Rollercoaster Bond Market
Interesting (read: disheartening) times in this rollercoaster of a bond market, huh? There’s the highest volatility in at least five years, colossal bid-ask spreads, scant liquidity in coupons above par, falling bond prices that have banks sitting on their hands, and a central bank that is still uncertain on how long and hawkish it plans to remain in tightening mode (don’t forget fear of a global recession, escalating geopolitical tensions thanks to Russia’s war on Ukraine, the UK’s tax-cut fiasco, and the potential for further defaults by developing nations). A year ago, 2-year Treasuries yielded 0.2%. They were 1% in January of this year, but today yield more than 4%.
The root cause? Inflation remains elevated. The Fed hopes that inflation expectations don’t become entrenched and thus increase the likelihood that high inflation will persist. History has taught us that price stability is essential to achieving maximum employment over the longer term, meaning that fighting inflation comes before worrying about rising unemployment in the Fed’s eyes. Restoring price stability may take some time and will likely entail a period of below-trend growth, which the Fed is committed to, even if further steps are necessary. The only thing that would cause the Fed to pivot is the banking system coming under stress.
Banking System Stability
Yes, the Bank of England did intervene in the UK bond market this week, committing to buy £65 billion of long-dated bonds for the sake of stability, which sparked a global rally. A bigger worry than the banking system coming under stress domestically is the potential for a housing downturn, at least with respect to prices. I’m talking about declines in housing markets that saw 30%+ home price appreciation for the last couple years, so a price correction is not unreasonable. Home prices declining in some overheated markets won’t trigger another collapse because banks don’t have much credit exposure to residential real estate lending.
August gross issuance of all agency mortgage bonds came to the lowest level since May 2019 and was the sixth consecutive monthly decline.
There are inevitable comparisons to 2008, but 2008 was a residential real estate bubble and a time when the vast majority of mortgages were not guaranteed by the government. Subprime no longer exists and, aside from non-QM (which resembles Alt-A more than subprime), every MBS is “money good.” Any exposure will be counter-party risk (e.g., those who had warehouse lines with someone like FGMC). So we won’t see a banking crisis, and we won’t see a forced selling of securities. Bottom line, fears about another 2008 are overblown.
Fed Winding Down QE4 at Opportune Time
The Federal Reserve is winding down QE4 at an opportune time. August gross issuance of all agency mortgage bonds came to the lowest level since May 2019 and was the sixth consecutive monthly decline. The $129 billion of supply in August was about 40% of the supply a year ago and just how much low mortgage rates during QE4 wrung the refi towel dry is seen in the conventional and government refinance indices since January 2021, which are down 91% and 89%, respectively. While it is hoped that money managers will fill the demand void left behind by the Federal Reserve and the banks, those are some very large shoes to fill.
The mortgage lending industry needs to get creative. It’s hard to find programs with a few points back, or even a par rate. The dramatic run-up in the price of homes combined with high inflation does give great incentive to financially stressed households to extract equity from their home to tide themselves over. Mortgage lenders have been squeezing all the equity extraction out of homeowners they can in order to keep the lights on. Unfortunately, there’s not a quick fix and it’s going to take some patience in riding out this market cycle. For further reading on the subject, check out our whitepaper from earlier this year, Understanding and Preparing for Changes in the Mortgage Market.