Current Market conditions this week. this blog will hopefully help you understand what drives the mortgage market
Current Trend Direction: Lower
Risks favor: Very Carefully Floating
Current Price of FNMA 3.5% Bond: $100.53, -19bp
Risks favor: Very Carefully Floating
Current Price of FNMA 3.5% Bond: $100.53, -19bp
Mortgage Bonds are trading lower on what appears to be a changing sentiment towards the risk of deflation.
For months there has been an ever-growing fear that our economy is headed towards deflation…where prices on goods and services are falling lower, rather than climbing higher, which is of course, inflation. These fears of deflation have helped Bond prices move sharply higher, as the fixed payment that a Bond provides to an investor goes further - or purchases more goods and services - in a deflationary environment.
But just in the last 24 hours, future deflation/inflation expectations have changed…and investors in the Bond market are now betting that the Fed will be successful in "creating inflation" via their Quantitative Easing plans, and will thus avoid continuing down a deflationary road. This was highly evidenced by the results of yesterday's 5-Year Treasury Inflation Protected Securities (TIPS) auction.
For the first time in history, the TIPS were sold with a negative yield. You read it right, a negative yield, specifically at -0.55% for yesterday's 5-Year TIPS. This is a very important development, so let's break down how this works and what it means. Investors pushed the price of the 5-Year TIPS to $105.50 for every $100 or "par value" of the securities, and this is what resulted in the -0.55% yield. Now think about it…if inflation stays low for the next five years, the fixed interest rate payments of 0.5% that these TIPS would normally pay over the course of five years would not be enough to repay the principal of $105.50 that was paid yesterday at the auction. So why would an investor in 5-Year TIPS bid up the price, and accept a negative yield?
Because TIPS investors are compensated at a higher amount based on an increase in consumer prices - that is the whole point of buying "Inflation Protected Securities." The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. And when a TIPS matures, the investor is paid the adjusted principal or the original principal, whichever is greater. So the fact that buyers actually were willing to pay a premium means that they strongly feel that the Fed will be successful in sparking inflation. For example, investors in yesterday's auction only need to see 1.5% inflation per year over the next five years to break even. To put it in perspective, inflation has risen about 3% per year since 1926.
So think about it - the media has been chattering about how the Fed has to be careful not to let inflation get "out of control" in the coming months and years. In fact, just this morning, there was a headline talking about how another round of Quantitative Easing (QE2) brings the risk of "unleashing 1970s inflation genie". Boy, has the outlook on inflation changed dramatically in the past 24 hours! So if inflation is expected, the unusual TIPS auction makes sense…and so does the decline we are seeing in Mortgage Bonds, which hate inflation.
There has been a lot of concern expressed about inflation over the past year, because many realize that inflation can grow very quickly, even from low inflation levels like we have presently, and is very hard to control once the inflation genie is indeed "out of the bottle." It seems like the media has finally woken up to the fact that inflation is a real concern…just as the Fed is getting the money printing presses warmed up, and will likely turn the switch on following their meeting on November 3rd.
Use this as an opportunity - talk to your prospects, clients and referral partners, and let them know what has happened over the past 24 hours. Those who are thinking that home loan rates will be moving significantly lower following the November 3rd Fed announcement may be deeply disappointed.
And if inflation weren't enough to beat up the Bond market, a report from Merrill Lynch said that the firm is trimming some of their MBS holdings, believing the current strength in Mortgage Bonds is "overdone."
In other news, the Treasury will sell $35B in 2-Year Notes today with the results to be released at 1:00pm ET. It will be interesting to see how this auction fares given yesterday's TIPS results, and the sharp decline in the rest of the Bond market over the past 24 hours.
The lagging Case Shiller Index showed that home prices for 20 metropolitan areas fell 0.3% month over month from July to August. This follows a 0.6% gain in July. The Index rose 1.7% year over year in August, down from the 3.2% year over year reading in July. This was not a great report, but even the negative news was unable to help Bonds, which are responding to the more important inflation story.
Consumer Confidence was reported at 50.2, which was better than expectations of 49.0. This helped Stocks and kept the selling pressure on Bonds.
This morning's "gap lower" or lower opening from the previous day's close shows the increased selling pressure on Mortgage Bonds before the opening of trading, meaning Bond sellers outnumbered Bond buyers in pre-market action, and prices had to be lowered just to attract new buyers at the open. This is not a good technical signal and may suggest further weakness.
Hopefully yesterdays Alert to Lock helped you avoid the sharp price erosion of the past 24 hours. However, with the pricing damage already done, on new transactions we can start the day floating, but very carefully. Today's auction results at 1pm ET could cause Bonds to move another leg lower.
