Market Update – March 26, 2010

The prices in the swap market (exchanging one type of debt or interest income for another) are creating some headlines lately. There is a massive amount of supply of new corporate debt hitting the capital markets in the U.S. and Europe currently, and the cost of exchanging interest payments for 10 years was 0.023 percentage point below low-risk Treasury yields. This implies that investors see more risk in holding triple-A-rated 10-year Treasury notes than in swapping rate payments with private counterparties. At the height of the credit crisis, when investors were in panic-mode about counterparties, that cost shot up to as much as 0.780 percentage point above the 10-year Treasury yield.  Tighter swap spreads indicate investors’ confidence (or complacency) about credit risk, and vice versa, but typically the spread is positive relative to Treasuries. But this time, the swaps market reflects demand to receive fixed rates as a hedge, especially by corporations issuing new bonds. That’s resulted in the 10-year swap spread moving to negative 5.5 basis points. It is easy to argue that this is another sign of how far credit markets have recovered: risk premiums in the interest-rate swaps market-in which investors exchange fixed-interest payments for floating payments-turned negative on the 10-year sector for the first time on record. There is one fundamental point, however, and that is market concerns about the US budget are growing as Treasury supply increases.

For the second to last time, the Federal Reserve today reported on their weekly purchases of agency MBS’s: a gross total of $8.26 billion agency MBS’s, selling $260 million for technical reasons resulting in a net total of $8.0 billion agency MBS purchases.

After Wednesday’s drop, fixed-income securities saw some volatility Thursday. The bond market headed south, causing investors to worsen their prices, then bounced back, resulting in some price improvements. The $32 billion 7-yr auction coming in around 3.37% with a bid-to-cover of only 2.61 didn’t help things, but then investors apparently thought, “We like these yields” and back the market came. Traders continued to see selling in 4.5% and 5.0% securities – current coupons, with hedge funds also selling, and banks selling heading into quarter-end. But in the afternoon buyers like private investors, the Fed, pension funds, and money managers started putting some of their cash to work – how exciting!

With the market well off of the lows, the treasury auctions out of the way, originator supply likely to decline, and convexity related mortgage selling finished for the time being, there is some short-term optimism about rates and bond prices. In addition, there is belief that when April rolls around, banks, with their cash, will step in and fill the void left by the Fed and helping current coupon production. Generally speaking, however, why would rates go down with the healthcare package adding to the deficit, questions about China and overseas buyers being increasingly concerned about our exploding deficits, and Bernanke stating he’d like the Fed to get their balance sheet down to its pre-crisis level. Don’t look for overnight Fed Funds to move up soon, but they don’t control long term rates – and many believe that although in the short term rates won’t go up too much, in the long term these factors will definitely push rates higher.

Call it old news, but the 4th quarter GDP was revised to 5.6% versus 5.9%, down .3% – about as expected. After the GDP news the yield on the 10-yr is at 3.88%, and mortgage prices appear to be .125-.250 better than Thursday