Morning Report: What low bond volatility means for mortgages

Vital Statistics:

	Last	Change
S&P Futures	2751.3	4.5
Eurostoxx Index	400.3	1.9
Oil (WTI)	62.0	0.2
US dollar index	86.0	0.1
10 Year Govt Bond Yield	2.50%
Current Coupon Fannie Mae TBA	102.313
Current Coupon Ginnie Mae TBA	103.063
30 Year Fixed Rate Mortgage	3.92

Stocks are higher this morning on good economic data out of Europe. Bonds and MBS are down.

Small Business Optimism slipped slightly in December, capping the strongest year in the index since the early 80s. Hiring was sluggish in December, with a lack of qualified workers being the biggest problem in construction and manufacturing. Compensation is trending up as well, as a net 23% of small businesses intend to raise compensation this year. 

Job openings were little changed in November, according to the JOLTs survey. This was a slight drop from October, and a touch below expectations. Openings increased for retail, and fell for government, transportation, and utilities. The quits rate was unchanged at 2.2%. Until we start seeing the quits rate move up, we probably won't be seeing broad-based wage inflation. 

Volatility in the bond market has hit a 52 year low, according to a Bank of America / Merrill Lynch report. This is not surprising: volatility in the stock market is also at record lows. Volatility is generally a sign of stress in the system, and it tends to fall during periods of stronger growth.

The drop in bond market volatility has major implications for the mortgage market as well, and helps explain a bit of why mortgage rates are behaving the way they are. While the 10 year has been steadily moving higher over the past few months, mortgage rates have been relatively stable. While mortgage rates do tend to lag Treasuries, something else has been going on, and that something has been low volatility. 

30 year fixed rate mortgages have an embedded option in them, which is the right of the borrower to prepay their mortgage without penalty at any time. That right to prepay is worth something, and that value explains the yield differential between government backed mortgage debt and Treasuries. The value of the prepayment option is determined largely by the volatility of the bond market - when volatility rises, the right to prepay is worth more, and when volatility falls, it is worth less. So, when the market is stable, investors bid up mortgage backed securities as the value of that option falls, which translates into tighter MBS spreads and lower mortgage rates. In fact, the difference between a 30 year fixed rate mortgage and an adjustable rate mortgage is driven by the value of that prepayment option and risk-shifting between borrower and lender. When volatility is low, the borrower is paying less for that option and 30 year fixed rate mortgages will be more attractive than ARMS. When volatility is high, ARMS will be much cheaper. During periods of low volatility, it makes sense to scoop up that prepay option on the cheap and take out a 30 year fixed rate mortgage. When volatility is high, you will end up getting a much lower initial rate with the ARM. Co-incidentally, the economic backdrop (stronger growth, accelerating inflation, and a Fed raising short term rates) also favors the 30 year fixed over ARMS. 

Morning Report - Bond Market Volatility

Vital Statistics:

	Last	Change	Percent
S&P Futures	2107.4	-8.6	-0.41%
Eurostoxx Index	3552.8	-31.0	-0.87%
Oil (WTI)	58.92	-0.7	-1.21%
LIBOR	0.279	-0.004	-1.35%
US Dollar Index (DXY)	95.23	-0.237	-0.25%
10 Year Govt Bond Yield	2.34%	-0.02%
Current Coupon Ginnie Mae TBA	101.1	0.1
Current Coupon Fannie Mae TBA	99.78	0.2
BankRate 30 Year Fixed Rate Mortgage	4.03

Stocks are lower this morning as talks in Greece stall. They have a big payment due to the IMF tomorrow.

Some labor market numbers this morning. Initial Jobless Claims fell to 276,000, a great number. That said, the final revision to productivity for the first quarter is in, and it fell to -3.1%. Unit Labor Costs rose 6.7%.

The IMF is urging the Fed to hold off raising rates until the first half of 2016. They also cut their forecast for US GDP growth from 3.1% to 2.5%, more or less matching what the Fed was forecasting at its March meeting. Given the weak Q1, that forecast is probably coming down in the June FOMC meeting. 

If you have been caught by surprise with the big moves in the bond market, you aren't alone. The volatility in the bond market has been stunning over the past several months. The mood of the markets seems to go from fear of deflation in Europe to fears of inflation in the US. Jim Bianco characterized the bond market like this: “You want to shove rates down to zero, people are going to make big bets because they don’t think it can last,” Bianco said. “Every move becomes a massive short squeeze or an epic collapse -- which is what we seem to be in the middle of right now.” IMO, the action in the markets is also a function of the fact that the major players in the markets right now are central banks, and they are taking positions based on social policy considerations, not economic ones. In other words, the ECB isn't buying bonds because it thinks they are cheap - it is buying them in an attempt to create inflation. When you have non-economic players (players that are not concerned about their p/l) dominating the market, the ones that do care about their p/l (everyone else) are bound to get whipsawed. 

Another issue is the fact that new regulations against proprietary trading has diminished the historical market stabilization role of trading desks. In the old days, when a big buyer or seller (say someone like a PIMCO) had an big order, they would find an investment bank to take the other side of the trade. The bank would bid (or offer) a little bit above or below the market and gradually work out of the trade over the course of the day or days. This had the effect of dampening volatility as it kept the market from getting whipsawed by big orders. Ironically, the regulatory push to "make banking boring again" has had the effect of making the government bond market anything but boring.

For mortgage bankers, the thing to keep in mind is that mortgage rates have been "fading" this volatility. In other words, they have been reluctant to follow big outsized moves. You can see it in the graph below, where the upper line is the Bankrate 30 year mortgage rate and the lower line is the US 10 year bond yield. Note how mortgage rates ignored the big dip in yields at the end of Janurary and have lagged the moves upward lately. Think about this when you are locking. If rates stop going up, mortgage rates will still probably keep rising to "catch up" with Treasuries. Even if rates fall, mortgage rates will probably stay up here for a while.  In a volatile market like this it doesn't make a lot of sense to be floating. Rates are still at historical lows, and can move up in a hurry. It would be shame to end up paying an extra 30 basis points on your mortgage because you were waiting to catch a rally that never came. 

Morning Report - More bond market volatility ahead?

Vital Statistics:

	Last	Change	Percent
S&P Futures	2065.1	-9.4	-0.47%
Eurostoxx Index	3702.4	-25.4	-0.84%
Oil (WTI)	47.54	-1.15	-2.13%
LIBOR	0.269	-0.001	-0.30%
US Dollar Index (DXY)	98.58	0.52	0.56%
10 Year Govt Bond Yield	1.94%	-0.01
Current Coupon Ginnie Mae TBA	102.5	0.0
Current Coupon Fannie Mae TBA	101.9	0.2
BankRate 30 Year Fixed Rate Mortgage	3.80

Markets are lower on no real news. Bonds and MBS are up.

Home Prices rose .87% month-over-month and 4.56% year-over-year according to Case-Shiller. This is January data. The West and Southwest continues to outperform the Midwest and Northeast. A measure of housing market "healthiness" indicates the housing market is in the best shape since 2001.

It looks like we are close to an agreement to extend talks with Iran for 90 days and to outline the big steps needed to get a deal. The main sticking points seem to revolve around the actual mechanics of lifting the sanctions. The main thing to keep in mind is that one way or another, the sanctions will probably be lifted and a big new oil producer will begin dumping crude on world markets. 

As we get closer to "liftoff," which is Fed-speak for increasing interest rates, market professionals are worried about the possibility of more volatility in the bond markets. They point to one trading day in October, where the 10 year bond yield traded in a 40 basis point range intraday. A combination of automated trading and the unintended consequences of regulation have hampered liquidity in Treasury markets during periods of volatility. 

Speaking of bond market volatility, the government will release the jobs report on Friday as scheduled, however the stock market will be closed and SIFMA is recommending a noon close in bonds. Suffice it to say that trading desks will be thinly staffed and we could see some volatility in rates. I don't anticipate much of a reaction in the bond market unless payrolls fall off a cliff or we see a big uptick in wages.