Wednesday, April 29, 2015

Eurodollar Futures and Mortgage Expansion

As the FOMC finishes their meeting, forward interest rates are at a fork in the road.  Since the end of 2008, when short term rates went to the zero lower bound, the expected date of the eventual rate hike has generally remained stable during episodes of QE and has moved forward in time when QE was off.  When QE3 began the expected date was around June 2015.  There has been some volatility in that expectation, but when QE3 ended, the expected escape date was still around June 2015.  This is some pretty solid evidence of QE3's success, but I wish it had been continued just a little bit longer.  Because, by ending it with some time remaining to the expected rate rise, the Fed has left open the possibility that economic stagnation would begin to push the date back again.

In fact, that is what has happened.  We can see in the first graph that through the course of 2014, the expected date of the rate hike moved in a fairly tight range around June 2015.  The second graph shows the date of the expected rate rise, both in terms of the number of quarters from 2012 and the number of quarters from today's date as we move through time.  As we can see, since the beginning of 2015, the expected date of the first rate rise has been moving forward in time on a 1:1 basis.  We are no closer to the date of the first rate hike now than we were in mid-February.

I think regulatory and market developments in the mortgage market are more important now than FOMC forecasts are.  If mortgages expand, rates will rise.  If they don't, rates will not rise, and if the Fed tries to raise them too much, I don't think they will be able to rise by much.

The slope of the yield curve peaked in late 2013 at about 35 basis points per quarter, and has since declined back to about 18 bp per quarter.  Previous rate hike slopes during the Great Moderation have been in the 50 to 75 bp range, so this is very low.  Again, I think this is highly dependent on mortgage expansion.  If the Fed begins raising rates without an expansion in mortgages, the yield curve will flatten.  If they begin raising rates and mortgages are expanding, then we are highly unlikely to see such a low rate of increases, no matter what the FOMC says they plan to do.

Here are four yield curves over time.  At the beginning of QE3, expectations had become very low - not much different than today's.  Then, by fall 2013, long term rates had rebounded significantly and the yield curve slope had steepened.  But, by the beginning of 2015, the slope had declined and long term rates had fallen to a level even below the pre-QE3 level.  Since January, the slope has declined slightly and the date of the first hike has moved back a quarter.  Rates at the long end have remained stable.

One possibility for the extremely low long term rates and slope is that, because of the zero lower bound, expectations are not normally distributed.  There may be a negative skew, so that the mode expected forward rates are higher than the median.  Normally the mean expected rate would be lower than the median in that case, but the zero lower bound truncates the values at the negative end of the curve, which has the opposite effect.  Regarding the slope, there could be a bifurcation of expectations, divided between rates rising at something more like the past rates of 50 bp per quarter or more, and another set of investors who don't expect a rise at all.

Or, another way to look at this is that there is simply a broad disequilibrium throughout the bond market, especially in the long term market, because the collapse in the real estate market has left a hole of $20 trillion worth of US real estate that evaporated, and the combination of a hobbled mortgage market and frictions in the own-for-rental market, that prevent capital expansion in that asset class from expanding enough to capture the large amount of low risk capital in US financial markets.

Mortgage expansion will solve both of these distortions, so I expect mortgage expansion to lead to an increased slope and a higher level for long term rates.  The FOMC announcement will bring some short term volatility, but rates forward enough to have a reduced exposure to the initial rate hike decision should be more exposed to mortgage developments than to transitive FOMC policy statements.

While the government continues to harass mortgage lenders, which is understandable given the consensus view that this is all their fault, mortgage originations appear to be on the rise.  This seems to be showing up in the Fed's H.8 reports, and Flow of Funds looks like mortgage levels are finally ready to rise.  But, this isn't a done deal.  There are even some more regulatory hurdles coming later this year.  And, it seems like there will be a lot of pressure to undermine housing markets if we start to see the 10-15% annual price increases that must be around the corner if mortgage markets begin to function.

In the meantime, I am positioned, tentatively, for this transition, but I consider tomorrow's FOMC announcement to be mostly a source of troublesome volatility until permanent factors become better established.

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