The last two days have proven one thing and that is the political season is fully upon us, and the ebb and flow of the race will  have a direct impact on trading direction and momentum. The juxtaposition between the chaos of the Democratic Party’s Iowa coming out party and President Trump’s State of the Union Address couldn’t have been more stark.  While the inability to call a winner in Iowa more than a day later may long be forgotten in November, the immediate impact is to bolster Trump’s reelection prospects and that no doubt is fueling part of the stock rally—and concomitant selling in Treasuries. The calculus seems to be that anything that points/hints at a Trump reelection, and continuation of the status quo, is good for stocks and other risk assets.  On the other hand, if a serious contender to Trump manages to emerge from the Democratic field that will likely send stocks lower as the prospects of a change in tax and regulatory policies will enter the risk equation.  In any event, we’re a long way from November but the last two days reminds us the horse race has just begun but with the Democrats stumbling out of the gate.


newspaper icon  Economic News

While coronavirus news and political handicapping are taking the lion share of headlines, and trading direction, this week is full of first-tier economic releases with the spotlight on the January jobs report this Friday.  Already, we’ve received a few economic releases that point to an economy that is continuing to perk along with little hint of an imminent downturn.

  • The ADP Employment Change Report was released this morning and found 291,000 private sector jobs versus 157,000 expected and 202,000 in December. The print is the highest since May 2015. The trend in ADP compared to BLS numbers this time last year was to overstate what would subsequently be reported in the BLS report. That trend shifted in the second-half of 2019 with the ADP understating BLS numbers until, that is, the December release which again overstated the BLS print by 63,000 jobs. Given today’s huge beat of expectations, we would go with ADP overstating the BLS expectation of 150,000 private sector jobs, but the extent of the ADP beat could lift those BLS expectations before Friday.
  • Most people even mildly interested in the economy know the manufacturing sector has struggled mightily over the past year as tariffs  and global trade tensions generated headwinds that have put the sector in contractionary territory since July. That is until Monday’s January ISM report printed at 50.9, signaling the sector is expanding once again, albeit just barely. But with the Boeing 737 Max troubles still ongoing, and the coronavirus impact yet to hit the numbers, the January report may be just a brief foray into expansionary territory before heading lower again. While the January ISM contains echoes of a number of strong regional Fed manufacturing surveys for the month, it will take sustained signs of global-demand stabilization to translate into a durable manufacturing upturn and with the aforementioned issues still outstanding it will be a tall order to maintain the January print.
  • The monthly trade balance reports get a lot more attention these days given the focus on trade deals and tariffs. For December, the overall trade balance (goods and services) widened to -$48.9 billion versus -$43.7 billion in November. The trade deficit has ranged from a  twelve-month wide of -$59.9 billion in December 2018 to a narrow -$43.1 billion in November 2019. While the deficit widened in December, for the year it narrowed from $627.5 billion to $616.8 billion, the first drop in six years. The slight narrowing in the deficit has more to do with a reduction in imports following the tariffs and trade-related angst rather than an increase in exports and that speaks to some softening/shifting in consumer demand.


line graph icon  It May Be Time to Consider a Prepayment-Mitigation Swap


Interest rates on mortgage loans have plummeted more than 100bps over the past year and that doesn’t include the potential further slide coming in the wake of the safe-haven trades stemming from the coronavirus scare. One result of the continued decline in mortgage rates is the increasing risk of accelerating prepayments in legacy MBS pools.


As a consequence, one swap that we’ve begun implementing  in the last month or so is to sell pools that are starting to exhibit faster prepayments and reinvest in newer vintage, lower coupon pools in order to limit prepayments as we move through 2020.   We have a Bloomberg template that will look back one year to determine how an MBS pool is yielding at 1-month, 3-month, 6-month and 1-year prepayment speeds.  A representative sample of this analysis is shown below.


If we look at the first pool (FN MA3152) the CPR, or prepayment speed, has increased from 17% to last month’s 25%.  At a current book price of 104, the yield has dropped 39 bps because of the increased premium amortization caused by the accelerating prepayments.  The second pool, (FN MA3180) prepaid at 19% CPR a year ago vs. 25% CPR last month. The three other pools have similar prepayment and yield performance. By considering a swap into more current, lower coupon production an investor may be able to insulate the portfolio from declining yields if prepayments continue to accelerate.


If your portfolio has material investments in MBS pools, and which portfolio doesn’t,  it may pay to have your CenterState representative run a similar analysis and determine if a swap could stabilize yields in the face of increasing prepayments.


Prepayment Mitigation Swap


bar graph iconAgency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 1.65 1.75 1.85 1.96 2.36 2.64
0.50 1.61 1.72 1.82 1.93 2.31 2.59
1.00 1.51 1.62 1.73 1.84 2.21 2.49
2.00 1.44 1.56 1.67 2.12 2.32
3.00 2.00 2.21
4.00 1.89 2.14
5.00 1.79 2.08
10.00 NA


Tags: Published: 02/05/20 by Thomas R. Fitzgerald