Fed Minutes Underscores Higher Rates Ahead

The Federal Reserve released the minutes relating to the 26th September decision to lift rates.  The impression from the more detailed disclosures is that more hikes are likely, and perhaps quicker than originally expected.  Members agreed to remove the sentence indicating that “the stance of monetary policy remains accommodative.”

US Mortgage Rates continue higher.

This is what the FED said:

In their discussion of monetary policy for the period ahead, members judged that information received since the Committee met in August indicated that the labor market had continued to strengthen and that economic activity had been rising at a strong rate. Job gains had been strong, on average, in recent months, and the unemployment rate had stayed low. Household spending and business fixed investment had grown strongly. On a 12-month basis, both overall inflation and inflation for
items other than food and energy remained near 2 percent.

Indicators of longer-term inflation expectations were little changed on balance.

Members viewed the recent data as consistent with an economy that was evolving about as they had expected. Consequently, members expected that further gradual increases in the target range for the federal funds rate would be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. Members continued to judge that the risks to the economic outlook remained roughly balanced.

After assessing current conditions and the outlook for economic activity, the labor market, and inflation, members voted to raise the target range for the federal funds rate to 2 to 2¼ percent. Members agreed that the timing
and size of future adjustments to the target range for the federal funds rate would depend on their assessment of realized and expected economic conditions relative to the Committee’s maximum-employment objective and symmetric 2 percent inflation objective. They reiterated that this assessment would take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

With regard to the postmeeting statement, members agreed to remove the sentence indicating that “the stance of monetary policy remains accommodative.” Members made various points regarding the removal of the sentence from the statement. These points included that the characterization of the stance of policy as “accommodative” had provided useful forward guidance in the early stages of the policy normalization process, that this characterization was no longer providing meaningful information in light of uncertainty surrounding the level of the neutral policy rate, that it was appropriate to remove the characterization of the stance from the Committee’s statement before the target range for the federal funds rate moved closer to the range of estimates of the neutral policy rate, and that the Committee’s earlier communications had helped prepare the public for this change.

In choppy trading in the US on Wednesday, it appears the markets are coming to accept higher rates ahead. The Dow Jones Industrial Average fell 91.74 points, or 0.36 percent, to 25,706.68.

The Fear Index eased a little to 17.40, down 1.25%, but volatility still stalks the halls.

The S&P 500 lost 0.71 points, or 0.03 percent, to 2,809.21.

The Nasdaq Composite dropped 2.79 points, or 0.04 percent, to 7,642.70.

The 10-Year Bond rate continued higher ending at 3.207, up 0.88%.

US Banks’ Mortgage Revenue Will Stay Depressed As Interest Rates Rise Further

According to Moody’s, on 11 October, the Federal Home Loan Mortgage Corp. reported that US 30-year fixed-rate mortgage rates reached their highest level since April 2011.

The average rate was 4.90% for the week that ended 11 October, compared with 3.91% a year earlier. For US banks, higher mortgage rates will constrain mortgage origination volume, keeping their once-sizable mortgage banking revenue at depressed levels, a credit negative. Higher interest rates will also heighten the potential that some customers will have trouble servicing their existing debt and could translate into weaker credit quality, a further negative for US banks.

Mortgage banking revenue at US banks has been on a downward trajectory for some time. This reflects both a drop in origination volume and lower gain-on-sale margins. The volume decline has followed a multi-year period during which consumers took advantage of rising home values and historically low interest rates to refinance their mortgages. Now that refinancing volume is at a lower level, home purchases are the source of most current originations.

Reduced gain-on-sale margins reflect heightened pricing competition that resulted from excess industry capacity. Going forward, although volume may not increase because of the climb in interest rates, gain-on-sale margins could rise as industry capacity contracts.

The 12 October third-quarter 2018 earnings reports from some of the country’s largest banks illustrate these trends. As shown in the exhibit below, both Wells Fargo & Company and JPMorgan Chase & Co., the country’s two largest mortgage originators, released results that showed mortgage banking revenue remains at or near multi-year lows. Specifically, at Wells Fargo, although mortgage banking revenue climbed in the quarter, for the nine months that ended 30 September 2018, mortgage banking revenue accounted for 3.9% of total firm-wide revenue, down from 10.5% as recently as 2013. At JPMorgan Chase, mortgage banking revenue declined in the third quarter and, on a year-to-date basis, it accounted for just 1.3% of total firm-wide revenue, down from 5.4% in 2013.

The recent rise in mortgage interest rates makes it unlikely that US banks’ mortgage banking volume and revenue can rebound materially in the next few quarters. However, given that mortgage banking has long been a cyclical business, the banks can improve their profitability by reducing capacity, as they have done in prior periods of lower volumes. Indeed, both Wells Fargo and JPMorgan Chase were reported to have reduced hundreds of positions within their respective mortgage banking units in the past few months. We believe both firms’ recent performance and response are representative of the wider industry trend More broadly, the recent rise in interest rates heightens the potential that some borrowers will have trouble servicing their existing debt, raising the potential of higher loan delinquencies. However, the US economy remains robust and the banks’ latest earnings reports show continued strong credit quality, an indication that higher rates have not yet undermined existing loan performance.

US Markets Get The Jitters

Overnight the US markets took a dive on the back of higher interest rates with the S&P 500 and the Dow marking their biggest daily declines since Feb. 8, and technology stocks at the center as investors jettisoned more risky assets.  Plus, Investors were also worried about the impact of trade tensions on corporate profits and Hurricane Michael’s landfall in Florida adding to the uncertainty.

The U.S. 10 Year Treasury yields rose again in extension of a trend over the last few weeks fuelled by solid U.S. economic data that reinforced expectations of multiple interest rate hikes over the next 12 months.

  It ended at 3.17, down 1.58% on the day, while the 3-month Treasury was up 0.12% to 2.27.

The CBOE Volatility Index (VIX), Wall Street’s “fear gauge,” rose 7 points, or nearly 44 percent, to 22.96, going above 20 for the first time since April 11 and hitting its highest close since April 2.

The Nasdaq ended at 7,422 and registered its biggest daily drop since June 24, 2016, hurt by technology stocks which had their biggest one-day drop since August 2011.

The S&P 100 ended the day down 3.41 percent, to 1,239, nearly 5% off its recent September highs.

The Dow Jones Industrial Average (DJI) fell 831.83 points, or 3.15 percent, to 25,598.74, a reversal from recent highs.

Gold however hardly moved, sitting at 1,198 almost flat for the day.

The Aussie slide further against the US dollar, and is currently silting at 70.59.

Expect more bad news from the local market today as uncertainty reigns supreme.  It’s too soon to tell is this is another blip, of a more fundamental swing in confidence, but we think the higher US rates are the key. So expect more falls ahead.

The local market opened lower.

 

The Great Bond Sell-Off

The US 10 Year Bond has spiked higher, in response to strong employment growth and comments from the FED, suggesting that interest rates in the US could rise faster and further. So we discuss the news.

In short, the global sovereign bond market breadth is looking sick.

The US 10 Year Bond Yield has spiked to 3.195, up 1.06% as I write this, and looks to be set to climb higher, to levels not seen in more than seven years.  The ADP National Employment Report showed private payrolls jumped by 230,000 jobs in September, the largest gain since February, while a report from the Institute for Supply Management showed services sector activity hit a 21-year high in September. Simply put, when the economy is firing on all cylinders and when traders have reason to defend against the possibility of even faster growth and inflation (something today’s data may well suggest), rates are forced to move higher.

Traders now see a 78.8 percent chance of a 25 basis point hike at the December meeting of the Fed, up from 77.4 percent a week ago. In contrast the 3-Month Bound Yield rose only 0.09% to 2.225, so the signs of an inversion have not really changed much.

But it’s worth looking more broadly. Here is an interesting picture, with the red line showing the 200 day moving average breadth of global sovereign bond yields in the developed markets. In other words, it shows what proportion of global government bond yields are trading below their 200 day moving average.

We are seeing fewer and fewer 10-year government bond yields trading below their 200 day moving averages. This suggests that government bond yields will continue to rise. The signs are there. In that context, the US 10-year government bond yield is the bellwether.

But there is something else here too. The US 10-year government bond yield is breaking higher at a time when bond market volatility is tracking around record lows.

Market watchers will tell you that low volatility is a good predictor of future higher volatility. We often see such low volatility around turning points in the markets.

So, putting this all together, it looks like bond yields will be rising higher – with significant consequences for our local banks funding. Already the BBSW has risen to more than 18 basis points from its February lows, having tracked lower recently. The changes in the US 10-Year will flow through into the international capital markets, and on into funding, and local mortgage rates.

US Mortgage rates skyrocketed today, in relative terms.  It was the single worst day in nearly 2 years, and among only a few days where effective rates moved more than 0.10%.

In addition, the Aussie will go lower. The exchange rate with the US dollar has fallen to 70.90, and is likely to fall further. Not only does risk importing inflation into Australia but it also puts more pressure on the RBA to lift the cash rate. Foreign money could well flow out, seeking the higher returns on offer elsewhere.

The big game of thrones in truly in play. And we are left holding the damp end of the stick.

The FED Lifts, More Ahead And What Are The Consequences?

We discuss the implications of the FED move, plus a final look at the 60 Minutes segments on home prices.

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The FED Lifts, More Ahead And What Are The Consequences?
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Fed Hikes As Expected – More To Come…

The Fed moved as expected, and continues to highlight more upward movements in the months ahead – in fact their language is arguably more bullish now.  The target range for the federal funds rate is now 2 to 2-1/4 percent.

In their projection release, they see GDP sliding from 2019….

… while inflation is expected to rise:

Information received since the Federal Open Market Committee met in August indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2 to 2-1/4 percent.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

Voting for the FOMC monetary policy action were: Jerome H. Powell, Chairman; John C. Williams, Vice Chairman; Thomas I. Barkin; Raphael W. Bostic; Lael Brainard; Richard H. Clarida; Esther L. George; Loretta J. Mester; and Randal K. Quarles.

US Unemployment Remains Steady At 3.9%

The US Bureau of Labor Statistics has released their August employment statistics.

Total nonfarm payroll employment increased by 201,000 in August, and the unemployment rate was unchanged at 3.9 percent, the U.S. Bureau of Labor Statistics reported today.

Job gains occurred in professional and business services, health care, wholesale trade, transportation and warehousing, and mining. Household Survey Data The unemployment rate remained at 3.9 percent in August, and the number of unemployed persons, at 6.2 million, changed little.

Among the major worker groups, the unemployment rates for adult men (3.5 percent), adult women (3.6 percent), teenagers (12.8 percent), Whites (3.4 percent), Blacks (6.3 percent), Asians (3.0 percent), and Hispanics (4.7 percent) showed little or no change in August.

The number of long-term unemployed (those jobless for 27 weeks or more) was little changed in August at 1.3 million and accounted for 21.5 percent of the unemployed. Over the year, the number of long-term unemployed has declined by 403,000.

Both the labor force participation rate, at 62.7 percent, and the employment-population ratio, at 60.3 percent, declined by 0.2 percentage point in August.

The number of persons employed part time for economic reasons (sometimes referred to as involuntary part-time workers), at 4.4 million, changed little over the month but was down by 830,000 over the year. These individuals, who would have preferred full-time employment, were working part time because their hours had been reduced or they were unable to find full-time jobs.

In August, 1.4 million persons were marginally attached to the labor force, little different from a year earlier. (Data are not seasonally adjusted.) These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

Among the marginally attached, there were 434,000 discouraged workers in August, essentially unchanged from a year earlier. (Data are not seasonally adjusted.) Discouraged workers are persons not currently looking for work because they believe no jobs are available for them. The remaining 1.0 million persons marginally attached to the labor force in August had not searched for work for reasons such as school attendance or family responsibilities.

Total nonfarm payroll employment increased by 201,000 in August, in line with the average monthly gain of 196,000 over the prior 12 months. Over the month, employment increased in professional and business services, health care, wholesale trade, transportation and warehousing, and mining.

 

 

 

U.S. Non-Bank Mortgage Lender Margins May Fall Further

U.S. non-bank mortgage lenders may face further margin pressure as interest rates continue to rise owing to higher funding costs relative to banks with lower-cost, stable depository funding, Fitch Ratings says.

Profitability metrics for non-bank mortgage lenders are generally weak, with expenses outstripping net revenues by approximately 21% across the five public non-bank mortgage companies for the 4.5-year period ending June 30, 2018.

We expect consolidation to continue as a result of weak profitability, with non-bank lenders seeking scale efficiencies to combat rising rates, persistently high technology and regulatory compliance costs, and declining refinancing activity. That said, non-bank lenders with multiple origination channels and established mortgage servicing platforms that generate higher fee income and more sustainable earnings should be better positioned for the shifting trends of the interest rate and economic cycles. These lenders are generally less exposed to cyclical swings in the mortgage market, as the complementary nature of origination and servicing businesses can serve as a natural hedge, reducing earnings volatility.

Aside from driving funding costs higher, Fitch also sees rising interest rates as a headwind to origination volumes, which could further pressure profitability in the medium term. Forecasts by the Mortgage Bankers Association (MBA) call for originations of $1.6 trillion annually from 2018-2020, down 6% from 2017 levels. Refinancings should drop to 24% of originations by 2020, down from 49% in 2016, in the face of rising rates, according the MBA.

Positively, mortgage servicing right (MSR) valuations generally increase with rising rates and economic growth, as prepayments fall and default risk lessens. Reflecting these dynamics, MSR valuations have increased in recent years, averaging 104bps of the unpaid principal balance of servicing portfolios for the five public non-bank mortgage companies.

Ratings assigned to non-bank mortgage servicers are typically in the ‘B’ to ‘BB’ rating categories, reflecting the highly cyclical and monoline nature of the business, valuation volatility associated with MSRs, elevated legislative and regulatory scrutiny, weak earnings profiles and reliance on short-term wholesale funding sources.

US Boom Phase – What Next?

Mark Zandi, Chief Economist, Moody’s Analytics has penned an interesting piece suggesting that there is excessive risk taking among US corporate, as the business cycle moves past its zenith.  There are some worrying similarities between corporate leveraged lending and the subprime mortgage lending of the last crash.

The U.S. business cycle has entered its boom phase. This is a period that typically comes closer to the end of the cycle, just prior to a recession. It is characterized by robust economic growth, tightening labor and product markets, intensifying wage and price pressures, monetary tightening, and higher interest rates.

Another feature of the boom phase of a business cycle is excessive risk-taking somewhere in the financial system. This fuels the boom and is eventually at the center of the subsequent bust. Subprime mortgage loans were the obvious culprit a decade ago, runaway internet stocks that pumped up a stock market bubble were the problem in the early-2000s recession, and the savings and loan crisis incited the early 1990s downturn.

Risk-taking is clearly on the rise in this cycle, the aforementioned overvalued asset markets and easier underwriting are testimonial, but it is unclear precisely what might do this cycle in. There has been handwringing that households may be overborrowing again. But this concern seems overblown. Household credit growth is consistent with income gains, and debt loads that had fallen sharply after the last recession show no indication of rising. Debt service burdens remain low. And personal savings rates look ample after recent data revisions.

To be sure, vehicle and retail card lenders were extending too much credit not too long ago, and credit quality eroded. But lenders have since upped their standards, and delinquencies have peaked. Student loans are a problem, but not for the financial system, since the bulk of these loans are backed by the federal government. Student loans are thus a taxpayer problem, which could manifest itself in the next downturn by adding to the nation’s fiscal problems; policy makers will be under intense pressure to forgive and forbear on more of this debt.

Even so, worries that the nation’s ballooning budget deficits and debt load could do this cycle in are also overdone. They are a corrosive on growth as they push up long-term interest rates, but we are still a long way from U.S. Treasury bonds losing their safe-haven status to global investors. Municipal debt is more of an issue. But, while it will likely exacerbate the next recession, it won’t be the catalyst for it.

Leveraged lending

The most serious developing threat to the current cycle is lending to highly leveraged nonfinancial businesses. Across all businesses, borrowing appears manageable. The ratio of debt outstanding to GDP is about as high as it has ever been, yet this is a continuation of a long-running trend and reflects a broadening in the availability of credit to more businesses. The ratio of debt to business profits looks even more benign—largely unchanged since the early 1980s, abstracting from recessions when profits are hammered.

However, while businesses appear to be in good shape in aggregate, a significant number of highly leveraged companies are taking on sizable amounts of debt. This is evident in the rapid growth of socalled leveraged loans—loans extended to companies that already have considerable debt. These loans tend to have floating rates—typically Libor plus a spread—with a below-investment-grade (Baa or less) rating.

Leveraged loan volumes are setting records, and loans outstanding have increased at a double-digit pace over the past five years to nearly $1.4 trillion. Businesses use the loans to finance mergers, acquisitions and leveraged buyouts, followed by refinancing, and to pay for dividends, share repurchases and general expenses.

Powering leveraged lending is demand from the collateralized loan obligation market. CLOs are leveraged loans that have been securitized, and global investors can’t seem to get enough of them. This is clear from the thin spreads between CLO yields and comparable risk-free Treasuries.

Approximately one-half of leveraged loans currently being originated are packaged into CLOs, with CLO outstandings approaching $550 billion.

Easing underwriting

To meet the strong demand for leveraged loans from the CLO market, lenders are easing their underwriting standards. According to the Federal Reserve’s survey of senior loan officers at commercial banks, a net 15% of respondents say they lowered their standards on commercial and industrial loans to large and medium-size companies this quarter compared with the previous quarter. The only other time loan officers eased as aggressively on a consistent basis was at the height of the euphoria leading up the financial crisis in the mid-2000s. Standards for loans to small companies have not eased nearly as much, since they are much less likely to be bundled into a CLO.

Covenants on leveraged loans—restrictions on borrowers to ensure they can repay their loans—have also deteriorated, according to Moody’s Investors Service. The rating agency’s loan covenant quality indicator has fallen to its lowest level in its six-year history. Borrowers are negotiating greater flexibility to manage their balance sheets by moving or selling collateral, and they are increasingly able to sell collateral without using the proceeds to pay down their loans. It is becoming more unclear whether the collateral backstopping loans will be available in a bankruptcy.

The easing in underwriting is also evident in the below-investment-grade or junk corporate bond market.

The junk market hasn’t kept pace with the surging leveraged loan market, but it is nearly as big, with more than $1.3 trillion in outstandings. Here as well, bond covenants have eroded substantially in recent years, according to the rating agency, with the Moody’s bond covenant quality indicator currently hovering near record lows.

Eerie similarities

Considering the leveraged loan and junk corporate bond market together, highly indebted nonfinancial companies owe about $2.7 trillion. Their debts have been accumulating quickly as creditors have significantly eased underwriting standards. As interest rates rise, so too will financial pressure on these borrowers. Despite all this, global investors appear sanguine, as credit spreads in the CLO and junk corporate bond market are narrow by any historical standard.

Regulators are undoubtedly nervous—they issued guidance to banks to rein in their leveraged lending in 2013—but an increasing amount of the most aggressive lending is being done by private equity, mezzanine debt, and other institutions outside the banking system and regulators’ purview.

Now consider that subprime mortgage debt outstanding was close to $3 trillion at its peak prior to the financial crisis. Insatiable demand by global investors for residential mortgage securities drove the demand for subprime mortgages, inducing lenders to steadily lower their underwriting standards.

Subprime loans were adjustable rate, which became a problem in a rising rate environment as borrowers didn’t have the wherewithal to make their growing mortgage payments. Regulators were slow to respond, in part because they didn’t have jurisdiction over the more egregious players.

It is much too early to conclude that nonfinancial businesses will end the current cycle in the way subprime mortgage borrowers did the previous one. Even so, while there are significant differences between leveraged lending and subprime mortgage lending, the similarities are eerie.

Does A Yield Curve Inversion Lead To A Recession?

Today we consider whether the shape of the yield curve is a good indicator of a future recession in the US.

To answer that question, let’s look at the longer term trends, using data from one of our favourite data sources FRED.  FRED is the St. Louis Fed datasets, which contains a wide range of useful indices.

Here is plot of the 10 year rates since 1980. The shaded areas are US recessions, when the economy shrank (generally seen as a negative indicator), certainly unemployment rose as is clearly evident as a direct result of the recession.

But now let’s look at the 10-year rate from the 1980’s, and overlay the 3-month rate also. In the video we follow the inflection points, and here is the thing. Prior to each of the last three US recessions, the short-term rate overtook the long term rate in a classic inversion of the yield curve. And we see recessions follow.

The logic behind the inverted yield curve as a recession indicator is simple: if long-term yields are lower than short-term yields, the market’s view is that growth will slow in the coming years. More often than not, that view has been right.

From this, we can say there is clear evidence that once the yield curve does reverse, a recession will likely follow. But what does that tell us about the current situation? Well currently short term rates have been rising sharply, more so than long term rates, as the Fed draws in their QE horns. If that trend continues, the yield curve will go negative, and in that case a US recession is highly likely. And on current trajectory that could happen within a couple of years.

However, beware, because there were cases when the US yield curve inverted but a recession did not follow. For example, in the late 1980s, the yield curve inverted and then steepened again, before inverting again later on before a recession hit. The curve also inverted very briefly in the late 1990s, too, and again in 2005-2006. However, the trends to my mind do signal a recession, but the timing does vary. Sometimes it happens in just a few months, in other cases it’s taken a year or two. But it does look like a yield inversion is an important signal to watch for, worth bearing in mind when people are taking about all the reasons why the stock market in the US should go higher still.