Tuesday, April 27, 2010

With a few key strokes the same people who proclaimed subprime mortgage-backed securities to be a low risk credit investment have plunged Portugal into the credit market nightmare that has besieged Greece. Standard & Poor’s cut the rating of Portugal’s sovereign debt by two notches to A-minus in a surprise move earlier this morning saying, the action “reflects our view of the amplified fiscal risks Portugal faces. Under our revised base case economic growth scenario, we expect the Portuguese government could struggle to stabilize its relatively high debt ration over the outlook horizon until 2013.”


As you may or may not know -- Standard & Poor’s is paid by the bond issuer to rate the credit worthiness of the bond issuer’s own debt. This neat little arrangement makes it a lot easier to see how mortgage loans made to people who had absolutely no hope of ever successfully making their payments on a long-term basis could have been securitized and passed off as high grade debt instruments. I find it hard to believe that capital market participants give any debt rating issued under this arrangement so much as a second glance – but they do. Perhaps the credit rating fee Portugal paid this time around was deemed to be too small – or perhaps it was made after the due date (you can’t see me obviously – but as I write this sentence my tongue is in my cheek.) In any case the massive downgrade of Portuguese debt has spawned a stampede of capital fleeing Euro-land for the relative safe harbor of dollar denominate assets like Treasury obligations and mortgage-backed securities. And the timing couldn’t have been better.



Uncle Sam has charged into the credit markets this week looking to borrow a record setting $129 billion in the form of yesterday’s $11 billion 5-year inflation-indexed securities, today’s $44 billion sale of two-year notes followed by $42 billion of 5-year notes tomorrow and concluding on Thursday with the sale of a $32 billion stack of 7-year notes. Yesterday’s 5-year inflation-indexed security sale drew solid demand but at the expense of notably higher yields -- and had been seen as a harbinger of additional upward pressure on the rate of interest Uncle Sam was going to have to pay on the debt he was looking to incur over the balance of the week. Much of that pressure has now been defused thanks to the diligent and timely work of Mr. Standard and Mr. Poor. Whoops – just noticed I’m awfully close to climbing on a soapbox here – so I’ll move on before I get too carried away.



The credit downgrade of Portugal aside – I still think the text and tone of the Fed’s post-meeting statement on tomorrow afternoon still carries the greatest potential to shift the trend trajectory of mortgage interest rates.



In the unlikely event the Fed chooses to tweak the language in their post-meeting statement to reflect their growing confidence in the economic recovery – and/or to provide a wink and a nod to those expecting policymakers to begin nudging their benchmark short-term interest rates higher on a sooner rather than later basis – expect mortgage interest rates to creep yet higher.
On the other hand, should the Fed decide to leave the verbiage in their post meeting statement unchanged -- look for mortgage interest rates to remain near current levels.