Wednesday 7/16/08 ... A couple of BAD days

Yesterday saw a massive sell-off in Mortgage Backed Securities (MBS), which are the bonds that directly govern mortgage pricing.  In the past, we have discussed "flight to quality" (FTQ) buying.  This occurs when, shaken by market uncertainty, investors pursue fixed income investments in order to lock in a guaranteed return on their investment.  The thought is that tying up money to earn a 4% rate of return on a bond is a better risk than hoping for an 8% return in the stock market.  When all is operating as it should be the FTQ "bid" (which is a short way of saying "the level of buying demand for safe haven securities such as bonds), is usually equally distributed among different kinds of fixed income investments.

But in especially turbulent times, and especially when that turbulence is perceived to be due, in large part, to mortgages, the FTQ bid can shift away from MBS and toward more certain safe-haven investments such as US treasuries.  basically, it would take an earth-shattering catastrophe for the US government to default on it's debt, AKA treasuries.  So they are generally considered to be a risk free investment.  With all the recent (both long term and near term) negative press for mortgage-related financials (Lehman Brothers, WAMU, bear stearns, countrwide, indymac, etc..), the fear of less-than-expected returns in MBS has driven investors to the lower-return, but safer US treasuries.  When more investors are buying treasuries, or more importantly, when fewer investors are buying MBS than there is an imbalance that leaves more buyers than sellers.  The sellers are forced to compete to move their product much the same way that a new grocery store must set it's prices to compete with the grocery store across the street.

The competition is the same in the bond market as in the grocery store analogy.  As prices are lowered, investors are earning a greater return in exchange for the risk.  In other words, "I don't want to buy your groceries because they'll probably make me sick, but if you lower the price enough, I may risk it and buy them anyway."  The problem is that so many buyers are in the treasuries supermarket, paying higher prices for the better groceries, that not only are MBS prices forced lower for that reason, but also because there are too many sellers and so it's truly a buyer's market, which we know, brings prices down.  When prices come down on a bond, it raises the yield that is paid to the investor.  Looked at another way, the investors are saying "if you want me to get on board with this potentially risky security, you'll have to give me more for my money."  Whether you look at it as sellers lowering the price in order to make a sale or buyers demanding more for their money, it doesn't matter.  The point is that the investors demanding higher yields means that those yields must be passed on through to consumers in the form of interest rates.  And so rates go up.

Yesterday was at least comforting in the sense that, although treasuries were much more popular yesterday, there was a substantial enough disinterest in stocks, that prices on MBS stayed relatively high, despite losing ground to treasuries.  Today, however, things took a drastic turn for the worse as inflation concerns were compounded with a stock rally to pull a significant amount of buying interest away from MBS.  Why?

First of all inflation...   If you can buy two delicious Big Macs today at Mcdonalds for two dollars, and there is a significant amount of inflation, a year from now,  you may only be able to get one big mac for two dollars.  That's all well and good as long as you always get your Big Macs the same day you pay for them.  But bond investors don't operate that way.  A bond investor is saying "I will give you two dollars today in exchange for 2 Big Macs in X years from now."  If inflation is not a factor, all will happen as planned.  But with inflation, those Big Macs become more expensive, so X years from now, the 2 dollars will only buy one Big Mac.  If inflation is an imminent concern, bond investors will account for their potentially empty stomachs by effectively saying, "since 2 bucks would only get me one delicious Big Mac after inflation takes its toll, I'm now only willing to give you half the original price for two big macs."  If the inflation example plays out as illustrated above, the investor in the inflationary example would earn the same return on 1 dollar per big mac as the investor in the non inflationary example would earn on 2 dollars per big mac.  Bottom line, inflation forces bond prices to come down today in order to offset an investors risk that those dollars invested today will be worth much less after inflation takes it's toll.  Since by offering a lower price, investors are effectively asking for more for their money, that extra yield is passed on to consumers in the form of higher interest rates.

The second part of the problem is a rallying stock market and it is a much more simple example to understand.  basically, if investors are enticed enough to put money into the stock market, they are either deciding not to add any money to the bonds market OR pulling money out of bonds to invest in stocks.  Either way, demand for bonds decreases, so rates go up.

We are entering a very ambiguous period.  More often than not, just about this time of year, interest rates are either topping out for the year, or they are nearing their bottom.  In analyzing both the fundamental market data and the technical data (which is simply a complicated way of examining trends of the price curves), there is evidence that we will rise still further in rates, but there is an equal amount of evidence that we turned a corner on June 13th and this week has just been a bump in the road on our way to improved rates.

Either way, rates SHOULD be better later on this year, BUT that does not do you much good if the near term (1 month or less) is uncertain and that is when you need to lock/close.  I'm sorry to say that is the case today.  As with each passing day, tomorrow will provide clues as to the continuance or reversal of the trend, but there is no sure-fire call right now.  In general, in times like these, it is safer to lock if your closing is taking place in the short term.  this will be especially evident if we have another "down" day tomorrow (down in price = up in rate).  But you can always stay tuned here for general updates.  For the absolute quickest updates, feel free to jump over to the professional blog, which is updated much more frequently and often several times a day.  It will usually be much harder to understand what is said, but if you read the MBS primer, you should be able to get an indication of what is happening on the day.