TRV Mid-Month Commentary | August 2015
The news cycle for the first half of August has been dominated by global growth concerns following the People’s Bank of China’s surprise decision to devalue the Yuan that resulted in the largest one day decline in two decades. Global markets largely saw the move as a play to increase export activity, spurring fears of a decline in global growth that set the tone for a risk-off mentality.
Global economic concerns have also caused investors to contemplate whether the Fed will move in September, and July’s change in Non-Farm Payrolls provided little guidance to potential Fed policy as the numbers came in at expectations. We note that the market has turned more bearish on a September hike as the Fed Funds futures market implies a 36% probability of such an occurrence, down from near 50% a few weeks ago. Although the Fed’s most recent Dot Plot implies two hikes in 2015, we are less certain of this outcome following recent news. Despite the uncertainty surrounding a September hike, 10yr yields managed to increase 2 bps to 2.18 while 5yr yields increased 7bps resulting in a 5bp 10/5 bear flattener.
In this backdrop, securitized credit faced headwinds as spreads were pushed wider and weaker credits underperformed due to a steepening of the credit curve. While weakened sentiment regarding the global economy has had an impact on the credit instruments, the US housing and economic fundamentals remain supportive. We view these dips as buying opportunities with the expectation that fundamentals will ultimately drive spreads tighter. At current levels, there is value in last cash flow tranches of GSE credit risk transfer bonds as well as in BBB-rated single family rental securitizations. Non-traditional ABS such as aircraft, NPLs, and marketplace lending transactions offer incremental yield and have weathered the recent volatility quite well due to strong investor demand.
Recent market action and the risk-off sentiment has likewise affected hedged return on the mortgage basis: hedged with 5yr Treasuries, premium 4.0s widened 2 ticks, while widening 8 and 5 ticks versus the 10yr and Treasury Curve hedges, respectively. Premium 4.5s, however, performed poorly against bullet and curve hedges having widened between 7 and 10 ticks. Since August 1st, the basis has cheapened between 5 and 9 ticks owing to deteriorating rolls, low level of rates and diminishing bank, oversea and REIT demand. We consider the timing may perhaps be ripe for a tactical long position, but our long-term view leans much more bearish. We tread cautiously at this juncture and look to September for clarity.
Since the end of June, we note that the mortgage rate has fallen 27 bps and that the refi index continues to climb from its June low. That said, we expect a 5-10% decline in prepayments from July to August on lower turnover and refi activity, particularly for cuspy 3.5s and 4.0s of 2013 & 2014. While this sounds counterintuitive, it is important to mention that the Refi Index is a leading indicator and refi applications take some time to work its way through the pipeline. Over the last couple of months, option-adjusted spreads on IOs and Inverse IOs have remained relatively stable. However, a surprise decision from the Fed could temporarily cause spreads to dislocate and provide advantageous volatility.
As September looms, we continue to find pockets of opportunity in our markets but remain cautious due to potential knee-jerk reactions. Overall, we think the coming months will yield abundant opportunity.