FIDAC Focus
The Economy
August, a traditionally slow month in the financial markets,
did not deviate from precedent. Volume on the New York Stock Exchange averaged
just 1.2 billion shares during the month, down from 1.5 billion share average
for the prior seven months. Summer holidays kept many investors on the
sidelines, as did the twin distractions of the Republican convention in New York City
and the Athens Olympics. Everyone who exhaled in relief when no terrorist
actions took place at these two events were reminded yet again by the tragedies
in Russia, the continued insurgent-led violence in Iraq and renewed homicide
bombing activity in Israel that it is too early to discount geopolitical risk
when surveying the investment landscape.
Although a credible case can be made that a “terrorist premium” is built into the US bond market—investable funds seek safe havens during times of perceived risk—there are likely other, more compelling explanations for the recent rally in long rates. Since June, the 10-year treasury has fallen from a peak of 4.87% on June 14 to 4.12 on August 31. Combined with the rise in the short end of the curve, the yield curve has flattened as the 2-10 year spread has narrowed over that time from 194 basis points to 173 basis points.
Strikingly higher oil prices have not affected interest rates the way they typically do. In times past when oil prices have shown steady increases, so have long-term rates. From 1983 to 1999, movements in the yield on the 10-year Treasury and the price of a barrel of crude oil had a correlation of 0.67. From 2000 to date, the movement of the two time series has a negative correlation of -0.22. What accounts for this? Mohammed El-Erian of Pimco, quoted in Barron’s last month, suggests that what may be different this time is that cash-rich oil exporting nations, faced with higher political risk and lower potential investment returns around the world, have been investing in Treasurys rather than making economically productive business investments. While Asian nations have been the locus of demand for Treasurys, says El-Arian, “[t]hey are now being joined by oil-exporting economies….reflecting their mounting current account surpluses.”
The paradox of higher oil prices is that while they are typically a source of inflationary pressure—the energy component of both producer and consumer price indexes is soaring—they also become a drag on the economy. Economists have argued that higher oil prices take money out of consumers’ pockets or that it is a functional equivalent of a 1% tax. (The always interesting Northern Trust economics team takes issue with the latter argument, saying higher oil prices are not the same thing as a tax. “Stop paying your taxes and stop buying oil. Care to bet on who will kick down your door first, Lee R. Raymond, Chairman and CEO of ExxonMobil or John Snow, Chairman and CEO of the IRS?” In other words, as the saying goes in the United States, there are only two things you can count on—death and taxes. But higher oil prices can lead to a substitution effect.) Another part of the paradox is that China is at once one of the drivers of the tightness in energy prices as well as a driver of disinflationary tendencies.
Which brings us back to what we believe is truly weighing on rates—the economy. Weak economic news kept coming over the month of August: Personal income growth slowed to 0.1% over the prior month, the slowest in almost two years. Consumer confidence declined. The Conference Board’s index of leading indicators trended down for the second straight month. Existing home sales fell for the first time in seven months, and new home sales had a second straight month of sizeable declines. Two retail bellwethers, Wal-Mart and Sears, reported slower sales in August. Ford and GM warned last week that weak sales and building inventories would lead them to cut production. Intel rocked the market with a sluggish outlook, cutting its quarterly profit forecast for the first time in two years. When inventories rose unexpectedly, the company responded with price cuts of as much as 35%. The price cuts didn’t work. Intel CFO Andy Bryant said, “Demand and consumption is less than we expected. It appears worldwide and weighted into the consumer space.”
To us, the economy is faltering and there is little pricing pressure. The employment report released on September 3 showed only a modest gain of 144,000 jobs in nonfarm paryrolls, making the three-month average just 104,000. Despite this, the numbers aren’t so awful that the Fed will be dissuaded from its measured pace of rate increases. In all likelihood, by the time we write next month’s commentary, the FOMC will have raised its benchmark rate by 25 basis points to 1.75%. The futures market agrees, and is still pricing in a 2% Fed Funds rate by the end of the year. If so, the Fed would clearly be making the case that dampening inflation is more important than sustaining growth.
The Mortgage Market
Mortgage prepayments slowed for the 3rd month in
a row in July with aggregate fixed rate speeds declining by about 17% from
June’s numbers and adjustable rate mortgage speeds declining at about half the
pace of fixed rates. However, August numbers are expected to show a
slight increase in prepayment speeds as most dealer forecasts are calling for a
5% to 10% upswing, reflecting the lower mortgage rates we experienced in
mid-July. In addition, leading prepayment indicators in August point to a
continued up-tick in speeds for September and the early Fall 2004. For example,
the MBA Refinancing index trended upward, going from 1600 at the end of June to
1804 at the end of August. Also, Freddie Mac’s Primary Mortgage Market Survey
Commitment rate has declined during the month to an average of 5.87%, 17 bps
below July’s average rate. In the last few weeks of August it seems the
interest rate outlook calling for higher rates has become less clear. As the
yield on the 10 year Treasury approaches 4.00% (August 31 close was around
4.12%) a further threat of a major increase in prepayments is possible as this
would push over 50% of outstanding fixed-rate MBS into the refinancing window
and increase the incentive for hybrid adjustable-rate mortgage borrowers as
well. Couple these lower interest rates with the abundance of mortgage products
available for homeowners and the continued housing price appreciation (according
to the National Association of Realtors, the median resale price of an existing
home was up 8.7% year over year in July) mortgage prepayments can up-tick or
remain near current levels until a move to higher interest rates is sustained.
The Markets
In August, the bondmarket rallied and stocks traded in a range. Gold rallied, oil stayed at
elevated levels.
