May Reports Signal April was the Bottom
Trading direction remains more focused on things other than economic numbers from May but we did get the ADP Employment Change Report this morning and it was better-than-expected. During the month 2.8 million people lost their jobs which was not as bad as the 9.0 million expectation and an improvement from the 19.6 million jobs lost in April. The BLS employment report on Friday is expected to show 8.0 million jobs lost versus 20.5 million in April with the unemployment rate climbing from 14.7% to 19.5%. The numbers are so jaw-dropping that the market is looking past them and only hoping to see some improvement (or is that less bad?) versus the historically awful April. The better-than-expected ADP print should help in that regard. Later this morning, the ISM Non-Manufacturing (Services) Index is expected to print 44.4 versus 41.8 in April. If that happens, the risk-on rally is likely to continue while Treasuries remain more circumspect and range bound while they wait for real improvement versus just “less bad.”
As we alluded to above, most fixed income investors have been bemused by the ongoing equity rally that persists despite all that has been thrown at it, the latest being ongoing protests that have enveloped most major cities, including Washington DC. While the foundation of the rally has it that with reopenings ongoing, and nationwide viral case counts trending lower, that the hoped-for second half rebound is still a possibility. At some point, however, stock prices have to bear some relationship to earnings and those earnings of late have not been all that great.
While two-thirds of S&P 500 Index members managed to beat earnings estimates that’s the fewest since 2012. As we mentioned, equity investors haven’t let those results dim their enthusiasm for a hoped-for revival in the second half of 2020, but it does point to the earnings constraint that companies will continue to face as they attempt to return slowly to some adjusted form of normalcy. If an earnings beat is all but a necessity in today’s financial world, expect those earnings estimates to be trimmed lower, and if that is the case, can those stock prices continue higher indefinitely?
Returning to the MBS Market and the Forbearance Program
We mentioned in April that with the forbearance program for mortgage debtors in the CARES Act, mortgage prepayments this year could see a period of quiet followed by faster speeds when the forbearance programs expire. The program allows struggling homeowners a temporary suspension of scheduled mortgage payments that borrowers are required to eventually make up. During forbearance, servicers advance principal & interest payments on behalf of the borrower to MBS pool owners. The law provides for up to a six month deferral period followed by another six month period, if deemed necessary.
Loans in forbearance jumped from 0.25% on March 2 to 8% at the end of May. That represents a total of 4.7 million households. During the forbearance period involuntary prepayments (foreclosure, etc.) should slow and voluntary prepays should slow as well as the economic fallout of the pandemic hangs over the country.
After the forbearance program runs its course, a delinquency buyout results in an involuntary prepayment if the borrower cannot repay the missed payments in a timely manner, and the servicer determines that the loan needs to be modified. The earliest we’re likely to see these involuntary prepayments is November which assumes a borrower throws in the towel after the initial six month deferral period. In all likelihood, however, there will be many more borrowers who apply for the second six month deferral. What this means is that prepays across the coupon stack should slow over the next year as these forbearance programs are in effect. As all MBS pools are priced above par, any slowing in prepays helps boost book yields via slower premium amortization. In addition, mortgage spreads to Treasuries are currently above the prior-year average after all the volatility in March. While absolute yields are still historically modest, at least the yield spread to Treasuries signals that MBS pools aren’t overly expensive at this time.
Agency Indications — FNMA / FHLMC Callable Rates
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