Wednesday, May 27, 2009

Yeah but this time I've got the money!

It was shades of 2002, only in reverse today. Mortgage servicers sold intermediate/long rates, which drove rates higher, which brought out more mortgage hedge sellers. Now we are set with some very basic problems.

The Fed can't keep mortgage rates at or below 5% with the Treasury market where it is. Can't happen. This chart is the Fannie Mae 30-year mortgage "current coupon" which is basically what the prevailing coupon would be on a theoretical par-priced mortgage. Or perhaps more importantly for those who don't trade MBS, this rate plus 50bps would be the prevailing borrowing rate based on how MBS are trading.

Not good. Fundamentals in the housing market are weak enough without having affordability take a turn for the worse.

Taking a longer-term look at the mortgage current coupon, we see its still a good bit below the pre-conservatorship levels. Still, worrisome.

Interestingly, the Fannie Mae 4% MBS fell two points today, about the same price action as the long bond! There are no natural buyers of 4% and 4.5% coupons. They are a trap, as I've discussed before, all downside and no upside. Someday I expect this bond will trade at $91. And your upside is... collecting a 4% coupon? For probably 10 years? Where do I sign up!?!?!

Where does this leave us? With a bunch of problems I'm afraid. The massive decrease in money velocity has left us with a Alderaan-sized hole in the money supply. The Fed has already lowered the funds target to zero, so the only way to get more money into the system is to print it. Plain and simple.

The most efficient means to get printed money out into the world is to buy Treasury bonds. Not only does this put cash into the economy, but it also should lower borrowing yields and thus increase velocity.

When the Treasury buying program was announced, it was assumed that the Fed had some ceiling on Treasury yields in mind. This was a logical conclusion, since classically the Fed operates with a target, and buys or sells Fed Funds to meet that target. Why not do the same with the Treasury market? Target the 10-year at 3%?

But 3% came and went. 3.25% came and went. 3.5% came and went. The market kept waiting for the Fed to increase its purchases, but their purchase amounts have been remarkably consistent. Almost as though their only goal was to get money into the system, and they didn't really care about where Treasury bonds actually traded.

Helicopter Ben is trying to do just that. Print money and pass it out. He's just using the Treasury market as his helicopter. He's not actually trying to push yields lower.

And what about Asia? What about the U.S.'s AAA credit rating? Is the dollar about to plummet and foreign investors run away like Han Solo from Stormtroopers? I can't say there is zero risk of this, but think about it. Doesn't the negative outlook on the U.K.'s credit rating strengthen the position of the U.S. in terms of foreign buyers? If China cares about credit ratings (which traders I've talked to say they do), then doesn't S&P's actions take away one of China's main alternatives to the dollar?

I think foreign diversification of reserves is a reality. The dollar's dominant role in international commerce is fading, but it will be a slow fade. Many are expecting a Death Star like explosion of the dollar. Think of it more like Palpatine's rise. Slow and insidious over the course of many years.

Complicating all this is a very real risk that further Fed purchases of Treasuries will look like a monetization of our debt. I don't think that's the goal, but I can see how Asian buyers, especially outside of China, would come to that conclusion. Richard Fisher of the Dallas Fed has expressed exactly these concerns.

So I don't know what the Fed's next move is, but if interest rates stay where they are, those green shoots are going to turn to yellow. They need more water to start growing.


Michael Krause said...

Nice piece. Totally agreed. 100%. We've now hit your 10 year bond target. Are you getting long?

ronald said...


Unknown said...

Thanks for the insightful post.

When you say that further Fed purchases will "look like monetization," I get a little confused. How is it anything but monetization?

Accrued Interest said...


I did add to my 10 and 30-yr position. I'm still biased to be long, and expect we'll see 3% again before 4.50%.


I define monetization as a permanent debt solution, as opposed to QE, which is a means of expanding the money supply. Its a fine line, but I think there is a very real difference.

viking said...

AI you dirty dog

at it again

still hasn't sunk in has it

bond market is dislocatings

it's on

tj said...
This comment has been removed by the author.
In Debt We Trust said...


Do you still think TBT and/or gold are bubbles?

Accrued Interest said...


I think interest rates should be lower, because I think this inflation/dollar fear is BS. I think we're going to slowly grind lower interrupted by sudden moves higher.

Lockstep said...

Nice piece.

I still would not go long until we have totally repriced the long end of the curve to about 5.5%. Better cautious than crushed.

I definitely think all of this treasury noise is directly driving oil prices into the stratosphere (relative to the demand decline and massive supply available).