The presence of an inverted Treasury yield curve over the past month, coupled with anticipated Federal Reserve tightening, has left a great deal of volatility in the market. However, while these measures should indicate a slowdown, the housing market is still very strong.
"You'd think with higher oil prices, higher mortgage rates, a faltering stock market, that housing activity would slow down a bit, but it's been remarkably resilient," said Michael Hoeh, head portfolio manager at Dreyfus Corp.
He credits this to a leftover wealth effect created from the equity markets over the past five years. "I've seen the affordability index for housing has really been at a relatively low point in history for the United States, and that's certainly helping," he said. Housing starts were up 1.5% in January, and the Mortgage Bankers Association's index that was released last Wednesday was "pretty strong," he added.
Spreads have also been on a roller coaster ride throughout the week. Overall, "Spreads have widened on the week by about eight basis points versus Treasurys," said Dale Westhoff, managing director at Bear, Stearns & Co.
"We started the week Monday morning, with 10-year swap spreads were around 92 and now, Thursday, they're out to 101.75," added Hoeh. "We've been wider during the week and we were very tight. We were tighter than 90 at one point this week, so it's been remarkable how much volatility there's been."
Difficult Hedging Decisions
These spread fluctuations have greatly affected hedging decisions. "It's become impossible to hedge mortgage-backed securities," Hoeh said. "Even if you're hedging with agency debt, or swaps, it makes it difficult, let alone try to hedge with the Treasury market, because it doesn't seem to be correlated to anything anymore."
"The best hedges, swaps and agency debentures, are used a lot more frequently now, in combination with the collateral and Treasurys," added Westhoff. "With that kind of volatility, it kind of reduced liquidity on the street. I think dealers' positions are down as a result of that and that obviously impacts liquidity in the market. I think the yield curve volatility has kept a lot of people on the sidelines, trying to adjust durations and come up with good duration measures for MBS."
Hoeh agreed. "I think hedging has become so tricky that it really diminishes people's willingness to make an investment or trade and change their investment profile, because it's just very unpredictable."
What About Prepayments?
With the mortgage rates up sharply this year, there is also an increasing concern about prepayment speeds. Rates this week were near 8.38%, putting over 90% of the market in the discount category.
"The question is whether we're going to continue to see robust prepayment numbers into the spring with this housing market or not," said Westhoff. "The leading indicators, the title search index and the MBA index, have rebounded back to like October, November levels. The question is whether that's going to translate into fast prepayment on 6%, 6.5% and 7% issues that are really deep discounts."
"I think people are really believing that prepayments are going to continue to drop off, but it's amazing at how resistant the housing activity has been," added Hoeh.
Look Out For a Recession, Maybe
With the Federal Reserve Chairman Alan Greenspan telling Congress that the economy is not slowing down enough and may have to raise rates further, observers are starting to see the first indications of an imminent recession.
"It looks like the market is definitely priced in on another 25 basis point move in March by the Fed. The curve has inverted more today, so that continues to be a factor in the MBS market," said Westhoff.
However, Hoeh has indicated that a combination of coincidental events, when looked at through history, are giving obvious signs of a recession. "Not only if you look at when the yield curve has been inverted, it's typically coincided with a run up in oil prices as well." He added that there have only been very few inverted yield curves in the past, and they all led into a recession.
With the higher oil prices, a more aggressive Fed, and the inverted yield curve, "Certainly things are lining up in a very ominous way," Hoeh said.
