Last week we had Citigroup warning that the market bottom is about to fall out, as the Fed is more than likely to disappoint already very lofty expectations (according to various estimates from both Goldman and the second Tier banks, i.e., all of them, the market has priced in roughly $500 billion in QE3 already). Today, Bank of America, which may or may not be with us much longer, has taken this desperate alarmism several notches further, and is warning that due to the gridlock in both the fiscal ("fiscal authorities have bombarded the markets with a quadraphonic message of hopelessness") and monetary ("the Fed is out of bullets anyway") stimulative pathways, the likely outcome of anything from DC will be nothig short of a disaster. To wit: "rather than a repeat of 2010, when the Fed saved the day with QE2, we think we are moving closer to a repeat of 2008, when major policy errors devastated the economy." For once we actually agree with Bank of America: "In our view, the pressure to “do something” is now far more likely to result in more desperate or radical measures, even if it is bad policy." Does this mean that we are looking at a TARP "vote down" market reaction this Friday if indeed the chairman disappoints? We will know for sure in about 100 hours, which just may be the longest 100 hours for bulls since the start of the artificial and solely QE inspired bear market levitation in March of 2009.
From Bank of America, "Deja Vu"
Summers just haven’t gone that well for markets in recent years. Many have noted the similarities between 2011 and 2010, or even 2008, but in fact the interest rate pattern in each of the past six years has been depressingly and remarkably similar: rising rates and economic optimism in the first half of the year ultimately giving way to pessimism and lower rates in the second half. It indeed seems like we have been here before. But rather than a repeat of 2010, when the Fed saved the day with QE2, we think we are moving closer to a repeat of 2008, when major policy errors devastated the economy.
For mortgages and housing, the 6-year pattern appears particularly problematic. Rates have hit new lows in each successive year since 2006 (Chart 13) but the response, in terms of increased home purchase mortgage applications (Chart 14), has also decreased in each year. The latest week’s sharp 9% drop in purchase activity, as mortgage rates hit a record low, was especially disturbing. The purchase index has not yet taken out the low from a year ago, but it is close to doing so. It appears as if the Fed’s multi-year move to lower rates has been pushing on a string all along when it comes to housing demand. The muted response of the refinancing index (Chart 15), while good for the IO trade we have long recommended, is another indication of the bad news on the mortgage and housing front.
Regardless, as Ethan Harris and Michelle Meyer note in Helplessly Hoping, the Fed is about out of bullets anyway. Meanwhile, the “fiscal authorities have bombarded the markets with a quadraphonic message of hopelessness,” proving that they are “too dysfunctional to deal with the US’s massive fiscal problems.” The situation in Europe appears to be even worse. Against this backdrop, economic risks are increasingly skewed to the downside, indicating that risk aversion is the appropriate market positioning.
We have been steadily adjusting our more optimistic view of risk taking in securitized products downward over the past month, as the debt ceiling debacle and its devastating market impact became reality. At this point, after another week of discouraging market and economic data (most notably for us the mortgage application data cited above), we turn more negative and see little reason to have anything but a market weight exposure to securitized products, in spite of the attractive nominal valuations (Chart 16, Table 5). Within agency MBS, we switch to a down-in-coupon bias and recommend paring back on IO exposure. In credit, our bias is to the highest quality, top-of-the-capital structure bonds.
The environment has become too overwhelmed by uncertainty, particularly on the policy front. In our view, the pressure to “do something” is now far more likely to result in more desperate or radical measures, even if it is bad policy. The most obvious immediate candidate for this is the concern that has hung over the agency MBS market for the past year: elimination of institutional obstacles to refinancing such as loan level pricing adjustments (LLPA) as a quid pro quo for a cut in the preferred dividend payments. The muted refinancing response to historically low interest rates shown in Chart 15 likely has become unacceptable from a policy perspective, and responses are available.
This, along with the increased possibility of a low for long rate environment, particularly if the Fed implements Operation Twist as expected, requires us to reset the benign prepayment expectations we have had over the past year. The capacity argument we made just last week now appears less likely to stand in the rapidly evolving political and economic environment. Just as banks have been pressured to modify existing borrowers, we can look for pressure to be exerted on banks to expand capacity, lower the primary-secondary spread, and refinance high rate borrowers who have faced challenges moving through the refinancing pipeline. In addition, the simple economic incentives of the refinancing business should help drive capacity expansion.