Who thought the hottest inflation numbers in a dozen years would lead to higher yields? Well, if you guessed that you would be only half right. The June CPI numbers were way above expectations, and that did lead to some selling on the short-end as investors brought forward Fed rate-hiking expectations. The longer-end, however, remains less impressed with those inflation numbers as those investors expect the Fed to do the same thing, hike sooner rather than later,  and that would quell some of the inflationary impulses as well as cool future economic growth. We talk about that in more detail below. In our podcast this week we sit down with Karl Nelson, CEO of KPN Consulting and talk mergers and acquisitions, credit unions, and  banking in a post-COVID world. The iTunes link can be found here and the Spotify here.



CPI Numbers Have the Treasury Curve Flattening

Yesterday, just after the CPI numbers were released, longer end yields went lower yet again (before reversing higher in the afternoon on post-auction weakness). Sounds strange, right? Inflation readings coming in hotter than expected and sending yields initially lower. Well, the calculus there is that with the hot pricing numbers the inflation hawks on the FOMC will grow in size and voice and force rates to be hiked sooner than currently expected. That expectation of a more aggressive Fed drove longer-term yields lower while shorter-term yields rose on the same prospect. That action drove the 2yr-10yr curve to flatten to levels last seen in mid-February.


Source: Bloomberg

The bigger question for the market is whether the latest data has convinced the thought leaders on the Fed that these price spikes are too big, too substantial, to just wave off as transitory. We have mentioned that there are five dots in the latest matrix that still felt no hikes through 2023 were appropriate. We are convinced that Powell is one of those dots, (along with most of the other Fed governors). It just so happens Chairman Powell will be spending the next two days on Capitol Hill being grilled first by House members then by senators who will be waving the latest inflation numbers like  a warning flag. If Powell backpedals on his transitory take expect the curve flattening to continue as the guard against premature tightening will be seen as falling away. The next two days will be very interesting.

MBS Yield Spread to Treasuries Still Below 1-Year Average

With all the gyrations in longer-term yields given the varying outlook for future Fed action, we thought it appropriate to see how the MBS complex was doing against those Treasury moves and the prepayment concerns that come from them. As the graph shows, the 30yr MBS yield spread to a combined 5yr/10yr Treasury blend is currently 70bps versus a one-year average of 76bps.

Source: Bloomberg

The graph also shows that yield spreads have recently risen from 65bps as July began to the current 70bps. That widening in spread is due to concerns that the latest rundown in market rates will lead to another round of refinancing which will cause accelerating prepayments that will cause book yields to fall as premium amortization increases. One thing we noticed in our latest quarterly bond accounting portfolio review was that while MBS/CMO purchases led all other categories, as usual, the allocation was down from prior quarters as investors perhaps were turned off by the limited yield spreads as shown above and moved into other categories. Yield spreads in other sectors, like munis and agencies, aren’t a bargain either so alternatives remain limited; thus, portfolio managers, while reluctant, continue to put the lion share of investment dollars into the MBS/CMO category.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.14 0.40 0.66 0.97 1.80 2.26
0.50 0.13 0.37 0.60 0.86 1.66 2.15
1.00 0.12 0.34 0.57 0.82 1.57 2.02
2.00 0.33 0.51 0.74 1.45 NA
3.00 0.69 1.39 NA
4.00 1.34 NA
5.00 1.31 NA
10.00 NA

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Published: 07/13/21 Author: Thomas R. Fitzgerald