Market Update
Dwight Johnston
Vice President, Economic & Market Research
Caution! Spikes Ahead on the Road to Recovery
In the forecast at the beginning of the year and in subsequent webcasts and commentaries, I've cautioned that we're likely to be subject to occasional big spikes in longer-term rates. This will come despite a generally negative economic backdrop and a fed funds rate that will remain close to zero for at least another year and a half. The theory was that the spikes would come mostly from "investor exhaustion" at the relentless issuance of new treasuries and not from any real concerns that the economy was ready to charge upwards and onwards. My theory didn't look too good for a while. Longer-term rates rose from the artificially depressed year-end levels, but the changes were incremental and measured. When the Fed announced on March 18 its program to buy $300 billion in treasuries and $1.25 trillion in agency mortgage-backed securities, my theory looked as if it would go down in flames as rates plunged.As stocks recovered, long-term rates did move higher despite the Fed's purchase program. The rate on the 10-year note moved from 2.50 percent to 3 percent, but it appeared that the 3 percent might be the cap on longer-term rates. But things started to unravel toward the middle of May. Rates first spiked after the results of a new treasury auction failed to meet expectations. Buying interest was extremely light, and the foreign bid was smaller than usual. But after the spike that week, rates adjusted back down for a week. Along the way, mortgage rates had risen as well but not as much as treasury rates. The yield difference between 10-year t-notes and various mortgage rate indexes (i.e., the FNMA commitment rate) narrowed to lowest levels on record. While the Fed's buying program on treasuries wasn't working, they were having much better luck with mortgages.
But things changed last week. After the market seemed to recover from the mid-month rate spike, bond prices plunged again. Again the Treasury's $101 billion in auctions last week were connected, but the results weren't bad. What was bad was the selling that occurred after every auction, and the wave of selling from mortgage-related accounts. It seemed to finally dawn on investors that the narrow spread of mortgages to treasuries was not sustainable, and those portfolio managers sold en masse. Mortgage rates spiked by almost sixty basis points in one single day. The 10-year note yield surged to 3.76 percent, and the FNMA commitment rate leapt to 5.05 percent. Again though the spike brought buyers and rates fell, but mortgage rates did not fall as much as treasuries.
This time around, there was only a one-day rest before rates spiked again. On June 1, ironically the day GM filed for bankruptcy, stocks surged and the yield on the 10-year note surged again to almost 3.75 percent after closing the night before at 3.47 percent. This is just the sort of volatile environment for rates we expected for one reason. The Treasury must sell $2 trillion in net new debt over the next twelve months. Maturities add $1.2 trillion for a total for $3.2 trillion. I would cite some previous historical cycle as a comparison, but this is incomparable. When the supply comes in a period of weakness, there is no problem in selling the debt. But when hopes are growing for an economic and a stock market recovery, selling the debt is a big problem. I also believe a lot of investors that could buy corporate bonds or agency mortgage-backed bonds (MBS) bought the MBS due to safety concerns. Now, with better sentiment regarding credit, they are selling MBS to buy corporates. Now we're faced with rising rates on treasuries and rising rates on mortgages.
The problem is not going away. The Treasury has no choice but to issue the debt. It's not a program that they can stop now that it's in motion. Tax revenues are plunging and government commitments are surging. In this environment, the Fed might likely be forced to increase the buy program of treasuries, but with all of their other funding commitments in different credit facilities, there is a cap on how much they can do.
In my opinion, the economy will fade again after the "hope rally" runs its course by mid to late summer. If nothing else, higher rates alone might kill the rally. Rates will fall again, and I believe we'll look back at this time as an ideal time to add to fixed income portfolios. But, and this is a big but, I could be wrong! I hate to admit it, but it's happened before. The risks are growing that the spikes in rates I expected could turn out to exceed my expectations both in peaks and lengths of time. This leaves us in this predicament. Rates will go higher if the economy improves, but higher rates might prevent the economy from improving. I guess it's the government's turn to learn the bitter lesson of too much debt and too much leverage.
You can get financial updates from Dwight throughout the day via Twitter. You can also follow Dwight’s insightful commentary each business day on Member Center or www.wescorp.org. You can e-mail him here.
Also, don't forget to download WesCorp's OnDeck with Dwight Johnston every Monday morning. This eight-minute podcast presents a weekly analysis of the financial marketplace and how it affects your credit union.