that no one is interested in a government shutdown, he may want to check with the White House. The president has threatened to shut down the government unless the FY18 budget includes funds for a border wall. Some analysts expect Congress to meet an Oct 1 budget deadline or else pass a continuing resolution to fund the government until it can agree on a budget. Goldman puts the odds of a brief shutdown at 50%. Budget brinksmanship has shut the government down as recently as Oct 1 to 16, 2013, which delayed several government economic reports and shifted the reporting schedule for several months. See JPMorgan, US Fixed Income Markets Weekly: Cross Sector Overview, 25 Aug 2017 and Goldman Sachs, US Economics Analyst: Fiscal Showdowns and Government Shutdowns, 25 Aug 2017. (GS, JPM, Milepost).

Markets: Harvey likely to trigger MBS defaults
The flooding in Texas from Hurricane Harvey will likely drive up mortgage defaults in an area with limited insurance for covering flood damage. MBS issued by Fannie Mae in the last three years has included 2.4% of its principal in Houston, Beaumont, Corpus Christi and Victoria, which have been heavily affected by Harvey.  Freddie Mac has drawn 2.1% of its recent issuance from those areas. Defaults stand to drive up prepayments in Fannie Mae, Freddie Mac and Ginnie Mae MBS over the next six months and drive up losses in the Fannie Mae and Freddie Mac credit risk transfer deals. Agency multi-family MBS and Home Equity Conversion Mortgages or HECM MBS could also see effects. See See JPMorgan, US Fixed Income Markets Weekly: RMBS Credit Commentary, 25 Aug 2017. (JPM, Milepost).

Markets: Corporate debt fundamentals keep improving
Corporate revenues and earnings continued to improve in the second quarter led by commodity related sectors, according to JPMorgan’s review of recent earnings. Profit margins improved and management generally was positive on prospects for the rest of the year. Management guidance and a weakening US dollar should improve credit further, the bank’s analysts wrote. That said, Corporate leverage still remains well above historical levels and interest coverage did not improve, even with the improvement in EBITDA. See See JPMorgan, US Fixed Income Markets Weekly: Corporates, 25 Aug 2017. (JPM, Milepost).

Markets: Mortgage applications keep falling despite low rates 
The Mortgage Bankers Association’s weekly report this morning showed that purchase applications fell 3% w/w in the week ending August 25. Refinance applications also fell last week, down 2% w/w, amid a 1 bp w/w drop in the 30-year mortgage rates to 4.11%. (S&P, Milepost)