August 20, 2014 | By Scott Minerd
The consensus among market watchers last September was that, with U.S. interest rates so low and the U.S. Federal Reserve (the Fed) about to withdraw stimulus, interest rates would trend higher. I took a different view, writing in a commentary that “10-year rates may be heading back to 2.25 percent or lower.”
When 10-year Treasury yields ended 2013 at 3.02 percent, some may have thought I had taken the wrong end of the bet. But in early August, 10-year Treasury yields went as low as 2.35 percent and I believe the path of least resistance on interest rates is still lower.
A number of factors have helped push Treasury yields lower. With yields on German 10-year Bunds dipping under 1 percent for the first time and Japanese government bonds yielding around 50 basis points, Treasuries look comparatively attractive. Add to that the perception that both the yen and euro are a one-way bet toward depreciation and it is reasonable to expect that international capital will continue flowing toward the U.S., pressuring Treasury yields down as quantitative easing draws to an end.
Tensions from Ukraine to Iraq have added to a flight-to-quality trade, boosting demand for U.S. Treasuries. With the size of incremental U.S. government borrowing also expected to decline because of shrinking federal budget deficits, Treasury yields could move lower.
My original forecast of 2.0 to 2.25 percent still seems reasonable. Nevertheless, markets do not move in straight lines, so yields could retrace to 2.5 percent in the near term. Ultimately, as rates head back toward 2 percent portfolio managers should use the rally to reduce interest rate risk.
U.S. interest rates have declined since the start of 2014 and, despite widespread expectations of rising rates, they could continue to fall. The path of least resistance on interest rates is still lower given a number of reasons, including the relative attractiveness of U.S. Treasury bonds over those of other comparable countries, such as Germany and Japan.
Source: Guggenheim, Bloomberg. Data as of August 19, 2014.
As anyone experienced in investing in the U.S. mortgage market knows there is a phenomenon that traders call the “refi bid.” When interest rates fall, a larger percentage of mortgages become economically attractive to refinance at a lower interest rate.
Whenever a threshold is breached where a large amount of mortgages make attractive refinancing candidates, prepayments spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.
Currently, I estimate that the next “refi level” will hit when the 10-year Treasury yield drops to about 2.25 percent.
An unusual feature of this potential wave of mortgage refinancing is that the vast majority of U.S. mortgages are on the cusp of being candidates for refinancing, given the relative stability of mortgage rates over the past year or so.
Additionally, there is one dominant holder of these mortgage securities that has vowed to reinvest in new mortgages as prepayments come in—the Fed.
Traditionally, in a refinancing rally, spreads on mortgage-backed securities (MBS) widen due to increased prepayment risk and expected increases in supply. Spreads will not widen on this occasion to the same extent as during previous refi rallies for a number of technical reasons.
Among those reasons is that the Fed, the biggest mortgage investor on the block, has made clear it will reinvest principal repayments dollar for dollar. Normally, the widening in mortgage spreads mutes the impact of the rate decline on mortgage rates, slowing the pace of refinancing.
This time, advertised mortgage rates are likely to fall more rapidly than in prior refi experiences.
During a “refi rally,” when interest rates fall, MBS spreads normally widen as prepayments rise. However, if we experience another refi rally, the rise in spreads should be muted relative to historical trends given the share of MBS owned by the Fed, which has said that it will reinvest principal repayments dollar for dollar.
Source: Guggenheim, JP Morgan, Nomura. Data as of August 19, 2014. RHS= Right Hand Side.
Given the likely rapidity of the interest rate decline, the potential for shortening in the duration of fixed-income investment portfolios could further intensify the current rally and lead to a more extreme decline in rates than would normally be anticipated.
Declining mortgage rates will also give a lift to housing affordability, which could help clear unsold inventories of homes and support new construction activity. This would further support the U.S. economy.
Ultimately, this expected run-up in bond prices and the associated decline in interest rates should prove unsustainable once the refinancing bid is past. For the near term, risks favor lower interest rates—perhaps sharply lower. In the medium term, as the economy strengthens further, this rally will reverse itself and will have proven to be a selling opportunity.
It is premature to sell now, but as 10-year U.S. Treasury yields approach 2 percent it should provide an opportunity for rebalancing portfolios. In other words, don’t chase the rally, but don’t fight it either. The opportunity to sell bonds is coming— but not just yet.
Spread is the difference in yield to a Treasury bond of comparable maturity.
A basis point (bps) is a unit of measure used to describe the percentage change in the value or rate of an instrument. One basis point is equivalent to 0.01%
Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.
This article is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product or as an offer of solicitation with respect to the purchase or sale of any investment. This article should not be considered research nor is the article intended to provide a sufficient basis on which to make an investment decision. The article contains opinions of the author but not necessarily those of Guggenheim Partners, LLC its subsidiaries or its affiliates. Although the information presented herein has been obtained from and is based upon sources Guggenheim Partners, LLC believes to be reliable, no representation or warranty, express or implied, is made as to the accuracy or completeness of that information. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and nonproprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed as to accuracy. This article may be provided to certain investors by FINRA licensed broker-dealers affiliated with Guggenheim Partners. Such broker-dealers may have positions in financial instruments mentioned in the article, may have acquired such positions at prices no longer available, and may make recommendations different from or adverse to the interests of the recipient. The value of any financial instruments or markets mentioned in the article can fall as well as rise. Securities mentioned are for illustrative purposes only and are neither a recommendation nor an endorsement. Individuals and institutions outside of the United States are subject to securities and tax regulations within their applicable jurisdictions and should consult with their advisors as appropriate.
Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Aviation, Guggenheim Real Estate, LLC, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2014, Guggenheim Partners, LLC. Guggenheim Funds Distributors, LLC is an affiliate of Guggenheim Partners, LLC and Guggenheim Investments. For information, call 800.345.7999 or 800.820.0888.
Funding and trading markets are not functioning well due to excessive leverage needing to be unwound in the financial system.
Markets often overshoot, and just because things are cheap doesn’t mean they can’t get cheaper.
Without the right programs, this shortfall in credit availability will increase and it will further deepen the crisis.
Brian Smedley, Head of the Macroeconomic and Investment Research Group, and Portfolio Manager Adam Bloch share insights from the fourth quarter 2019 Fixed-Income Outlook.
Anne Walsh, Chief Investment Officer for Fixed Income, shares insights on the fixed-income market and explains the Guggenheim approach to solving the Core Conundrum.
You are now leaving this website.Guggenheim assumes no responsibility of the content or its accuracy.
Your browser does not support iframes.
2020 Guggenheim Partners, LLC. All rights reserved. Guggenheim, Guggenheim Partners and Innovative Solutions. Enduring Values. are registered trademarks of Guggenheim Capital, LLC.