June 25, 2018
Mortgages traded mostly in line with the Treasury curve this past week. Current coupon 15-year MBS yield spreads ended the week 1bp wider to Treasuries, while 30-year MBS yield spreads widened 2bps. Mortgage rates and volatility moved in a narrow range this week as the economic data was relatively light.
The yield curve continued to flatten with the 2/10s spread narrowing from 37bps to 35bps. A new cycle low of just 34bps was reached this morning. As noted previously, this trend has been beneficial for valuations in the MBS sector as investors have sought defensive structures that provide near-term cash flow.
The housing data from last week was mixed with housing starts rising more than expected. Builder confidence remains strong but pulled back because of the growing concern of rising construction costs, as the price of lumber has increased 59% YoY and is essentially double the average over the past 15-year years. While new construction remains positive, existing home sales are struggling with a 2% decline YoY.
Activity last week was primarily focused on the following:
- 10-Year 2.0s, 2.5s, and 3.0s – Investors continue to favor 10-year MBS for the incremental spread and shorter cash flow structure, as rates have increased and the yield curve has flattened.
- 15-year 2.5s – This coupon has underperformed most other coupons over the past month. The cheapening trend along with the flattening yield curve has resulted in a relatively small pay up over TBA for pools with seasoning between 18 to 36 months. In some cases, investors can potentially receive an outsized reduction in price volatility for a modest trade-off in projected yield. Please see the latest Strategic Insight discussing the current merits of slightly seasoned, below par 15-year MBS.
- FNMA DUS and Freddie K’s – Trading activity in this sector has been modest due to a lack of product in the secondary market and potentially reflecting the fact that the spread between Agency CMBS and pass-throughs has converged closer together. Traditionally, the focus in this sector has largely been on the 3- to 7-year part of the curve, with investors seeking locked out cash flow and positive convexity. However, due to the bond market sell-off, certain discount pass-throughs (~150bps out-of-the-money) offer less negative convexity now and have comparable valuations to Agency CMBS.
Mortgage Rates and Refinance Activity
- Mortgage rates were relatively stable for the week ending 6/22.
- 15-year mortgage rates held firm at 3.89%, 52bps above the 12-month average of 3.37%, and 19bps above the YTD average.
- 30-year mortgage increased 2bps to 4.45%, 41bps above the 12-month average of 4.04%, and 16bps above the YTD average.
- 15-year mortgage rates have increased 69bps in 2018, while 30-year mortgage rates are up 60bps YTD.
Mortgage applications for the week ending June 15 rose 5.1% on a 4.3% increase in purchase apps and an unusual 6.1% increase in refi apps. Regardless, refi apps on a 4-week moving average basis are at their lowest level since 2001.
New Construction Activity So Far Unfazed by Higher Mortgage Rates: Housing starts rose more than expected in May, up 5.0% (exp. +1.9%), as activity in the Midwest skyrocketed. New home starts rose 62% MoM in the Midwest while they fell in the South (-0.9%), the West (-4.1%), and the Northeast (-15.0%). Back at the national level, starts rose at a 1.35 million annualized rate, the best pace since the housing correction began. Single family starts rose 3.9% and multi-family rose 7.5%. However, new permits filed for construction fell for a second month, down 4.6% after a 0.9% drop in April. The drop in new permits was primarily the result of weakness in the South and the West while new permits in the Northeast jumped 42.1% and 7.2% in the Midwest. Despite the May weakness for building permits, they remain up 8.3% YoY while new starts are up a stellar 17.8% YoY – despite a 60+ bps increase in mortgage rates over the past year.
Home Builders Less Confident as Costs of Construction Remain High: The NAHB’s home builder confidence index cooled unexpectedly in June, slipping back to 68 to match its lowest level of 2018. While disappointing, the index has oscillated around 70 for the last several months which continues to be one of the strongest levels of the cycle. Each of the key metrics saw a 1-pt moderation; current single family sales (75), single family sales over the next six months (76, lowest since September), and prospective buyer traffic (50, lowest since October). Pricing headwinds from higher rates, low housing supply, and new construction input costs have yet to subside. Officials from the NAHB said “Builders are optimistic about housing market conditions as consumer demand continues to grow, …Improved economic growth, continued job creation and solid housing demand should spur additional single-family construction in the months ahead.” But, “builders are increasingly concerned that tariffs placed on Canadian lumber and other imported products are hurting housing affordability. Record-high lumber prices have added nearly $9,000 to the price of a new single-family home since January 2017. …builders do need access to lumber and other construction materials at reasonable costs in order to provide homes at competitive price points, particularly for the entry-level market where inventory is most needed.”
Existing Home Sales Were Disappointing in May: Existing home sales, expected to rise 1.1% in May, fell 0.4% to an annualized rate of 5.43MM units. That represented the slowest annualized pace since January and extended an essentially sideways trend that started in early 2016. Looking at the details, activity in three of the four regions slowed: South -0.4%, West -0.9%, Midwest -2.3%, Northeast (smallest volume) +4.6%. The signals from other metrics in the report showed the story was consistent with prior months. Demand for existing homes remained steady based on the average home moving from listing to closing in just 26 days. On the supply side, total inventories grew by 50k to a total of 1.85MM helping to push months’ supply up to 4.1; both were the highest since September. However, that didn’t keep the median price from reaching a new all-time high of $264.8k and the NAR’s chief economist from saying “The housing affordability issue is becoming a crisis.” The group’s president echoed his concern, saying “seller clients are dealing with a seesaw of emotions when deciding to put their home on the market…While they’re thrilled that they will immediately find multiple buyers interested in their listing, many fear they’ll have extreme difficulty finding another home to buy.”
White House Proposes GSE Reform, Remains Lofty Goal: The White House released a proposal to reorganize many aspects of the federal government last week which included a list of 32 recommendations. Two of those recommendations, which had previously been discussed by the administration, are relevant for high-grade fixed income investors, divestiture of assets owned by the TVA and GSE reform. Divestiture of TVA assets could result in a widening of spreads for TVA debt to more resemble secured utility debt. GSE reform would have a bigger impact on investors but the proposals protect bondholders and passage of reform still appears distant. While Congress has made some legislative progress recently, that has slowed and the looming mid-term elections are likely to keep that slow. The GSE proposal paralleled the Corker (and other) plans and called for ending the conservatorship of Fannie and Freddie, reducing the housing market’s dependence on the GSE’s, and providing an explicit government backstop for some smaller component of housing finance that would be accounted for on-budget.
Michael S. Erhardt, CPA
Senior Vice President
Vining Sparks, IBG