We have highlighted the unusual negative swap spread relationship in the fixed income market. The inversion continued down the curve to the 7 year maturity – which makes the 7 year auction even more important. The message from the markets is clear – Uncle Sam is a worse credit than those evil CEOs. Taking a step deeper into the pool, we view the strength in swaps (lower yield) as a sign investors are still betting the Government is the ultimate put option.
Has the Greenspan Put Become the Bernanke Put?
While Alan Greenspan was Chairman of the Federal Reserve, his monetary policy was affectionately referred to as the Greenspan Put. As a refresher, the Greenspan Put referred to the Chairman’s inclination to respond to every economic hiccup with a rate cut. Some have argued (and we would not push back) that the Greenspan Put was part of the reason risk was embraced and consequences were ignored – if the Fed was always there to catch the markets fall then why not buy!
In our view, negative swap spreads are just another sign that the market is betting on a Federal Reserve/U.S. government put option. The Fed and the Treasury appear to have successfully rescued the financial system from the brink of disaster. However, the method was no different than Alan Greenspan – central banks and governments have succeeded in reflating the balloon. By keeping rates low the Federal Reserve is encouraging/causing investors to reach for yield.
To be clear, we do not think rates should increase anytime soon, but the mechanism used by the Fed has resulted in unintended consequences – anomalous negative swap spreads.
Are Mortgages Next?
As investors are reaching for yield they are running out of markets, especially those perceived to be less risky. At the end of this month the Fed is scheduled to end its quantitative easing program focused on the mortgage market. The logical and conventional thought is removing the Fed bid will result in a sharp rise in mortgage rate – not surprisingly we see it differently.
Counter-intuitively, mortgage rates have begun to decline over the last few weeks. The chart illustrates the spread of Fannie Mae (FNM) MBS over Treasuries – for most of this year investors could get an additional 35+ bps for buying MBS. Over the last few weeks, this spread has dropped significantly, despite Fed support coming to an end.
In our view, this drop in rates is the result of investors reaching for yield. Fannie Mae MBS are de facto government bonds although political rhetoric has kept the spread over treasuries wide. As we expected, the congressional hearings this week on housing finance had no results. Investors are now beginning to embrace the idea that the government will support the housing market and by extension the GSEs.
As the Fed pulls away from the mortgage market and investors reach for yield, the stabilization and rise on MBS prices will attract more buyers of MBS. It is this private market support that should keep mortgage rates low.
The Trade
We bought both Fannie Mae and Freddie Mac (FRE) last week in anticipation of a lackluster housing finance hearing. The recent drop in swap rates and decline in mortgage rates have us more encouraged about these positions. A continued fall in mortgage rates will boost the value of the GSEs mortgage portfolio. A knock on effect could be lower delinquency rates ARMs.
As the market embraces mortgages, we shall be adding to our long positions in FNM and FRE.
Disclosures: Long FNM and FRE
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