Strong Evidence of Continued Low Rates in 2012
Posted by Barry Simson on January 19, 2012
The bond market has three main issues it is talking about these days.
The first is the absolute level of rates. The second is the level of mortgage rates and specifically whether they need to go lower to help spur the economy. The third is whether we will be hit with a “Japanese scenario” or a “European scenario.” The Japanese scenario is having low rates for a long time with low economic activity, while the European scenario is one where budget deficits chase away bond buyers, causing rates to climb significantly until budgets are fixed.
For anyone keeping track, a generic portfolio of bonds (formerly known as the Lehman Brothers Aggregate Bond Index) was a better investment than the S&P 500 index over the past 10 years. Those who dumped their 7% long term bonds for equities during the tech boom lost out. This is a rare occurrence when the bond market continually returns more than equities. The most recent Treasury auction for 10 year notes had a yield of less than 2% for the first time in history. The Consumer Price Index (CPI) was up 3.4% last year. If it stays at that level, 10 year Treasury bonds will have a negative return net of inflation in 2012.
Last year we figured (a different author) that rates could not decline further, yet rates declined significantly. Short rates declined to about half of what they were and longer rates declined by a third. Two years ago, regulators told bankers to be ready for higher rates, invest short as higher rates were coming. Banks’ earnings are being hurt by the skimpy return on those short investments as they wait for higher rates. As a depositor, you are affected by the low rates being offered on your deposits. So how low can rates go? A number of Treasury auctions of short bonds have shown negative yields. Apparently the buyers were just happy to know they will get their money back.
We have seen a significant drop in mortgage rates over the past year. During the early part of last year rates of 4.75% or higher were the norm. Now rates are closer to 3.75% for a 30 year fixed rate loan. Rates can be under 3% for a 15 year term loan. Members of the Federal Reserve Board (the Fed) have been actively giving speeches about the need for housing to pick up. There has never been a strong recovery without a strong housing market. There have been suggestions that Quantitative Easing 3 (QE3) will occur targeting mortgage rates and causing them to decline further. We believe this will occur driving mortgage rates even lower. However, the debate will be which came first, the chicken or the egg? Is a strong housing market the result of increased economic activity or does increased housing activity create a strong economy? Given we have had three or four years of incentives, artificially low rates and up to 16 different housing and refinance programs, it appears a strong economy leads to a strong housing market. Before a strong housing market can appear, all the houses associated with delinquent and foreclosed loans need to be sold so a more normal market can begin. The overhang of those houses will take over a year to clear out.
One side note on sub-prime mortgages. While some banks have had legal issues surrounding their role in the sub-prime mess, recently the Securities and Exchange Commission indicted the first individuals for their roles in the problem. Those individuals were not Wall Street bankers but the heads of FNMA and FHLMC. We have long maintained that FNMA/FHLMC dictate residential loan credit standards. Mortgage originators like Countrywide could not originate sub-prime loans without someplace to sell them. FNMA and FHLMC were initially the major purchasers of those mortgages. In fact, both those corporations had mandates from the Housing and Urban Development Agency (HUD) to increase their purchases of loans made to low income borrowers. Part of the background data the SEC collected showed that 1.) The agencies knew that to increase their purchases of loans made to lower income individuals, their credit standards would need to be relaxed, which would lead to increased defaults, and 2.) There was very little volume of sub-prime loans until FNMA and FHLMC began purchasing them. Once FNMA/FHLMC changed their credit criteria and began purchasing sub-prime loans, volume escalated and once it was significant, then Wall Street got into the act.
The final question is, what will happen to rates? While markets bounce around, we do not believe there is any reason to expect a significant increase in rates at this point. With one exception, to be found later in this discussion. To have rates rise, you need to have significant economic activity, fears of inflation or a lack of demand for your securities. There is nothing to indicate that there will be additional strength to the economy going forward. The employment situation is not good, the regulatory situation is not good and business confidence is not good. Expectations for inflation this year are that it will fall from last year. The Fed is targeting inflation rates between 1.5% and 2.0%. The final item is demand. U.S. Treasury securities are still the safe haven security despite a downgrade last summer. With the European debacle continuing and tensions in the Middle East, there is still plenty of demand for Treasuries.
The one exception to the low rate scenario is if the U.S. enters a European type scenario. We call it PIIGS R US. By that I mean the situation where bond buyers and currency traders begin to demand higher yields on U.S. Treasuries as a result of our budget deficits, the same as they are doing in Europe. For that scenario to occur, Europe would have to come up with a final solution to their budget and entitlement problems so that the traders would begin to change their focus to the U.S. They have been wrangling about this in Europe for two years and we expect that wrangling to continue for a while longer. We have seen the problems in the U.S. when Congress tries to negotiate any sort of deficit reduction. So if the focus shifts to the U.S. and our rates do start to rise, we anticipate that it will take some time for our elected leaders to figure out what to do, just as it is in Europe.