As if things aren’t crazy enough as it is, with all of the end of the quarter business, this past week will mostly be remembered for the Mueller Report release and the 3-month – 10 year Treasury yield curve inversion. While the latter of the two is the only part that has any implications on our markets, the former certainly provides fodder for us citizens who have been sitting watching a circus for the last two years. Whether you enjoy seeing Rachel Maddow cry or Sean Hannity slap some “I told you so’s!” in your face, the bottom line is that (seemingly) the probe is over, and no matter which side of the aisle one leans, it is time to move on and quit harping, unlike Kevin after getting dumped by Winnie, or Brenda moving on from Dylan. The inversion of the yield curve always has its effects on the markets, most important of which is the historical prediction of an economic recession “X” number of months down the road. It’s no secret the market has been heading in this direction for the last 18 months, particularly as the Fed continued to raise short term rates while ignoring the data pointing to a global economic slowdown, and thereby inherently flattening the curve to pre-2008 levels, despite the calls of many (including the President) to cease and desist. Alas, now we find ourselves in a situation where Fed Futures have reversed course and are now pricing in one, if not two, rate cuts by year-end 2019, something bond pros are clearly cheering and buying into, giving 10 year yields a chance to rally well inside the elusive 2.50% mark, and better than the chance Chester Copperpot was given when searching for One Eyed Willie’s Treasure. The shape of the yield curve, however, is an anomaly, looking more like Disney’s Splash Mountain, and there is more there than meets the eye.
While the talk of the week has been the 3 month – 10 year Inversion, only slightly less analyzed has been the steepening basis between the belly of the curve at the 5 year versus the 30 year-long bond, whose spread reached its widest levels in years this past week (65bps), another indication of a pending economic recession, as the belly of the curve is usually seen as the safest bet for investors at times of uncertainty. Meanwhile, sharp swings in generic Swap Spreads, which saw significant tightening towards the middle of the week on the heels of mortgage convexity hedging (snore – we have no clue what you are talking about, David – this is when I sound smart), only to gap back out over the last few days, has only confused things further, making a tough week for those of us trying to figure it all out while still mourning over Aunt Becky’s secret life and not winning the $750MM Powerball. I as well thought either myself, or Flynn at the very least, were a shoe-in.
This morning, stocks are opening higher, after ending the day in positive territory yesterday, hoping to round out the quarter on a strong positive note. Reports that a trade deal with China is getting closer and closer, and we are now at the stage of doc reviews looking for errors and typos, has largely overshadowed global growth concerns which has hijacked our markets over the last few weeks. Treasury yields are trading higher this morning on the heels of optimism surrounding a trade deal. Ten-year Treasury yields are trading in at 2.42% and up 7bps from the low of 2.35% hit midweek. Now, unless you are the one bond geek analyzing the market over 15 computer screens and historic stochastic data dating back 50 years from your basement in Milwaukee (that’s pronounced mill-e-wah-que, which is Algonquin for “the good land”), it’s almost incomprehensible that we are even talking about 10 year yields sub 2.50% at this stage of the cycle, as many of us who think we are smart and try to convince ourselves that we know what we are talking about were predicting yields closer to 3.75% at this point in the timeline, and only reminds us of the famous quote from the late New York Yankees Legend Yogi Berra, “It’s tough to make predictions, especially about the future.” All we can do at this point is take the good and take the bad and there you have the facts of life…
What About the Commercial Real Estate Market?
The steep market rally in Treasury yields is having a profound impact on the Fixed Income Markets, and commercial real estate is not immune. While banks, insurance companies, and other balance sheet lenders will use the rally to take their time in assessing markets and competition, the normal reaction from the securitization world would be for spreads to widen into the yield rally. Given the sharp shift in yields we would have expected a piercing reaction in spreads as well perhaps almost on a one-for-one basis. However, the muted response in spreads has been a welcome sight for many, especially those of us in the CMBS and Agency CMBS world, and makes us nearly as happy as El Guapo was after receiving a sweater for his “40th” birthday. Yes, Fixed Income products for most part have continued their first quarter 2019 rally in the face of our new market reality.
On the Agency CMBS front, we did see some minor spread leaking in New Issue DUS and recent New Issue Freddie K’s; however, nowhere near the levels we would have expected. At this point, we would call DUS spreads maybe 2-3bps wider across the curve week over week. Recent New Issue Freddie K’s are trading at or near levels prior to the dip in yields with A2 bonds trading high 50’s over swaps. Given the fact that top tier new issue AAA CMBS is trading low to mid 80’s, when looking on a historical basis and the continued momentum in CMBS spreads, the delta to Agency CMBS is thin at this point and only leads us to believe that perhaps tightening in DUS and Freddie K’s may be on the horizon, in the face of lower Treasury and Swap yields.
As for GNMA’s, given the sensitivity of these bonds to a lower yielding environment, the rally has certainly affected spreads on both project and construction loans, with spreads widening nearly 10bps on the week, and wider for lower par yielding coupons. Project loans at the belly of the price curve, $103-$105 mark, are trading around swaps plus 90bps, with construction loans trading nearly 70-75bps past that, and potentially wider depending on conversion time and first draw size. It’s been a rough 3-6 months for the GNMA market; however, we are hopeful that as the market becomes comfortable with the new reality on yields, the REMIC execution will eventually make it work again and spreads will hopefully tighten from here.