The back and forth over US/China trade negotiations has another hurdle to deal with after the US Senate joined the House in passing a bill supporting Hong Kong protestors. China hit back quickly with a “don’t say I didn’t worn you” statement from the foreign ministry and that dark turn has equities on the back foot and Treasuries rallying. While it remains unclear whether President Trump would sign the legislation, the fact Congress has, in effect, issued its own warning has soured the mood in Beijing. Add in poor results from consumer bell-weathers Home Depot and Kohl’s yesterday and stocks, sitting at all-time highs, look a little precarious. Additional consumer-based earnings will be a focus today and Target beat this morning as did Lowe’s, so maybe Tuesday’s misses were more company-specific problems than sector troubles. The minutes from the October 30 FOMC meeting this afternoon will get some attention as well. Investors will be looking for clues that will guide future rate moves, but given Chair Powell’s congressional testimony last week, and other recent Fed speak, it seems the committee is comfortable sitting on pause well into 2020. We think, however, that the typical bout of year-end economic enthusiasm gives way in early 2020 and mounting signs of slowing in early 2020 will force the Fed to resume cutting rates by mid-year.
It’s not an earth-shattering statement to say that the U.S. economy has been reliant on the consumer for some time. The more insightful question becomes two-fold: whether that strength is likely to continue, and whether other segments of the economy are likely to awaken and start to carry some of the load? In light of those questions we offer the following observations:
- Home Depot and Kohl’s both posted disappointing results yesterday, raising fresh doubts about the health of the American consumer heading into the crucial holiday season. The two retailers cut their annual forecasts for the second time this year. While both companies blamed the shortfalls on specific issues -- lumber deflation at Home Depot and lower demand for women’s apparel at Kohl’s -- the weak results from two bell-weather companies sent jitters across markets that have soared to record highs in recent days. Those troubles, however, may be more company-specific as Target and Lowe’s beat estimates this morning and their stocks are looking to open higher.
- Given the troubled state of the US/China trade negotiations—and the seemingly limited scope of a deal if one is secured— business investment and trade are likely to remain under a cloud of uncertainty as we move into 2020, thus, it seems unlikely those sectors will shift from headwinds to tailwinds for GDP anytime soon.
- The somewhat tentative feel around consumer consumption and the continued uncertainty over business investment and international trade have early reads on fourth quarter GDP at somewhat concerning levels. The Atlanta Fed’s GDPNow model sees the quarter at 0.42% while the New York Fed’s model is calling for a similar 0.39%. Bloomberg consensus still expects a decent 1.7% but mediocre early quarter results are showing in the models and that is also buttressing Treasury prices at the present time.
- The 10yr Treasury yield is currently sitting at 1.74% having rallied 23bps in the last two weeks. Given the above we see a range into year-end between 1.70% and 2.00%. Thus, if some positive news develops over trade and reports of solid holiday spending arrive expect yields to drift up towards 2.00% before year-end but without the momentum to crack that level.
Investment Comparison – Relo 30yr 2.5% Coupon MBS vs. 20yr 2.5% Coupon MBS
We’ve discussed in recent weeks the hedging advantages of a 20yr 2.5% coupon MBS pool for the typical asset-sensitive bank. If rates continue lower and variable rates reset, and prepayments and calls accelerate, the asset-sensitive bank is at risk of narrowing net interest margins. As discussed previously, the lower coupon 20yr pools will be less prepay-sensitive to the lower rate environment and at small discounts to near par prices, yields remain stable. Another mortgage bond that provides similar performance but with a little more yield is a Relocation 30yr 2.5% Coupon MBS.
Relo pools are created from specific borrowers that are “relocating” to a new area in support of their employer’s needs. Typically, these are employees that are critical to a business expansion and/or opportunity and that creates certain unique characteristics of these loans/pools. Usually, the loan rate is bought down by the employer as one way to entice the move, and while project times are variable they typically fall in the three to five year range. Thus, the typical pool sees little prepayments in the early years due to the rate buy-down and the short expected life of the pool. After the three to five year project horizon runs its course, loan prepays accelerate as the employee moves on to the next assignment. This allows an investor to reap a 30yr yield with limited prepay and extension risk.
A comparison between a 20yr 2.5% pool and a Relo 2.5% pool is below. Take note of the slightly higher yield of the relo (2.49% vs 2.40%)along with a bit less price volatility given the expected prepay profile (-17.4% vs –19.3%). If your bank balance sheet is asset sensitive and you’re looking for ways to diversify the hedging of lower rates on your net interest margin, consider the advantages of a Relo MBS and contact your CenterState Bank representative.
Agency Indications — FNMA / FHLMC Callable Rates
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