Why A Record Steep Curve Means The End Of The Fed's Subsidies To Banks

Over the past week, one of the less noticed and more notable developments, was that the 2s10s quietly climbed back to just short of all time record wides: at 273 bps, the curve is just 13 basis point away from the all time record 286 bps achieved on February 2, 2010. For those who still don't understand how this most recent gift to the banks by the Fed and the government works, the math is that for every 100 bps in spread widening, banks make profits by borrowing free at the 2 Year and lending out at the 10 Year spread (on a Price x Volume basis, although as we will discuss momentarily while the price (i.e. spread) may be there the volume is missing), even as home prices decline by about 12% for each percentage point. In other words, in the past year the entire double dip in home prices can be attributed to the spike in long-term rates, which have in turn caused mortgage rates to jump to year highs. All of this has been predicated by increasing concerns that the Fed will allow runaway inflation, as a result pushing 10 and 30 Year spreads (and gold) ever higher. And while traditionally, a steep curve implies substantial bank profits, this time it is really is different, as demand for mortgages, by far the biggest bank product beneficiary from rising LT interest rates, is non-existent - recent new and refinancing mortgage applications are plumbing 15 year lows, meaning that even if banks make exorbitant profits on a spread basis, there is just not enough of them to go around, which in turn means that banks once again have to rely on accounting gimmicks such as declining reserve provisions to pad their books. And unfortunately for the banks, every incremental basis point increase from here on out only means accelerating home price deflation (regardless of how many days in a row cotton, wheat and whiskey closes limit up), which will wreak havoc on myth of any "recovery." This is in fact the most salient point of Scott Minerd's of Guggenheim latest letter: while the bulk of his latest thoughts is focused on Europe, we believe that the critical part if really that dealing with US interest rates. As he concludes: "The story in housing remains a compelling reason yields on the 10-year note above 4 percent are simply not sustainable at this juncture." We complete agree, which also means that the strawman of higher bank earnings due to the yield curve is now dead and buried. Alas for all the bank bulls, from this point on the only direction the curve can go is down... Unless of course the Fed really loses control of the long end in which case all bets are off and QE3 is sure include purchases of MBS.

From Scott Minerd:

In terms of interest rates in the United States, my view continues to be that of a period of sustained low rates with only marginal room to rise. The core of the story for why rates must stay low has to do with the continued depression in the housing market. Estimates for the current level of shadow inventory – i.e., the number of homes in some stage of default or foreclosure – broadly range from 4 million to 8 million units. Specifically, on November 17, Fed governor Elizabeth Duke told Congress that the Federal Reserve expects an additional 4.25 million foreclosure filings in 2011 and 2012.

When long-term interest rates rise, housing activity slows. Rates above 4 percent would create a myriad of issues for the housing market, not the least of which would be hamstringing the ability of financial institutions to work through the backlog of foreclosures on their balance sheets. Since the backup in interest rates began approximately eight weeks ago, we’ve started to see housing activity wane and housing prices decline again. If housing prices decline meaningfully, there is significant risk of another wave of mortgage defaults. The story in housing remains a compelling reason yields on the 10-year note above 4 percent are simply not sustainable at this juncture.

Further evidence against rates rising meaningfully comes from the historic relationship between the Fed funds rate and the 10-year Treasury yield. Over the past 30 years, the 10-year note has never been able to sustain a spread to the Fed funds rate greater than 375 basis points without precipitating a major rally. Currently, a spread of 375 basis points would translate into a 4 percent yield on the 10-year Treasury, which further leads me to believe that this is a pretty hard ceiling. I don’t necessarily think yields will get to 4 percent, but I do think they may test 3.80 before coming back down to the 3 percent range in the second half of the year.

On the other hand, Bernanke is not stupid, and we are confident that should long rates continue to surge which will make his precious banking cabal even stronger in the eyes of the propaspintura, the Chairman will simply do what Bill Gross has been telegraphing for months now: launch QE 3 with a muni and MBS focus. And if the S&P dares to dip even a little as a result, ETFs and REITs as well, as the US takes one more step toward becoming a Japanese style economic catastrophe.

Full Guggenheim Partners letter link.