Monday, June 10, 2013

Tapering Fully Priced In Yet?

Tapering Fully Priced In Yet?
by Craig Dismuke
According to some news outlets, S&P has revised its U.S. credit outlook from negative to stable this morning. This is breaking news and the rationale is not yet available. However, the expiration of the payroll tax cut, higher tax rates for some citizens, and cuts in government spending are surely helping improve the U.S. outlook.

This week’s economic calendar is a bit lighter than last week’s. However, there are two important reports on the health of the U.S. consumer. Thursday’s Retail Sales report and Friday’s UM consumer confidence report will be important to watch. If they are both improved, as is expected, it will point to a consumer who continues to shake off the headwinds. This would be supportive of tapering which would hurt bond prices. However, it is also worth noting that bond yields will eventually quit rising once the taper is fully priced in. It looks like we may be nearing that point. The German 10-year Bund is currently at 1.55% while the 10-year JGB is trading at 0.84%.

Another Jon Hilsenrath article (WSJ) made the rounds last Friday when he said the Fed was still “on track to ease up on bond buying later this year.” After Friday’s labor reports, Hilsenrath immediately interpreted the reports as being not bad enough to stop the tapering talk, but not good enough to warrant tapering at the next meeting. Perhaps this interpretation came from the Fed and perhaps these are the training wheels that Bernanke thinks the markets need to transition to data-dependent policy. Either way, the article helped to push Treasury yields higher through Friday afternoon. The 10-year Treasury yield rose from 2.05% Friday morning to 2.17% by the close.

As a Bloomberg article puts it this morning, the “silver lining” to a poor recovery is that the pace of growth hasn’t been good enough to create excess slack. As a result, the expansion is lasting longer than normal. This seems like arguing that the worse a golfer plays, the more shots they will get to take before their round is over. The article is correct in pointing out that a weak expansion has left the economy with a huge hole in the labor market still after four years. Inflation is not on the rise. Income growth has turned into income contraction. And household debt continues to shrink (although this is likely in its final innings).

There has been a lot of optimism around the Corker/Warner GSE reform bill introduced and highlighted in MT last week. The reform debate is about trying to create a system in which mortgage loans are cheap and yet taxpayers do not have exposure to losses. When taxpayers have complete exposure, mortgage loans will be their cheapest (this was essentially the Fannie/Freddie scheme although the GSEs did have a small buffer of capital which marginally reduced taxpayer exposure). When taxpayers have no exposure, mortgage loans will be more expensive (because they have to then rely on the borrower’s credit rather than the government’s ability to tax). Despite everyone’s best efforts, there is no free lunch here – and someone has to take on the credit exposure. The current proposal simply finds a middle ground between those two extremes which gives the finance companies more exposure than Fannie/Freddie had and, in the process, reduces the taxpayer’s exposure. Doing so will necessarily result in higher mortgage loan rates than under the Fannie/Freddie scheme and the current scheme. As a result, lawmakers will be reticent to act too quickly given the tenuous housing recovery

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