Tuesday, October 6, 2009

Investors are making space in their portfolios for today's record supply of three-year notes - resulting in a weak start for the mortgage market.


Today's auction follows yesterday's very successful offering of 10-year Inflation-Protected Securities. Most analysts strongly believe the 3-year notes will draw an equally strong demand from buyers. There is some slight concern that the Chinese week long, national holiday may result in lower foreign investor participation than normal - but in terms of the 3-year notes - the impact should be minimal.


There are concerns about the market's ability to absorb tomorrow's $20 billion of 10-year notes without the full support of the Chinese credit market participants. Since June the overall demand for Treasury debt by both domestic and international investors has remained brisk - as our economy shank deeper into the depths of a massive recession, the dollar fell on international currency markets, inflation was a "no show" and the Fed pledged that their benchmark short-term interest rates would remain near zero. Even so, trees-don't-growth-to-the-sky and investors' appetite for any class of asset eventually wanes.


In the world of single-family mortgages fixed income investors, those that buy assets like longer-dated Treasury debt obligations and mortgage-backed securities, by necessity live in the future - not the present. The radars for these "guys" are focused six months or more into the future and their trades are driven largely by the perception of "what-will-be" - rather than shorter-term (day or days) traders who focus more simply on "what is". It is this very distinctive difference between trading styles that can/will create an environment of rising mortgage interest rates in a period of time when near-term macro-economic reports suggest rates should be trending steady to lower.


A well bid 10-year note auction tomorrow and solid demand for Thursday's 30-year bond offering will be viewed by many as a solid indication that fixed-income investors see no looming threat of inflation anywhere on the horizon - which by extension - suggests these investors believe economic growth will once again begin to wane in 2010. The good news here is that mortgage interest rates will almost certainly continue to hover within a whisper of historic lows while the bad news is that the demand for mortgage financing will likely continue to contract as joblessness rises and the consumer develops a "bunker mentality" with respect to spending of any sort.


On the other hand, if the Treasury's 10-year note and 30-year bond offering result in higher yields for both of these instruments, fixed-income investors will be putting their-money-where-their-mouth-is with respect to their belief the sustained economic growth will prevail -- which will in-turn lead to an increase in employment opportunities followed by a notable increase in mortgage demand. Granted, if this scenario develops it will set the stage for a slow but progressive move to higher mortgage interest rates - which may actually prove to be a "good thing".


As mentioned in this space before, there are an increasing number of reasons to think we've reached a point in the economic cycle where a modest uptick in mortgage interest rates created by accelerating economic growth will actually create a better market place for mortgage originators -- than a economic backdrop that supports yet lower mortgage interest rates could ever come close to generating.