Don't Assume Dollar Market Stability
New York | Many of the readers of The Institutional Risk Analyst probably hoped to see a more peaceful year in 2021. Sadly the first week in January is feeling pretty much like the last week of December. But we’re happy to note the publication of our latest bank profile in our Premium Service, with a “neutral” risk rating on that sadly under-levered institution known as Bank of America (NYSE:BAC). We write:
"The bank’s funding base and liquidity are strong and credit expenses likewise are well under control, but our concern is that BAC does not seem to have the earnings potential commensurate with its size. The second largest US bank is a low-risk counterparty but also a mediocre equity investment. Given the risk averse nature of Mr. Moynihan and his board, BAC is unlikely to take the sort of tough decisions that would restore sustained profitability, including reducing the size of the bank and asset sales.”
Americans await the start of a new and hopefully more steady government under President-elect Joe Biden, but the assumption of market stability is not a given. The obvious good news is that the markets worked through the year-end without any major mishaps. Stocks generally ended 2020 on or near 52-week highs, making for a heady start of the year, while corporate credit spreads continue to dance sideways.
But even as stocks move higher and benchmark bonds slip, the credit markets remain very short of collateral, a fact that may cause the next “taper tantrum,” albeit this time due to the shedding of Treasury cash balances. The 10-year Treasury note has risen in yield above 1% for the first time since March of 2020. Buy high yield spreads have still not recovered to pre-COVID levels.
Rising long term rates is not the end of the world by any means, but it does mean that the Fed-fueled boom of 2020 is ending as the Democrats take control in Washington. This perhaps augurs a return to more traditional market correlations? Does Janet Yellen demand the same respect from global markets as deal guy Steven Mnuchin? Like Alan Greenspan, Chair Yellen may be tested very soon in her tenure.
Meanwhile, the short end of the yield curve is getting forced down by the unrelenting global demand for Treasury collateral and dollar credit, which is basically at zero offshore. Can the incoming Biden Administration authorize and spend another $1 trillion in the next 90 days? The answer to that question holds the attention of bond investors (See “Wag the Fed: Will the TGA force Rates Negative?”).
Our pal @Stimpyz1 maintains that real interest rates remain “WAY too high. The Fed's own models show it. R* is negative. Shadow funds are 0%, and they were NEGATIVE 4% in 2014--when things were not NEARLY as bad then as now…” Looking at the collateral markets, he’s probably right. Of note, the FOMC minutes show the central bank remains committed to continuing QE “at least at the current pace.”
While members of the FOMC openly discuss allowing inflation to go as high as 3% before taking action to stay within the second part of the Humphrey-Hawkins dual mandate, namely price stability, the central bank’s own models suggest that even today's monetary policy remains too restrictive. The prospect of the Treasury returning hundreds of billions in cash to the Street over the next quarter, may actually drive market yields down toward the Fed’s theoretical R*.
Meanwhile in the mortgage sector, there is mounting evidence that the interest rate party is ending early – at least in terms of heady equity market valuations. KBW published a decidedly bearish note on Rocket Companies (NYSE:RKT), predicting that refinance volumes are likely to fall dramatically in 2021. (See our earlier comment, “Nonbank Update: Rocket Companies.”)
The folks at KBW are good analysts, but many people on Wall Street don't seem to recognize that the Mortgage Bankers Association (MBA's) estimates are very conservative and subject to upward revision as we go. For years we have started the year with the baseline estimates in the model, only to see open market bond purchases by the Federal Open Market Committee render the model pretty much useless as a predictive tool.
Wall Street is now writing equity market research dependent upon these decidedly conservative estimates. Specifically, the MBA tends to equally weight the chance of rising rates in their forward lending volume model. Even if the 10-year note yield rises, the secondary spread for mortgages may and probably will continue to contract due to 1) competitive pressures and 2) the fact of rising FOMC purchases of 2% and 1.5% coupons in conventional and agency MBS.
The most heavily purchased MBS coupon yesterday (1/6/21) was the 30-year UMBS 2% for February settle, with $1.6 billion taken, Bloomberg reports. You can expect to hear growing numbers of investors and media pick up on this bearish, falling mortgage volume narrative, but the actual results for 2021 in terms of volumes may be significantly higher than the estimates from the MBA and the GSEs.
Note: We’re a buyer at $3 trillion for 2021 volumes. Could be closer to $4 trillion. And remember, the FOMC does not set secondary market spreads, lenders do. We’re not communists yet.
It is interesting to hear the recent comments of former Fed governor Kevin Warsh with respect to markets and the dollar, noting the radical and bipartisan shift in the consensus regarding US monetary policy during the Trump years may not find ready market acceptance under a Democrat administration. But as we know, Wall Street can get comfortable with just about anything given sufficient yield to commission.
While much of the conventional wisdom in the media believes that Biden now effectively controls the Senate, the politics of spending and regulation, for example, will put a great deal of pressure on the Democratic coalition. Indeed, as COVID becomes the exclusive problem of Joe Biden and Kamala Harris, we fully expect to see some strange alliances take shape on the floor of the Senate.
Once the distraction of Donald Trump is removed from our collective misery, politics as usual will resume. Remember, the political agenda of the Democratic Party is well to the left of most Americans regardless of what you hear in the mainstream press. Without Trump pissing in the political well, as was made clear in Georgia and Washington this week, we see the potential for significant Republican gains in 2022.
Meanwhile, due to the arithmetic fact of 50/50 split in the Senate, we also see the possible formation of a “tyranny of the center,” comprising members of both political parties. Discrete alliances may exercise effective control of the Senate and outside the leadership of both parties. One single vote can change policy, especially if it is the last vote purchased.
In the event, the tyranny of the center might be at least one positive outcome from four painful years of President Trump, but the bond markets may think otherwise. The assumption of a stable financial and economic transition in the US during 2021 is perhaps the greatest risk facing the global markets. In Georgia, President-elect Biden promised to send every American a check for $2,000 funded entirely with debt. Really, Mr. President? Really?