Top of the Street: A march, a mystery, a BEATing on taxes and more

The Fed takes a dovish final bow. LIBOR jumps as banks temporarily trim lending. Tax reform could BEAT foreign banks. DQs rise in PR. And a read on politics and economics. Contributions from Barclays, JPM, MS, NY Fed and Milepost.

Markets: The Fed marches on. Cautiously.
The Fed last week hiked as expected and raised the cap on monthly portfolio runoff, but concern about inflation led it to signal only three more hikes in 2018. Some analysts had expected four. The Fed’s had an upbeat take on both the labor market and economy seemed less convinced that inflation will move closer to the 2% target. Core inflation for November came in at a weak 0.12%. Core PCE inflation is likely to come in this week at a year-over-year pace of 1.5%. Chair Yellen also so made some notable comments that future yield curves could be flatter or more frequently inverted than in the past. See JPMorgan, US Fixed Income Markets Weekly: Economics, 15 Dec 2017. See also Morgan Stanley, Global Interest Rate Strategist, 15 Dec 2017. (JPM, MS, Milepost).

Markets: LIBOR’s mysterious rise
The cost of short-term funding almost always rises at the end of each quarter as banks trim lending to reap a wide range of benefits from a smaller balance sheet, but the rise this quarter is especially sharp. LIBOR and other funding rates have jumped even after accounting for the recent Fed hike, and sharp cuts in lending from the eight US global systemically important banks may be to blame. These banks will have to set aside a capital surcharge in 2019 based on their balance sheet at the end of 2017. The capital surcharge depends on a score that includes size, complexity, international activity, connections to the rest of the financial system and short-term wholesale funding. Many of these banks are on the edge of scores that would push up their capital surcharge by 50 bp, so there is clear incentive to pull back. Reducing funding is one flexible way. Steady demand for funds with falling supply has pushed up rates, but that will likely reverse after the New Year. See JPMorgan, Making sense of Libor’s mysterious rise, 14 Dec 2017. (JPM, Milepost).

Markets/banking: Tax reform could BEAT foreign banks
Measures in the pending tax reform bill designed to stop a form of tax arbitrage could hurt foreign banks’ business in the US. The measure, the Base Erosion Anti-Abuse Tax or BEAT, targets the strategy of having a parent in a low-tax country make a loan to a US affiliate that allows the affiliate to deduct interest and reduce taxable income. Under the Senate version of BEAT, a bank’s gross interest payments to a foreign parent or affiliate would trigger an additional tax. The Institute of International Bankers or IIB, representing foreign banks in the US, has argued for the House version, which would tax the smaller net interest payments to foreign affiliates. The IIB argues that the Senate version is punitive and would hurt foreign bank lending, especially in the repo market where eight of the 10 largest lenders are foreign banks. JPM, US Fixed Income Markets Weekly: Short-Term Fixed Income, 15 Dec 2017. (JPM, Milepost).

Markets/economy: Puerto Rico’s homeowners roll further into delinquency
While an initial wave of mortgage delinquencies after Hurricane Maria appears to have peaked, a rising share of Puerto Rico’s homeowners are rolling further past due. The share of Puerto Rico loans running 30 days delinquent surged from less than 5% before the storm to 22% in October before dropping to 9% last month. Loans running 60 days delinquent jumped from 5% in October to 16% last month. And loans 90 days delinquent jumped from 3% before the storm to 7% last month. This is all based on Ginnie Mae data. Tax reform also may add to the pain. Both House and Senate versions included a foreign import excise tax that would apply to Puerto Rico manufacturers exporting to the US. That could squeeze the island’s economy. See JPM, US Fixed Income Markets Weekly: Agency MBS, 15 Dec 2017. See also Barclays, Municipal Weekly: Rate Hikes and Tax Cuts, 15 Dec 2017. (Barclays, JPM, Milepost).

Markets/economy: Politics shapes expectations but not economics
The last presidential election improved both Democrat and Republican expectations about household finances and the economy but had no detectable effect on actual spending so far, according to a newly released NY Fed study. Counties that voted Democrat generally had a more optimistic outlook before the election, but optimism in counties that voted Republican surged ahead after the election. Expectations have fallen since, especially in Republican counties. Nevertheless, “the election had little partisan impact on spending,” according the the NY Fed. The NY Fed study is here. (NY Fed, Milepost).

Top of the Street: Reasons for short rates to rise this week, banks stockpile liquid assets, Ginnie Mae disappoints

The Fed gets its last hurrah for 2017. Banks look liquid. Ginnie Mae looks weak. Contributions from JPM, MS and Milepost.

Markets: Lots of reasons this week for short rates to rise
The Fed should hike this week, and it has a 50% chance of using its dots to signal four hikes in 2018 instead of three. Also look for the Constitution Avenue crew to announce a drop in it’s portfolio by as much as $20 billion a month starting in January, up from $10 billion currently. The US debt ceiling, which Treasury hit last Friday, may also nudge up short rates. Treasury can use $286 billion in extraordinary measures to fund the government through March. But it also will need to issue a steady supply of bills. The curve should almost fully flatten by the end of next year. See JPMorgan, US Fixed Income Markets Weekly: Treasuries, 8 Dec 2017. (JPM, Milepost).

Markets/banking: Banks stockpile liquid assets
The biggest US banks hold more than enough liquid assets to meet current bank liquidity rules, according to recent filings, which should help them weather Fed tightening. The eight largest hold $2.37 trillion in high quality liquid assets or 124% of the amount needed to cover the cash expected to leave the bank in regulators’ stress scenario. Nearly 85% of the liquidity portfolio sits in reserves held at the Fed, US Treasury debt or Ginnie Mae MBS. Another 15% is held in Fannie Mae or Freddie Mac MBS and less than 1% in other assets. As the Fed let’s its portfolio run off and starts to draw down reserves, the banks seem to have a sizable cushion for meeting liquidity rules. See JPMorgan, US Fixed Income Markets Weekly: Agency MBS, 8 Dec 2017. (JPM, Milepost).

Markets: Ginnie Mae disappoints
MBS investors hoping that Ginnie Mae would solve its recent prepayment problems were disappointed last week, and prices on the most sensitive Ginnie MBS dropped 8/32s to 16/32s below Fannie Mae. The agency announced new measures to dampen speeds in new pools, but the measures looked light. Speeds in new Ginnie Mae pools have been rising quickly in recent years, and the agency in December 2016 stopped originators from pooling loans that went through a streamline refinance within their first six months. That only delayed the prepayments. Last week Ginnie Mae extended that rule to cashout refis starting April 1. The agency also will add prepayment performance to a scorecard it calculates for each issuer, but there’s no clear enforcement mechanism for poor scores. It will also limit the pooling of loans with rates well above average. Much of the problem seems to be coming from VA loans, but Ginnie Mae has left it to the VA to apply a tangible benefit or fee recoupment test to refinanced loans, and VA has provided no public guidance. See Morgan Stanley, Agency MBS Weekly, 8 Dec 2017. See also JPMorgan, US Fixed Income Markets Weekly: Agency MBS, 8 Dec 2017. (JPM, MS, Milepost).

Markets: Eight things you need to know to trade fixed income in 2018
If you missed last week’s summary of key themes in the Street’s annual 2018 outlook gaze into the future, see our post for Mon, 4 Dec 2017. It’s there, hundreds of pages reduced to a few bullets. Brought to you by Milepost.

Top of the Street: The eight things you need to know to trade fixed income in 2018

The Street has started delivering its annual gaze into the future, with some running more than 400 pages. Although much of it seems like a forced march through every possible topic in every possible market, there are nuggets of insight. Here is what you need to know, with contributions from Barclays, DB, GS, JPM, MS and Milepost.

1. The economy: growth, but rising risk of recession
The Street is looking for real GDP to run between 2.0% to 2.5%. Strong consumer spending and business investment lead the way with modest growth in housing and government spending and little from trade. Tax reform and post-hurricane rebuilding edge the numbers up slightly. Unemployment drops toward 3.5% and wage pressure helps push inflation toward the Fed’s 2.0% target. Of course, no one seems to have a good explanation for the low inflation of 2017, so that should temper any confidence in inflation predictions for 2018.

Beyond 2018, the risks of recession start to rise if the labor market keeps heating up and the Fed needs to cool things off with more tightening. Both the Fed and fiscal policymakers could find their options limited. The Fed could push funds a few percentage points above zero, but that’s not much room to ease by historical standards. And both the House and Senate tax bills would add a net $1 trillion to deficits over the next 10 years, taking national debt as a share of GDP from 80% currently toward 100% by 2030. Rising debt could limit any new fiscal stimulus. Constraints on monetary and fiscal policy could make it harder to climb out of the next recession.

2. The Fed: up in rates, and out of QE
The Fed hikes once a quarter next year or possibly more, according to consensus, although that seems to depend on a credible rebound in inflation. The Street’s economists seem to expect that rebound, but a little humility might serve well here. Inflation for now is a puzzle, and the market is pricing in less than two hikes. The truth is probably somewhere between the economists and the market. Uncertainty around inflation is a clear risk. The Fed’s exit from QE also picks up steam until as much as $50 billion a month is rolling off in the fourth quarter.

3. Rates: flat and stable
The yield curve flattens significantly in 2018, with 2-year rates rising as much as 85 bp and 10-year rates going up by only half that amount, according to JPMorgan. The Fed and heavy new Treasury supply help push up short rates while expectations of modest inflation and low real growth keep longer rates stable. Implied forward rates have the 2-year up a more modest 30 bp and 10-year up 15 bp. But Morgan Stanley expects inflation to continue running below the Fed target by 30 bp to 60 bp and the 10-year rate to finish around 2.00%.

The outstanding balance of Treasury debt rises by more than $1 trillion, mainly in 5-year and shorter maturities. The spread between the swap and Treasury curves narrows inside the 5-year mark. The outstanding balance of Fannie Mae debt drops by $15 billion and Freddie Mac by $30 billion while outstanding Federal Home Loan Bank debt rises by $65 billion.

Volatility, after sinking to historic lows in 2017, stays low or drops further. Limited economic surprise, reasonable liquidity and programmatic selling of options by portfolios that need income suppress any bounce to higher volatility.

4. Credit: stronger and tighter
Another year of tighter spreads on US corporate debt will owe thanks to rising GDP, rising corporate earnings and higher yields on US than on Euro corporate credit. Rising earnings should help credit quality by trimming leverage and lifting interest coverage. Buying of investment grade Euro credit by the European Central Bank into mid-2018 should help, too. But spreads are already tight, so opportunity is limited. Investment grade, high yield, leveraged loan and CLO markets all grow. A surge in supply from M&A or slowing growth, however, could sting.

5. MBS: replacing the Fed
Nothing matters more in this market than the Fed’s shrinking agency MBS portfolio. More than $150 billion should flow out of the Fed next year. Combined with natural growth of around $250 billion in outstanding MBS, conventional wisdom calls for wider mortgage spreads. But conventional wisdom has been wrong so far, with tighter spreads since the Fed officially announced its exit. Banks and REITs have taken up the Fed’s slack. That could continue, with mutual funds joining the parade if spreads on corporate debt continue to narrow. The best predictor of risk-adjusted MBS spreads in 2018: exactly where they are now.

Fannie Mae and Freddie Mac credit-risk transfers should continue feeding demand for fresh RMBS credit exposure, with securitization of non- and re-performing loans complementing the risk transfers. Home prices look reasonable, up from their 2009 low by 40% while commercial real estate has jumped 85%. Rising prices have generally tracked rising income. However, studies by the Cleveland Fed and PwC estimate that reductions in the mortgage interest deduction could cut home prices in some metro areas by as much as 10%. Recent tax legislation, which cuts the deduction, could soften the resi credit markets next year and beyond.

6. CMBS: adjusting to the new retail
Changes in the retailing business should matter to CMBS in 2018 since loans to malls season many of the private deals. Brick-and-mortar malls are under attack. Loans secured by retail properties hurt private CMBS performance in 2017. Expect more pain in 2018.

More broadly, prices on office, industrial, retail and apartment properties stand 20% or more above pre-crisis peaks. Property income has been strong and growing, interest rates low and most alternative investments expensive, so higher prices are not unreasonable. But, with many assets, the margin for error is small.

The CMBS backed by Fannie Mae, Freddie Mac and Ginnie Mae now have $500 billion outstanding, well above the $350 billion in outstanding private CMBS. Agency CMBS includes more affordable apartment building than the private market, and agency occupancy rates are near 95%. Agency CMBS issuance should keep outpacing private. Agency CMBS outperform private.

7. ABS: the strong consumer
Spreads in credit card, auto and student loan deals last year reached the tightest levels since the 2008 financial crisis, and the Street expects stable or possibly even tighter spreads in 2018. Household debt-to-income has dropped since the 2008 financial. Home prices are up, unemployment down. Steady economic growth and even lower unemployment next year should support stable-to-tighter spreads on consumer debt. The risks to the consumer rise as the risks of recession pick up beyond 2018.

8. Municipal debt: tested by tax reform
Tax reform reshuffles the muni debt market in 2018. Elimination of advance refunding of muni bonds drives issuance down by 10% to 20%, and spreads tighten. Elimination of deductions for state and local taxes raises concerns about the credit of high-tax issuers as those areas face a higher local cost of living, less disposable income and cloudy prospects for population growth. Local demand from wealth investors for the debt from high-tax issuers nevertheless surges. Lower corporate taxes cut demand for muni debt from banks and insurers, which currently hold 23% of the market.

For more detail on these and other themes, please see the following: Barclays, 2018 Municipal Outlook: Opportunity Knocks, 1 Dec 2017; Deutsche Bank, The Outlook: MBS and Securitized Products, 21 Nov, 2017; Goldman Sachs, US Economic Analyst: 2018 Outlook: Too Much of a Good Thing, 17 Nov 2017; Goldman Sachs, 2018 US Housing and Mortgage Outlook, 21 Nov 2017; JPMorgan, US Fixed Income Markets 2018 Outlook, 22 Nov 2017; Morgan Stanley, 2018 Global Rates Outlook: Toward the First Flat Curve, 1 Dec 2017; Morgan Stanley, 2018 Global Securitized Products Outlook: Cherry Picking, 27 Nov 2017.