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Economic Update

  • Technical factors have contributed to higher real yields in multiple large fixed income markets in recent months
  • Housing affordability is the worst it has been in decades amid a sharp rise in mortgage rates and sticky home prices
  • Liquidity has tightened notably over the last year for financial institutions, and the outflow of core deposits has coincided with nearly the same amount of inflows for time deposits and money market fund balances

Technical factors have overwhelmed fundamentals in multiple corners of the bond market as 2023 has progressed. This phenomenon is perhaps most visible in the $25 trillion U.S. Treasury securities market. Supply and demand imbalances have helped fuel a surge in intermediate and long-end yields over the last several months. Some of the move can be attributed to an improved economic outlook feeding the ‘higher for longer’ narrative, but real, or inflation-adjusted, yields are up sharply over the last several months as well. Exhibit 1 tracks 5-year and 10-year Treasury Inflation Protected Securities (TIPS) yields so far this year, and while some critics argue that the TIPS market doesn’t fully or accurately capture market inflation expectations, yields have clearly risen beyond what can be explained by a higher forward path of short-term rates after the regional bank scare last Spring. This has coincided with a significant increase in Treasury funding needs (supply), driven by both increased budget deficits and the Fed’s Quantitative Tightening (QT) efforts, the latter of which is effectively adding more than $700 billion per year to the supply/demand imbalance. A popular explanation for the recent sell-off in long-end Treasury yields is expectations for a higher and more persistent fiscal budget deficit. Some have suggested a return of the ‘bond vigilantes’ made famous in the 1990s during the Clinton administration.

Exhibit 1

Source: Bloomberg

A technical imbalance exists in another large sector – Agency MBS. For the last 15 years, the largest sponsors of this asset class have been the Fed and financial institutions. Both buying segments have been sidelined for the last 18 months for differing reasons. While this is not the only reason for spread widening over that timeframe (surging interest rate volatility has been a prime contributor), other investors (e.g., money managers) haven’t been able to pick up the slack even while shifting to overweight MBS positions in recent months. This could limit future spread tightening if QT and current liquidity conditions for financial institutions persist. However, current valuations and yield carry remain very attractive on a historical basis, more specifically for current/recent production coupons.

Housing Affordability (or lack thereof)

The selloff in long-end yields over the last six months has pushed mortgage rates north of 8% for the first time since 2000 according to BankRate’s national average of 30-year conventional loans. With home prices remaining stubbornly high, thanks in large part to a dearth of supply, housing affordability measures are the worst we’ve seen in many years. Exhibit 2 tracks the National Association of Realtors’ housing affordability composite index, which began in Q1 1986. The most recent release as of Q2 was at the lowest level on record, and with mortgage rates continuing to rise in Q3, affordability has only worsened.

Exhibit 2

Source: National Association of Realtors, Bloomberg

A recent Wall Street Journal article highlighted an analysis from commercial real estate firm CBRE showing the growing gap between the average monthly mortgage payment at current rates relative to the average apartment rent. The former is now 52% higher than the latter, by far the highest since CBRE began tracking the data in 1996. The previous high for this premium, which was negative for most of the post-crisis era, was 33% in the second quarter of 2006. On a positive note, 82% of all homeowners with a mortgage have a rate below 5%, and 62% have a rate below 4%, according to Redfin. Considering that mortgages are the largest liability for most U.S. households, it has been a major source of strength for consumer balance sheets, even if current rates are restrictive for new homeowners (and housing turnover/supply).

Where Have All the Deposits Gone?

The banking industry has faced numerous challenges over the last few years, particularly amid the Fed’s extraordinary tightening campaign of the last 18 months. After a surging inflow of liquidity during the pandemic, core deposits, in aggregate, have turned the other direction, creating liquidity challenges for the industry. Exhibit 3 provides a simple, but telling, illustration of where those deposits have migrated. Beginning in March 2022, the chart tracks changes in total money market fund balances plus bank time deposits, compared to the change in bank deposits (excluding time deposits). From 3/30/2022-10/18/2023, the former category rose $1.84 trillion while the latter fell $1.67 trillion. For much of the post-GFC era, financial institutions relied on an ever-rising and historically-high level of non-maturity deposits, with little demand for money market funds and CDs. This coincided with short-term rates near the zero bound and Fed quantitative easing for much of that period. However, institutions are now grappling with an outflow of lower-cost core deposits and the prospect of that trend continuing for the near/intermediate future. To maintain profitability in such an environment, asset pricing, capital allocation, hedging, etc. remain critical areas of focus for the banking industry going forward.

Exhibit 3

Source: Federal Reserve H.8; Santander Capital Markets; ALM First

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