We’ve discussed in these pages numerous times how dependent the economy has become on the consumer to carry the economic load. That’s why the Conference Board’s Consumer Confidence reading yesterday was a bit of a surprise. The September print came in below expectations at 125.1 versus the 133.0 forecast and 134.2 in August. While the June 2019 number was slightly lower at 124.3 the drop in September was the largest month-over-month decline since December 2018 when financial turmoil was raging. The Conference Board’s measure had recently been climbing while the University of Michigan’s sentiment index has been deteriorating since July. Economists at Deutsche Bank Securities have said that the gap widens ahead of recessions because the Conference Board measure is more backward-looking with a focus on employment, while the Michigan gauge is slightly more forward-looking because of its emphasis on personal finances. With two-thirds of the economy tied to consumer consumption, and with business investment still moribund, any hiccup by the consumer will get the market’s and the Fed’s attention.
The aforementioned miss on the Conference Board’s Consumer Sentiment read for September helped add fuel to a bond rally that had been ongoing beforehand stemming from some mediocre results overseas. Yields are back in the middle of recent ranges with the 10-year at 1.65% which is comfortably nestled between the early September low of 1.48% and the mid-September high of 1.90%. First-tier releases aren’t forthcoming until Friday’s Personal Income and Spending and Durable Goods but there’s still a few chances for Treasuries to be tested.
That testing could come today with speeches from Fed members Charlie Evans (neutral voter), Esther George (hawkish voter), Lael Brainard (dovish voter), and Robert Kaplan (dovish non-voter). Given the make-up of the group it will be most interesting to hear the comments of Charlie Evans as he’s at times been very dovish but more recently moved into the neutral camp. Add to the fact he is a voter and the topic, “Economy and Monetary Policy” his comments will be watched closely by the market.
The divided nature of the Fed was a key takeaway from last week’s FOMC meeting, especially as illustrated in the Dot Plot matrix. We would characterize it as a Fed that has cleaved into three factions. There is a group of five that didn’t really want to cut last week, (and we assume the two dissenters come from that group). Meanwhile, there is another group of five that were ok with the rate cut but nothing more. There is a third faction of seven, however, that were ok with the rate cut and forecast another cut this year. The key then is to glean which dots belong to which officials, as unlike men all dots are not created equal. Most importantly, while there are 17 officials supplying rate estimates there are only nine voters on policy. So determining those voters from those in the peanut gallery, as it were, is key. In general, the voters this year lean dovish so it’s likely that of the seven members looking for anther rate cut this year most carry voting credentials with the two dissenters not wanting to cut rounding out the voting roster.
Our takeaway is that while the median didn’t project another rate cut, those actually voting on policy are more than likely projecting another cut this year if information starts to indicate a stalling in economic momentum combined with docile inflation readings. So, we’re comfortable in thinking another rate cut is coming this year. October may be too soon given the divisions on the Fed so target December, especially if weakening consumer confidence does evolve into weaker spending.
Easily the most popular investment security we’ve been selling in the last month or so has been the 20-year, 3.5% fixed-rate coupon FNMA MBS pool. The security carries a nice balance of yield and performance in the base-case scenario and in both higher and lower rate environments. The 3.5% coupon slots in nicely between a higher coupon pool that might carry too much prepayment risk and lower coupon pools that may experience excessive duration extension in higher rate environments.
We prefer new-issue pools in this case as the underlying loans will reflect much of the recent rally in yields and as such shouldn’t experience excessive prepayments in the near-term. A current offering is displayed below via the YT screen from Bloomberg. As shown, the consensus base-case yield is 2.49% with a 4.17 year duration. If rates drop 100bps,the yield still manages to exceed 2.00% (2.07%) which is not bad considering fed funds will most likely be under 1.00% in such a scenario. Conversely, rates higher 100bps, the yield increases to 2.83% as prepays slow, so that yield pick-up cushions some of the duration extension as it moves from 4.17 years to 6.19 years.
So, if you’re looking for an investment that strikes a nice balance between solid current yield, and also decent performance in either a modestly higher or lower rate environment you’d be hard-pressed to find a better mix than a new 3.5% coupon, 20-year MBS pool. If you have an interest, please contact your CenterState representative.
Agency Indications — FNMA / FHLMC Callable Rates
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