The U.S. Treasury Yield Curve Flattens
As we draw closer to the next FOMC meeting in March, when the committee is expected to announce a federal funds rate target increase (the first of several this year) and another pullback in daily MBS purchases, short-term rates have gone up this year relative to long-term rates. With the Fed expected to raise the overnight Fed Funds rate and Discount Rate several times this year, short-term rates will likely head even higher, and long-term rates may not move as much, leading to a flatter yield curve.
Many of you know that the shape of the yield curve is determined by plotting yields of bonds with equal credit quality but different maturity dates (e.g., 2-year Treasury note versus 10-year Treasury note versus 30-year Treasury bond). The yield curve normally exhibits convexity, or slopes upward, because long-term debt instruments should, in theory, yield more than short-term debt instruments as a result of a higher risk and liquidity premiums.
Normally, the 10-year Treasury yield is the “benchmark” that those concerned with mortgage rates watch. Still, the belly of the curve – referring to durations from roughly three to seven years in the middle of the curve – is essential because MBS traders follow shorter maturities. That is because the expected duration of a typical 30-year mortgage is closer to those time periods. When the yield curve flattens, the belly of the curve sees the most volatility.
An inverted yield curve (where short-term rates are higher than long-term rates) has historically been a strong recessionary signal, preceding every recession since 1950 by seven to 24 months. Additionally, the yield curve remained in negative territory for several consecutive months prior to the last three recessions. However, recent Fed research indicates the 2s-10s spread may not be the best signal of an upcoming recession. It suggests the spread between the 3-month Treasury bills and 18-month Treasuries could be more predictive. Keep in mind that even if the yield curve does not invert, a flattening yield curve is also a predictor of slower economic growth.
What does this flattening yield curve ultimately mean for the mortgage industry? Well, it is both good and bad. On one hand, it is a signal that the market believes the current level of inflation is temporary and will return to its historical 2% level. This would eventually mean downward pressure on mortgage rates, leading to more refinances and better affordability for home buyers. On the other hand, a flattening yield curve is also a signal that economic growth will decelerate as well, which would hurt demand for homes. We could see a rate situation where adjustable-rate mortgages (ARMs) and 30-year fixed-rate mortgages have similar coupons.
The recent flattening of the yield curve has occurred in anticipation of both the Fed raising rates in the short term and slower economic growth over the longer term, both of which are reactions to the main challenge facing the U.S. and the global economy in the next decade: the threat of faster-than-expected inflation. Keep in mind that there are a number of factors other than market expectations about the future path of interest rates that are influencing long-term yields. The Index of Leading Indicators is well in positive territory, the stock market remains supported despite a recent correction, and employment growth is positive, as evidenced by January’s strong payrolls report.
An upward sloping yield curve rewards investors for the longer-term risk of buying Treasury securities. The bigger concern than the yield curve flattening is twofold: that much of the demand for Treasuries is artificial and that the Fed has already missed the boat when it comes to fighting inflation. The size of the Fed’s balance sheet relative to the economy is larger now than before previous recessions and has manipulated the yield curve as a result. Expectations are that the Fed will stop tightening before deterioration in the economic fundamentals could spell the end of this current economic expansion and risk a recession. Join us next time as we discuss the Fed’s impact on future MBS pricing.
Rising MSR Values
The start of 2022 has brought with it higher mortgage rates, but that also means the benefit of higher MSR values. While the industry is always focused on origination volume, now is also a great time to take a deeper look at your MSR strategy. MSR can act as a natural hedge against rising rates for mortgage companies. Companies may hold the asset to pay off before maturity, or only sell on an as-needed basis to accomplish quarterly earnings.
Whether you are retaining or releasing the majority of your MSR (and MCT can certainly help with that decisioning), many of our clients are hedging any drop in origination volume with the added profitability of the MSR asset. As mortgage origination business dies down a bit due to higher interest rates, servicing revenue goes up and can supplement any loss of revenue from less business coming in. The value of the MSR asset has risen along with expected duration because higher mortgage rates lead to less payoffs.
Determining the value of the MSR asset is paramount, both for retain versus release decision making as well as enterprise goals. You may choose a long term retention strategy solely because you don’t want to pass customers to competing companies that may leverage your client base for cross-sell or recapture opportunities. Or maybe you have come to the conclusion that servicing MSRs can be complex and expensive, potentially with significant opportunity cost.
There are prospective opportunities afforded by both retaining and releasing MSR, but with a myriad of assumptions that go into deriving the underlying MSR value, considerable judgment is not only recommended, but required. One incorrect assumption can materially affect the estimated fair value of the servicing rights. Some key behavioral assumptions used in estimating servicing income are prepayment speeds, delinquency rates, and discount rates. On the revenue side, it is important to incorporate late fees, contractual service fees, ancillary income, and float income.
We are firmly in a rising rate environment, which means that those that previously sold MSRs jeopardized future earnings. Before making the decision to retain or release MSRs, it is important to understand how the decision may affect both long and short term earnings. Once a portfolio of MSR note rates is already below current market rates, the incentive to refinance is relatively unchanged even with further large market rate increases. At that point, upside gain in MSR value is limited and selling a portion of MSR holdings can be either strategic or need based.
Something that needs to be addressed are the implications that come along with servicing responsibilities, such as accounting for fair value benchmarks, changes in the regulatory environment, and increased servicing costs on top of already thin margins.
Maybe you want to sell to recognize the spread between current Lower of Cost or Market book basis and Fair Market Value. That consideration, along with the potential need for impairment testing, amortization, and possible risk volatility mitigation, makes managing the MSR asset complex even for those with the necessary resources. While delegating those responsibilities to a third party is a valid option, others not wanting to manage the complexity of this asset may decide that a released strategy is in their best interest.
It might be helpful to pivot to a more dynamic strategy for MSRs this year. MSRs are a liquid asset, and making a decision on when to cash in will impact future revenue streams. Choosing between the servicing grid and the cash flow model is something you should highly consider. Servicing grids are only updated monthly or quarterly making them not a very flexible option, though they are a common and easy to understand option. Cash flow is more accurate which can help improve hedging performance based on more legitimate predictions.
Looking for more help? Whether you are getting your agency approvals, selling through co-issue, or actively growing your portfolio, MCT offers a suite of tools along with an experienced team to help you with all your mortgage servicing rights needs. Choose the combination of services to achieve your MSR risk management goals.