MBS and the Core

Doug Nolan

The Dow (DJIA) traded as low as 24,122 in late-Monday afternoon trading. By Friday's open, the Dow had rallied 1,457 points, or 6.0%, to 25,579. Relatively speaking, the Dow was a tame kitten. From Monday's intraday lows, the Nasdaq100 rallied as much at 7.8%. The Semiconductors won this week's Wild Animal competition, rallying 12.7% (week's lows to highs). At 11.9%, the Biotechs were a close second. The Homebuilders (XHB) rallied as much as 11.3% before ending the week with a gain of 7.3%.

A couple obvious questions come to mind: Bear market rally or just another "buy the dip, don't be one" opportunity for a market again ready to scale new heights? Is President Trump now ready to strike a trade deal with China - or was he just goosing the markets ahead of the midterms?

Let's start with the markets. They certainly had the likeness of a classic "rip your face off" bear market rally. The Goldman Sachs Most Short index surged 9.0% off Monday lows. For the week, this index rose 6.1%, showing off a 2.5 beta versus the S&P500's return (6.1%/2.4%). In the semiconductor space, heavily shorted On Semiconductor, NXP Semiconductor, AMD and Micron Technology gained 23.9%, 18.5%, 14.8% and 13.9%, respectively. A long list of heavily shorted retail stocks gained double-digits this week, as the XRT Retail Index surged 4.3% for the week.

There were a number of heavily shorted biotech stocks that posted 20% plus gains for the week. A bunch of regional banks rose between five and nine percent. And I'd be remiss for not mentioning (everyone's favorite short) Tesla. In just 10 sessions, Tesla rallied (38%) from a low of $253 to Friday's $346 close.

It's certainly worth noting that short squeeze dynamics were not limited to U.S. equities. Let's start at the epicenter of global crisis dynamics, the big banks. The Hang Seng (Chinese) Financial index rallied as much as 8.3% off the week's lows, to end the week up 6.3%. Japan's TOPIX Bank index rallied 5.4% for a weekly gain of 3.9%. Italian banks rose 6.1% this week. European banks (STOXX600) rallied 7.4% off Monday lows, to post a weekly rise of 5.4%. Deutsche Bank recovered almost 11% to finish the week up 8.8%.

The Wildness definitely included the emerging markets. The EEM ETF rallied as much as 10% off of Monday's lows to end the week up 5.6%. Major stock indices were up 7.0% in Argentina, 6.8% in South Africa, 5.0% in India, 4.4% in Taiwan and 4.0% in Turkey. Brazil's Ibovespa index gained 3.4% this week, increasing gains from June trading lows to 25%. Curiously, the Brazilian real declined 1.6% this week. Overall for the week, key EM currencies were caught up in the global short squeeze. The Argentine peso jumped 3.8%, the Turkish lira 3.0%, the South African rand 2.1%, the South Korean won 1.8%, the Indonesian rupiah 1.8%, and the Indian rupee 1.4%. Down 3.3%, the Mexican peso was the glaring exception.

Ten-year Treasury yields traded as low as 3.06% in nervous Monday trading. And while yields ended the week significantly higher, it's worth noting that the October 5th closing high of 3.23% was only 17 bps higher than Monday's "risk off" low yield. That's a meager pullback in yields considering the drubbing global equities were taking.

There's a number of possible explanations for the recent stickiness of Treasury yields, including: 1) Inflationary pressures have gained more momentum than in the recent past. 2) Global de-risking/deleveraging is impacting global market liquidity more generally, with effects even in safe-haven sovereign debt markets. 3) U.S. fixed-income markets have succumbed to deleveraging and resulting waning liquidity. 4) Markets now don't expect the Fed to respond to "risk off" dynamics as early or aggressively as in the past. 5) The U.S. economy maintains significant momentum, especially in terms of tight labor markets.

Ten-year Treasury yields jumped eight bps Friday on the back of stronger-than-expect payrolls data. At 3.21%, yields are only two bps below the seven-year highs posted a month ago. October's 250,000 job gains were a full 50,000 above expectations, as tight labor markets turn tighter by the day. After 10 months, y-t-d job gains of 2,125,000 are running 18% above comparable 2017. October's 32,000 added manufacturing jobs were double expectations, with 2018's 227,000 added manufacturing jobs 64% above comparable 2017. Last month's 3.7% unemployment rate compares to October 2017's 4.1%. October's 3.1% y-o-y gain in Average Hourly Earnings was the strongest since April 2009 - and compares to the year ago 2.3%. If I were a bond, I'd be on edge.

November 2 - Bloomberg (Christopher Maloney): "The bloodbath last month in the mortgage-bond market points to what the future may be like without Federal Reserve hand holding. Investors are now wondering if anyone will step in to stop the bleeding. Returns on mortgage-backed securities in October lagged Treasuries by 37 bps, the most since November 2016… Last month's weakness coincided with the Fed ending its mortgage purchases as it winds down the $1.7 trillion MBS portfolio it amassed since the financial crisis to support the market… In a situation rarely seen over the last four decades, there isn't going to be a government entity -- which before the financial crisis included Fannie Mae and Freddie Mac -- at hand to provide liquidity for mortgage-backed securities…"

Benchmark MBS yields jumped 10 bps Friday to 4.06%, the high going back to April 2011. Yields surged 16 bps this week and are now up 108 bps y-t-d.

My thesis holds that the global Bubble has been pierced at the "Periphery." After erupting at the "Periphery," de-risking, deleveraging and Contagion have been gravitating toward the "Core." Sinking MBS prices (spiking yields) confirm my view that "Periphery to Core Crisis Dynamics" have now attained important momentum at the "Core."

My assumption has been that a most-prolonged period of ultra-low rates and QE liquidity backstops has heavily incentivized leveraged speculation around the world. Globally, levered "carry trade" strategies (borrow cheap in one currency to purchase higher-yielding securities elsewhere) have proliferated. It's worth noting that the NY Fed's holdings on behalf of foreign (chiefly central bank) owners of Treasuries/Agencies dropped $19.8bn last week (to a 3-month low $3.414 TN), the biggest decline since April. I see this as likely evidence of speculative de-leveraging, capital flight, and foreign central bank purchases (dollar sales) to support their currencies. For years now, speculative international flows into EM were at least partially recycled into U.S. markets (including central bank purchases of Treasuries and Agencies). It would appear these flows have slowed significantly - and perhaps are at risk of reversing as global deleveraging gains further momentum.

I believe huge speculative leverage has accumulated here at home as well. I have posited that higher-yielding corporate Credit has been as bastion of speculative excess. And going all the way back to the early-nineties, the mortgage arena has been treasured by a flourishing leveraged speculating community. The MBS marketplace has generally been highly liquid, with securities easily financed in the booming "repurchase agreement" ("repo") market.

The above Bloomberg article noted a "situation rarely seen over the last four decades." The market is questioning the source of market liquidity going forward. This has become a pressing issue now that the Fed has begun liquidating its MBS portfolio. The predicament is compounded by the GSE's unsound financial position, one that limits their capacity to provide a powerful liquidity backstop as they did throughout the nineties and for much of the mortgage finance Bubble period (until their growth was impeded by revelations of accounting fraud).

If it is correct that de-risking/deleveraging dynamics have reached the "Core," the MBS marketplace faces challenges. In particular, as the hedge funds suffer mounting losses elsewhere (i.e. stocks, global markets, corporate Credit…), they will turn more averse to risk generally, including a vulnerable MBS marketplace. And as the speculator community moves to de-risk in MBS, it is not obvious who will step up to buy. Alternatively, as they hedge interest-rate risk by shorting Treasuries, this places additional selling pressure on a Treasuries marketplace already facing massive issuance and formidable Fed liquidations.

Mortgage-backed securities are a problematic instrument. When yields drop, borrowers refinance or are more likely to purchase new homes. MBS owners get their money back much sooner than they would prefer (with lower reinvestment yields) When yields rise, MBS duration increases as borrowers hold their attractive mortgages longer.

Over recent decades, this fundamental MBS weakness was more than offset by two critical factors. One, the GSE's eagerness to purchase securities, especially during deleveraging/crisis backdrops. Second, the Fed's willingness to aggressively cut interest-rates in the event of "risk off" marketplace liquidity issues (or, better yet, to buy $1.8 TN of MBS). With rates and yields currently rising, MBS vulnerability is obvious. Meanwhile, traditional offsetting liquidity advantages (GSEs and Fed) are anything but readily apparent going forward.

After the mortgage finance Bubble collapse, it was only natural to anticipate a significant widening of risk premiums throughout the mortgage complex. I expected a fundamental repricing of mortgage Credit, but it was not to be. The Fed slashed short-term borrowing costs to zero and expanded its balance sheet to $4.5 TN, including the purchase of $1.8 TN of mortgage-backed securities. Moreover, after a period of shrinkage, the GSEs again began expanding their mortgage holdings. Between expanding Fed and GSE holdings and the relatively weak household demand for mortgage borrowings, mortgage borrowing costs collapsed.

MBS yields averaged 7.75% during the nineties, and then sank to 6.00% during 2000 through 2007. Well, benchmark MBS yields averaged an extraordinary 3.25% between 2009 and 2017. This pricing anomaly might have finally run its course, with major ramifications for the mortgage marketplace, overall securities market liquidity and the general economy. For a very long time, the MBS marketplace acted as both a key source of marketplace liquidity and a centerpiece of government (Treasury and Federal Reserve) policy activism. The Fed's post-crash efforts to collapse borrowing costs both significantly reduced household mortgage payments, while enriching the holders of mortgage securities. But now losses for levered holders of MBS are mounting, including for the Fed and the barely capitalized GSEs. Payback Time.

I don't want to dismiss the importance of the unfolding U.S. and China trade war - or possible successful negotiations. A trade agreement would be market positive. The markets were buoyed this week by constructive comments from President Trump and Chinese officials. Commentators were understandably skeptical of the timing just days before the midterms. Yet it doesn't take highly speculative "oversold" markets much to be incited into a decent short squeeze.

At the same time, I don't believe the U.S./China trade spat has been the major force behind global de-risking/deleveraging. Stated differently, this dispute worsened the situation but was not the catalyst behind the bursting of the global Bubble. Indeed, from a de-risking/deleveraging perspective, Friday's yield jump was ominous. Fixed-income investors and speculators have no doubt been hoping that "risk off" would provide some relief on the market yield front. With an equities short squeeze and strong payrolls data, the pressure just became too intense.

MBS yields have broken out to the upside, with corporate and Treasury yields close behind. Equity market players are certainly hoping a trade deal is in the works. Fixed-income players not so much. And it is within fixed-income on a global basis that problematic leverage lurks. Leveraged "risk parity" strategies saw some relief from this week's equities rally, but they must look at rising market yields with increasing trepidation.

We're now only days from the midterms. It's an especially difficult event to handicap from a market standpoint. Red wave or blue wave. I don't recall midterm elections where the outcome had the potential to be so market moving. Blue wave - big. Red wave - big. Making things all the more interesting, there has been major market instability heading into the elections. This ensures there have been major shorting and hedging efforts - to hedge/speculate both on the markets and midterm outcomes.

I'll assume large quantities of put options and derivative protection have been purchased. In the event of a red wave, there is ample firepower for an unwind of hedges and short covering to spark a rally. In the event of a blue wave, a market downdraft would see aggressive hedge-related selling by players caught on the wrong side of derivative protection previously sold. The stock market response to the anticipated blue House and red Senate split decision is not clear at all. But maybe equities have become a diversion. In a week where the focus was on short squeezes and tantalizing equities rallies, perhaps the more decisive development was in surging MBS and corporate yields.

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