by Asset Allocation Committee

Mortgage-backed securities have rather odd characteristics compared to Treasuries.  At their most basic level, mortgages are bonds—prices are inversely related to yields.  The pricing on mortgages assumes a certain level of refinancing activity.  However, when yields rise, expected mortgage duration tends to extend because mortgage holders are less likely to refinance.  When yields fall, expected duration shortens as mortgage holders replace their existing mortgages with new ones at lower rates.  Usually, mortgage bonds tend to act like options; they act “normal” within a certain range of yields, but duration adjustments occur if yields change above a given range.

Some bond fund managers are required to maintain a given duration level.  If the manager is holding mortgages and refinancing activity rises then the fund’s duration could shorten.  This would require the manager to take steps to re-extend duration.  A fast way to accomplish this goal would be to buy long-duration Treasury futures.  These instruments are liquid and generally have a set duration.

In general, refinancing tends to take place when interest rates fall below the level of the current mortgage, taking closing costs into account.

The chart on the left shows the 10-year T-note yield; we have regressed a time trend through the data.  Clearly, yields have been on a downward path since 1990.  The chart on the right shows the 10-year T-note yield less trend on the lower line and the mortgage refinancing index on the upper line.  Evidently, refinancing activity tends to rise when rates are below trend.  Since 2016, the steady rise in rates relative to trend has depressed refinancing.  However, we have seen a lift in refinancing recently.  On the one hand, the dip in rates doesn’t look like enough to overcome closing costs.  On the other hand, paying a higher rate on a new mortgage may be the only way a homeowner can capture price appreciation.

This chart shows the ratio of the new rate to the old rate.  When the old rate is higher than the new rate, the ratio is less than 1.0.  Note that this ratio is now at a new record high.  Essentially, buyers are refinancing at a less advantageous rate to extract home equity.

We suspect the most important factors of the recent bond rally have been changes in monetary policy expectations and reduced inflation fears.  But, the rise in refinancing has likely played a role as well.  We doubt that the attractiveness of locking in a higher mortgage rate will continue indefinitely, therefore this bullish factor should dissipate in the coming weeks.

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by Asset Allocation Committee

Long-dated Treasury bonds have enjoyed a strong rally in recent weeks.  Fears about future U.S. economic growth, falling global economic growth and a reversal in monetary policy expectations have all conspired to lower yields.  The question now is whether or not yields have fallen more than is justified by the fundamental factors.

This is our model of the 10-year T-note yield.  Independent variables in the model include fed funds, an inflation proxy,[1] the yen/dollar exchange rate, German 10-year yields, WTI oil prices and the fiscal deficit as a percentage of GDP.  The standard error line is 70 bps; thus, at current fair value, the 10-year T-note yield would be “rich” around 2.15%.

In general, the first two variables have the most explanatory power.  The current yield is well below the fair value of 2.86%.[2]  One way to account for the decline in yields would be if the market was projecting easier monetary policy.  Leaving the rest of the independent variables unchanged, to reach a 2.40% 10-year T-note yield would require fed funds of about 1.50%, or a 100 bps reduction from current levels.  Since such a cut is unlikely in the near term, it is arguable that the 10-year yield has overshot to the downside.

However, another possibility is that inflation expectations are falling.  Inflation expectations have a powerful effect on long-dated debt yields.  Our current inflation proxy puts inflation at 2.10%.  To achieve current yields, inflation expectations would need to fall to 1.41%.  Although inflation expectations are not directly observable, we assume such expectations are slow to change.[3]  Thus, it would be unlikely that a drop in inflation expectations alone would account for the recent decline.  However, inflation expectations falling to 1.8% and fed funds at 2.00% would bring yields close to 1.40%.

It is quite possible that falling inflation expectations and forecasts of easier monetary policy can justify the current 10-year yields.  The risk is that the FOMC keeps policy steady and inflation eventually surprises to the upside.  Thus, we would not see the current environment as conducive for extending duration. 

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[1] We use a 15-year moving average of the yearly change in inflation for inflation expectations.

[2] We use monthly averages in the above model; thus, the March yield is 2.63%.  The April yield will be much less.

[3] Milton Friedman assumed such expectations were built over a long period of time, perhaps two decades or more.

by Asset Allocation Committee

One factor we have been tracking is the recent behavior of retail money market funds.  We have noted that households began building money market funds about the time that the equity market peaked and U.S. trade policy began to turn toward protectionism.  In the coming months, money market funds continued to rise even as the S&P 500 made new highs.  However, as equity markets fell in Q4, money market funds rose rapidly, with the pace of the increase rivaling what we saw in 2007-08.

This chart shows retail money market funds and the S&P 500.  The gray shaded area shows the 2007-09 recession.  The orange shaded areas show periods when money market funds fell below $920 bn.  When money market funds fell to those levels, equities tended to stall.  In recent weeks, the pace of increases in retail money market funds has slowed but still continues to rise, even with the market’s recovery.  It may be difficult for equities to move much higher without retail participation.

In light of this analysis, which we have been discussing on a regular basis, another thought emerged—what is the role of cash in a portfolio?  To examine this issue, we decided to look at cash instruments in the holdings of households.

It turns out that cash has a complicated history.

This chart shows the percentage of deposits in household financial assets.  From the early 1950s into the early 1980s, the level of deposits generally rose.  This rise was probably due to a number of factors.  During this period, there was a steady rise in household income; at the same time, the financial system was heavily regulated.  Regulations limited households’ flexibility in investing.  However, by the mid-1980s, Regulation Q, which put caps on deposit rates, was removed.  And, the financial services industry greatly expanded the products available and improved the logistics of investing.  Financial deregulation increased the access to borrowing for households; thus, the need to save for purchases diminished.  Income inequality also rose after 1979, which likely concentrated saving into fewer households.  With more liquidity, these high income households were more likely to look for other investment opportunities.  Essentially, the bull market in stocks that began in the early 1980s and ended in 2000 was supported by a more than 10% point decline in the share of deposits in household accounts.

Household deposits function as an investment, a way to smooth out spending and a flight to safety instrument.  Thus, one would expect there to be a close relationship between consumption and deposits and a rise in deposits relative to consumption during periods of crisis.  In fact, these features do exist, but there was a significant break in the relationship starting in 1990.

The chart on the left shows the time series of personal consumption and household deposits; the one on the right shows a scatterplot with regression lines.  Note that after 1990, the relationship curve shifted to the right, meaning that fewer deposits were required to support consumption.  Deposits rose sharply in 2005, even faster than consumption.  That was when the housing crisis began and there was clearly a flight to safety.

Since 2005, there has been a steady increase in deposits relative to consumption, which would suggest a generalized increase in fear relative to the period from 1995 to 2005.

This chart shows the ratio of deposits to consumption.  In 2000, deposits fell below 70% of consumption. The ratio rose after that and has currently reached 90%.  Note how fast the ratio rose after housing peaked in 2005—there was a clear flight to cash that culminated in the Great Financial Crisis.  That level of fear has persisted, shown by the high level of deposits relative to consumption.

In conclusion, as the first chart shows, we have seen a lift in money market funds.  This does suggest an elevated level of fear in financial markets.  However, the recent rise should be viewed within the context of overall cash holdings in households.   Essentially, households are holding high levels of deposits relative to consumption, suggesting rather high levels of caution already.  We still believe that retail money market funds need to decline in order to see equities rise this year; however, it also seems that households are not as complacent as they were in 2005 and therefore the likelihood of a financial crisis is probably not very high.

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by Asset Allocation Committee

The Financial Accounts of the United States, formerly known as the Flow of Funds Report, was released last week.  It is a plethora of information about the state of the economy.  Below we discuss the charts we find most noteworthy.

First, here is the saving balance by sector.

The tax cut has led to an increase in business saving and a wider fiscal deficit.  Household and foreign saving was essentially unchanged.  We are watching to see if the administration’s trade policy reduces the trade deficit; if it does, then foreign saving, the inverse of the trade deficit, will decline and require higher saving from the other three sectors to offset that saving decline.

Second, the share of national income going to capital and labor were mostly stable.

Since the end of communism in the early 1990s, capital has been taking a steadily larger share of national income.  In each expansion, the capital share has made a higher peak.

Third, the drop in equity markets adversely affected household net worth.

Net worth relative to after-tax income took a dive in Q4; the recent recovery in equity markets should reverse this dip, but we do note that in previous cycles such declines tended to signal that the business cycle was coming to a close.

Fourth, owners’ equity in real estate finally reached 60%, a level which we consider normal.  This was the level the market was at pre-1995, when the government eased the rules on home ownership.  During the real estate crisis, equity plunged as falling home prices collided with excessive mortgage debt.  From a financial perspective, this suggests the residential real estate market has overcome the trauma of the Great Financial Crisis.[1]

Finally, household deleveraging is continuing, although the pace has slowed.

This chart shows household debt as a percentage of after-tax income.  From the early 1980s into 2005, household debt rose steadily.  The Great Financial Crisis led households to lower their debt levels relative to income.  Although there is no generally accepted level that signals when deleveraging has been achieved (we would prefer around 80%), the continued decline is both good and bad.  It is good because the reduction in debt is supportive for household balance sheets.  However, growth will tend to be slower during periods of deleveraging.

Overall, the report does show the tax bill affected business saving and government dissaving.  The recent market decline was reflected in the slide in household net worth.  Capital is still gaining on labor; the housing market is now on a more solid footing compared to a decade ago.  And, household balance sheets are improving.  Overall, we view the report as consistent with steady, slow growth.

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[1] This is only true for the financial system.  Many communities are still struggling with the aftermath of the crisis.