Dancing on the ceiling
Dancing on the ceiling —The yield curve has been inverted since the summer of 2022, but now seems to be righting itself. The spread between two- and 10-year government yields closed last week at five basis points (bps), following a nadir of -108 bps in July 2023 and a recent low of -50 bps in July 2024. The impetus for the steepening is the belief that the Federal Reserve (Fed) will embark on an easing cycle at the September 1718 meeting of the Federal Open Market Committee.
While we await the Fed’s decision and ensuing commentary, the market is pricing in the possibility of multiple rate cuts in 2024 to the tune of about 100 bps by the end of the year. Indeed, last Friday Fed Governor Christopher Waller opened the door for a cut larger than 25 bps. “The balance of risks has shifted toward the employment side of our dual mandate. … Policy needs to adjust accordingly. The current batch of data no longer requires patience, it requires action,” said Waller. He added that a “series of reductions will be appropriate,” and that he is “open-minded about the size and pace of cuts” and would advocate for “front-loading rate cuts if that is appropriate.”
As we explained in the August 26 Talking Points, once the unemployment rate begins to rise, it tends to rise with serious momentum. Likewise, once the yield curve returns to positive territory after a period of inversion, employment tends to falter within a year (see chart below). Stated differently, the economic landscape that warrants a reversion in the yield curve tends to correlate with a weaker labor market.
It is easy to assume that once the Fed begins to lower rates, the yield on all Treasuries will follow. But that isn’t necessarily the case. As the chart below shows, the 10-year Treasury note doesn’t always mimic the Fed’s action (for more on this topic, see last week’s Talking Points).
Once the Fed begins rate cuts, it tends to continue cutting gradually and consistently (see chart). The move on the 10-year Treasury, meanwhile, tends to be noisier (more volatile).
The knock-on effects to our market from rate cuts are mostly positive. Fixed-income returns tend to increase when worsening labor-market cycles combine with an accommodative Fed. The total return index of mortgaged-backed securities (MBS) also does well in such conditions (see chart).
The extent of spread compression going forward is less clear. As one would expect, the housing bust of 2007 to 2008 had a harmful effect on spreads in our market (see chart). However, earlier cycles were positive: Fixed-income securities with our convexity profile can (and did) become relatively attractive to peer-group alternatives. This cycle seems to have experienced the worst already, with the regional bank failures of 2023 and the ensuing year-plus journey to find an appropriate investor base.
We continue to hear that bank buying appetite is on the rise, along with money manager interest. A positive sloping yield curve also helps Ginnie Mae REMIC sponsors and Freddie Mac because they fund long-term loan purchases largely with short-term debt. A Real Estate Mortgage Investment Conduit (REMIC) pools mortgage loans together and issues MBS. An upward sloping yield curve benefits REMIC sponsors and other buyers of fixed-rate housing obligations as well because they can earn a positive interest carry while they aggregate MBS and/or loans to securitize.
These conditions, in turn, might translate into tighter spreads; accumulation won’t be as cost-prohibitive a component as it was with an inverted Treasury yield curve. The bottom line: Changing dynamics ought to bode well for the housing and healthcare finance industry during the upcoming cycle—barring any outsize upticks in loan delinquencies or other idiosyncratic events relevant to MBS in the near term.
FROM THE DESK
Agency CMBS — It was another strong week for Fannie Mae DUS and Ginnie Mae project loans. Clean, high-tier, $10 million DUS continues to trade very well—by as much as five bps through the plain-vanilla alternative. We saw the first 15-year DUS trade in a long time, with a basis of about +10 bps to generic 10/9.5-year DUS. Spreads were mixed, but bid dispersion tightened and end-buyer interest was strong.
Ginnie Mae project loans were very well bid too, leading to a broad tightening of about three bps, week over week (WoW). Any higher coupon new origination may require more punitive prepayment premiums (like multiple years of 10% up front), as investors begin to consider bond convexity heading into the upcoming easing cycle.
Municipals — AAA tax-exempt yields were lower throughout the yield curve, WoW. Only a few housing and healthcare sector deals came to market. The 30-day visible supply (deals expected to come to market over the next 30 days) is already over $21 billion—the largest 30-day supply since just before the 2020 election. Issuers are looking to price transactions before the November election, in hopes of avoiding any post-election market disruptions. Municipal bond funds had a tenth straight week of inflows last week, with $956 million coming into funds (over $11.39 billion of inflows, year to date). The high-yield fund component continued to see inflows as well, with $341 million of inflows last week (twentieth straight week of inflows).
Economic Calendar for the Week Ahead
| Indicator | Release | Period | Consensus | Prior |
|---|---|---|---|---|
| CPI, MoM | 09/11/24 | Aug | 0.2% | 0.2% |
| CPI, Excluding Food and Energy, MoM | 09/11/24 | Aug | 0.2% | 0.2% |
| CPI, Excluding Food and Energy, YoY | 09/11/24 | Aug | 3.2% | 3.2% |
| PPI Final Demand, MoM | 09/12/24 | Aug | 0.1% | 0.1% |
| PPI, Excluding Food and Energy, YoY | 09/12/24 | Aug | 2.5% | 2.4% |
| Initial Jobless Claims | 09/12/24 | Sept 7 | 230k | 227k |
| Continuing Claims | 09/12/24 | Aug 31 | 1,850k | 1,838k |
Summary of Global Fixed-Income Markets
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