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Last week saw an unexpected drop in rates as trade war headlines rocked financial markets. Things looked set to calm down this week, but the drama continued. This time around, mortgage rates were able to keep slightly better pace with the broader bond market. The result is a return to levels that are very close to the lowest in more than a year.

What do we mean by “keep better pace with the bond market?”

There are many different kinds of interest rates based on many different underlying assets.  It’s a common misconception that mortgage rates are based on US Treasury yields.  While certain adjustable rate mortgages can use the US government bond market as an index, the most prevalent mortgage–the 30yr fixed–is actually based on a mortgage-specific bond known as a mortgage-backed security (MBS).

There’s good reason for the misconception though!  MBS yields tend to follow Treasury yields in almost perfect proportion.  The chart below overlays MBS yield movement with 10yr Treasury yields.  As you can see, they’re frequently almost indistinguishable.

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The highlighted portions of the chart show a common phenomenon.  When rates really get on a roll, the mortgage market can struggle to keep pace.  We saw this in late March and again in the past few weeks.  The net effect is that mortgage rates haven’t yet returned to the same late-2017 lows seen in 10yr Treasury yields.

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If the move in mortgage rates still looks pretty good to you, you’re not alone.  At the lowest point of the week, rates were extremely close to the lows seen at the end of March.  Those were the best levels in well over a year.

The favorable interest rate environment is not lost on housing!  While it certainly doesn’t hurt that we’re in the throes of the Spring/Summer homebuying season, low rates are definitely helping to prolong a nice rebound in homebuilding, sales, and sentiment.  Both the NAHB housing market index (builder confidence) and Housing Starts (new residential construction) data came out this week, and both added to the trend leading back up from late 2018 lows.

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As for the market moves underpinning the low rate environment, this week was more diverse compared to last week’s heavy dose of trade war news.  Granted, there were still several trade-related headlines moving stocks and bonds this week, but rates specifically benefited from a clash between Italy and the EU over the country’s proposed budget on Wednesday.  Later that same day, US Retail Sales data came out much weaker than expected.  After a modest correction on Thursday, more US/China trade headlines kept bond yields and interest rates from rising.

In the slightly bigger picture, however, it continues to look like the most volatile reaction to the trade war flare-up has come and gone as of last week.  The net effect is that stocks and bonds look like they’re trying to move back in the other direction (i.e. higher).  This is even more apparent in stocks.  Bonds probably would have followed had it not been for the Italian news and the weak economic data (both of which have a more pronounced effect on the bond market whereas trade war headlines were equal opportunity market movers).

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Next week is fairly light on economic data with only few reports worth mentioning (New Home Sales, Existing Sales, and Durable Goods Orders).  In addition to the data, we’ll also get the Minutes from the most recent Fed meeting, which will give markets a bit more context for the Fed’s current line of thinking.  That would normally be a bigger potential source of volatility, but numerous Fed members have been on the speaking circuit with a fairly unified message about keeping rates steady and needing to be “patient” before deciding if the next move is a cut or a hike.

Finally, the week will be cut short for an early close on Friday and a 3 day weekend for Memorial Day.  Weeks leading up to major holiday weekends are often idiosyncratic from a trading standpoint.  In other words, we may have to wait until the following week to get a clearer sense of the prevailing interest rate momentum.

10yr Treasury yields are widely thought to dictate mortgage rate movement. This week’s trade war headlines caused plenty of volatility and a general decline in Treasury yields, but mortgage rates had a hard time keeping up.

Before we get to the finer points of Treasuries vs mortgage rates, let’s recap this week’s reaction to various trade-related headlines.  There’s no question that volatility increased in a major way, as can be seen in VIX chart below.

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The big spike right out of the gate suggests that markets were reacting to news that hit over the weekend.  Indeed, the culprit was a set of Trump tweets about raising Tariff’s on Chinese goods.  Combined with a story from the Wall Street Journal suggesting China was considering “pulling out of trade talks,” the message to markets was clear: something had gone wrong in the trade negotiation process.

Generally speaking, a trade deal between the US and China is almost universally viewed as good for global financial markets as well as the economies of both countries.  Economic strength tends to coincide with higher stock prices and bond yields.  As such, it was no surprise to see stocks and bond yields fall as trading began for the week.

From there on out, markets were transfixed by trade war drama.  Here’s a quick recap of the highlights and the corresponding logical impact on stocks/bonds (“bonds” = “bond yields” in this list).

  1. Initial tariff tweets cause immediate drop in stocks/bonds, but markets bounce back amid an absence of additional news for most of the day on Monday.
  2. Monday, close of business.  US Trade official Lighthizer: China has backed away from agreements.  This caused another move lower in stocks/bonds, both on Monday afternoon and again when markets opened on Tuesday
  3. Early Wednesday morning, Reuters exclusive detailed how China had “backtracked on almost all aspects of trade deal.”  Stocks/bonds fall again
  4. Mid-morning, White House reports that China is sending a delegation and “wants to make a deal.”  Stocks and bonds move back up briefly
  5. Wednesday evening, at a campaign rally, Trump says China “broke the deal.  They can’t do that, so they’ll be paying.”
  6. Thursday mid-day, Trump says he received a “beautiful letter” from President Xi, and cites Xi as saying “let’s work together to see if we can get something done.”  Stocks and bonds bounce.
  7. Finally, stocks and bonds fall back in line with lows as trade talks conclude for the week, only to bounce back up to the day’s highs following positive comments from Trump in the afternoon (not highlighted below)

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Before this fairly wild week, it looked like rates had decided to move higher after being unable to break below key levels last week due to Fed Chair Powell’s press conference on Wednesday.  Stocks didn’t love what they heard from Powell but were nonetheless able to hold near all-time highs.

Powell aside, stocks and bonds were both moving gradually higher anyway.  Viewed in the bigger picture, this week’s trading resulted in a fairly obvious reversal of those trends.

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To come back to our original thesis, although we are certainly seeing a general decline in Treasury yields this week, mortgage rates are just as certainly having a hard time keeping up.  This will be especially puzzling to anyone laboring under the misapprehension that Treasury yields always dictate mortgage rates.

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While it is very true that Treasuries represent the benchmark/core of the US interest rate market, and also very true that mortgages tend to correlate almost perfectly with Treasury movement, there are notable exceptions.  Mortgages are actually driven directly by mortgage-backed securities (MBS).  Simply put, these are bonds composed of groups of mortgages for the purpose of managing risk and providing liquidity among mortgage investors.

Because the government took control of the two biggest issuers of MBS during The Financial Crisis, MBS returns are just as guaranteed as Treasury returns.  If that were the only thing investors cared about, MBS would always move in lock-step with Treasuries.

But MBS are subject to a huge variable that Treasuries never have to worry about: human behavior.  Whereas the government will pay the agreed-upon yield on a Treasury security as long as it lasts, a mortgage borrower will only pay the agreed-upon yield (aka “interest”) as long as they have their mortgage.  For a variety of reasons, they may decide to move or refinance.  When that happens, the investor is no longer receiving the stream of payments with interest that it signed up for.

The early retirement of a mortgage is referred to as “prepayment” in the secondary market, and it goes hand in hand with another MBS buzz word: “speeds.”  This simply refers to the speed at which certain vintages of MBS are being paid off.

To make a long story short, the monthly prepayment report showed a drastic increase in speeds early this week.  This suggested MBS were a bit overvalued relative to Treasuries, and a logical correction ensued (even though it seemed paradoxical on the surface).

The good news is twofold.  First, the correction is over for now and in fact, mortgages outperformed Treasuries on Friday.  But more importantly, this was only ever cause for concern when looking at rate movement under a microscope.  Both mortgage rates and Treasury yields are operating very close to the lowest levels in more than a year.

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The week ahead should be telling for markets as traders are able to get back to business following this week’s trade war diversions.  Economic data will return after being mostly absent or inconsequential this week.  In that regard, next Wednesday’s Retail Sales report is likely the most important data point followed by a smattering of other mid-tier reports in the 2nd half of the week.

It was an action-packed week for financial markets. Earnings were in full swing. There was a ton of economic data to digest. And of course, there was the Fed announcement and press conference to cause volatility from Wednesday afternoon on. But one of the most interesting developments was the big bounce in Pending Home Sales on Tuesday.

Pending Sales are an advance indicator of actual home sales because they track home purchase contract activity.  As such, they often lead Existing Home Sales numbers by several weeks.  Both pending and existing home sales also tend to lead home price appreciation, which has been cooling significantly in recent months.

In other words, if we’re seeing a big bounce in Pending Sales, we’re likely to see a continuation of the bounce in Existing Home Sales, and in turn, at least some stability in home price appreciation.

Of course, one of those “all things being equal” caveats applies, but generally speaking, if consumers are in a position to buy more and more homes, the conditions that support stable-to-stronger home prices are typically in place as well.

The only catch is that it can take quite a while for the stability in price appreciation to show up.  This can be seen in the chart below where the most noticeable bounces in home sales tend to occur 8-10 months before we see a response in price trends (keep in mind, the blue line tracks home price CHANGE and not home prices themselves–i.e. as long as the line is above zero, prices are moving up).

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By Wednesday, the big week of economic data and events was in full swing.  A weak manufacturing report pushed rates lower in the morning and markets reacted favorably to the Fed announcement at 2pm.  In this context, “favorably” means that the prices of both stocks and bonds increased (and when bond prices increase, yields/rates move lower).

In fact, both stocks and bonds have been actively trading their expectations for Fed policy all week.  If the Fed is friendly, it’s seen as a rising tide that lifts all boats.  If the Fed is feeling less accommodative, both stocks and bonds suffer.  The result is a breakdown of the typical correlation expected of stock prices and bond yields (aka “rates”).

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While the Fed announcement itself was helpful for both stocks and bonds, 30 minutes later, Fed Chair Powell delivered prepared remarks that sent markets scrambling in the other direction.  The offending comments included

  • A less dire assessment of foreign/global economic risks
  • A “merely technical” classification of a policy change that markets may have misinterpreted as a sort of Fed rate cut
  • Fair warning that the Fed might make adjustments to its balance sheet that favor shorter term interest rates at the expense of longer term rates (like 10yr Treasury yields and mortgages).

All of the above was enough for an immediate spike in bond yields and a quick reversal for the stock market as seen in the following chart.

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This momentum carried through to the next trading day and it wasn’t ultimately reversed for the bond market until the reaction to Friday morning’s economic data.

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If you pay exceptionally close attention to economic data you may be wondering how the apparently strong jobs report could possibly result in rates moving lower.  After all, strong jobs numbers are usually bad for bonds/rates.

In this case, strong jobs growth is old news and traders are at least as interested in other parts of the report.  Specifically, the wage growth component matters as much as anything these days due to its implications for inflation (which in turn matters because low inflation means the Fed can continue to be friendly).  While the job tally was stronger-than-expected, wages and weekly hours were lower than expected.  The implication is bad for inflation, which is already struggling, depending on the metric.

If we use inflation data that came out this week (Core PCE), we can see that it was already beginning to slide to 1.6% even though wages improved in 2018.  If Friday’s wage data speaks to a peak/plateau in wage growth, it doesn’t bode well for inflation.  The takeaway is that the Fed won’t need to hike rates any time soon.  Indeed, speculators see a greater chance of a Fed rate CUT being the next move in December or January.

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All of the above having been said, Friday’s movement in Fed rate hike expectations was a drop in the bucket relative to the opposite movement of the previous 2 days.  In the following chart, the orange line moves lower as markets perceive a greater chance of a Fed rate CUT.

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With the last chart in mind, 10yr Treasury yields tried and failed to break below 2.50%.  True, it did happen during the day on May 1st, but we wouldn’t consider 2.50% to be ‘broken’ unless yields held under 2.50% through the close of business (and ideally for an additional business day).  The implication is that rates remain susceptible to volatility in the coming weeks.  Given all of the inflation implications underlying this week’s volatility, next week’s inflation data on Thursday and Friday could be more important than normal