Gambling Psychology, Inflation Fears, The Flattening Yield Curve, and Why Mortgage Prices are Sometimes "Sticky"

A “handsel” is a gift given to wish good luck for the year ahead. The word dates back to the 1300s, and derives from “hand” and “selen,” an Old English word meaning gift or donation, a cousin of the word “sell.” A handsel can also be the first instalment of a payment or bond, although we tend to use the less colorful term “first payment.” The word “mortgage” comes from Old French “morgage,” literally “dead pledge,” from mort (dead) and gage (pledge). The term “mortgage” is used interchangeably with “home loan” or “lien” or “deed of trust.” There are technical and legal differences, of course, and it is good for your staff to know the differences. Shifts in terminology aren’t confined to our business, of course. Marketing wizards have determined that people in their 20s and 30s don’t like the term “diet” and have begun replacing soda pop labels with “zero sugar” drinks. But “home ownership” is a term that sticks with us and is easy to understand. It is good for the community, good for the country, and arguably the best wealth-creation strategy for individuals. We know that homeowners spend money (like paint, lawn care, dog food, pizza on Friday night) and serve as economic players in the local community. And of course we know that homeownership can lead to generational wealth. And our industry helps! (During this seasonal quiet time the daily podcast is having some down time but will return Monday, January 3. Earlier versions of the audio are available here; questions about interviews and sponsorships should be directed to Robbie Chrisman.)

Baby Needs a New Pair of Shoes!

Would brokers or loan officers call the process of locking a rate “gambling?” Of course not. People tend to believe that they can predict the future, given current information and past events. SEC Rule 156 requires mutual funds to tell investors not to base their expectations of future results on past performance before they invest. Who predicted the pandemic’s affect on housing values? There is an old joke: Economists were invented to make weather forecasters and astrologers look good. As the Mortgage Bankers Association’s Dr. Michael Fratantoni puts it, “All forecasts are wrong but some are useful.” 

The study of gambling, and why it becomes a habit for some, is fascinating. Take slot machines. Did you know that, neurologically speaking, pathological gamblers got more excited about winning than non-gamblers? And that, for near wins (three cherries and an orange, or however they work these days), to gamblers the near wins, while still a loss, looked like wins neurologically? Their brains reacted almost the same way. But to non-gamblers, a near win was a loss. Same event, different reaction. People with a gambling problem receive a mental high from the near wins which keeps them playing longer. Gaming companies and casinos are well aware of this tendency, of course, which is why programmable slot machines are programmed to deliver a nearly constant supply of near wins. The same with state lotteries.

Mortgage banking is one of the few industries where someone outside the industry (the borrower) can lock in a price in the future. (Of course traders in futures can lock in prices, as can companies that use commodities like oil, wheats, hog bellies, and so on in their business.) Capital markets staff will tell you that, from a hedge cost perspective, it is better to lock in a rate and price after the loan has been underwritten and processed, and the property’s value confirmed. But of course loan officers, especially those dealing with builders whose timelines extend months into the future, bow to competitive pressures and will try to lock a rate in as soon as possible. Life…

Inflation is by far the #1 economic concern going into 2022. If inflation is running above 6 percent, and you are earning near 0 percent on your savings, or you received a 3 percent raise for 2022, that’s a problem. Many are worried about a period of escalating prices, and don't trust what they're hearing from mainstream economists and central bank officials. At the start of 2021, the U.S. was forecast to end the year with 2% inflation, but it is close to 7% instead. Fed Chair Jay Powell has subsequently backtracked on his "transitory" thesis, with the term endangering a delayed reaction to the current price environment.

Traditionally inflation has been a symptom of easy money policies, or some dramatic economic conditions (Germany after World War II, or Venezuela for the last several decades). What we’re seeing in the United States is due to supply bottlenecks and increased consumer spending. If those factors were to ease, or if families were to hunker back down due to continued variants coming our way, much of those fears could dissipate. Fed watchers hope that the Federal Reserve could also pull off a delicate balancing act, where both growth and inflation decelerate, but not so much that the economic expansion is put in jeopardy.

Capital Markets

The bond market has been relatively non-volatile as of late as the world digests continuing data showing the latest variant (omicron) is less lethal and more mild than expected. Priced in are the Federal Reserve’s end of bond buying in the spring of 2022 and the Fed ratcheting up short term rates 2-3 times next year. That doesn’t mean we won’t see some volatility with interest rates as there always are with domestic and international surprises.

My years on an MBS trading desk taught us, however, when bonds, and therefore rates, make a big move higher or lower, often the “primary” markets, or what borrowers see from lenders, and the “secondary” markets, what lenders see from investors via MBS (mortgage-backed securities) prices, disconnect. This especially happens when bonds rally, and rates drop. But they don’t drop fast enough for LOs’ liking. Lenders tend to hem and haw and hold back pricing into rallies. Potential prepay speeds, high specified pool payups, and terrible roll valuations certainly factor into it. The disconnect between primary and secondary mortgage markets that capital markets staff grapple with, in any bond move.

Let’s say there’s a bond rally. What happens? Investors holding now deep “in-the-money” MBS immediately repriced TBA (to be announced, or generic pools of Agency mortgages) assumptions to reflect faster prepayment speeds. Unfortunately, this behavior has a significant negative impact on liquidity. Price makers, i.e., institutions paying for MBS, are forced to counterbalance convexity hedging and indexing needs of investors with the pipeline hedging demands of lenders who are experiencing a spike in fallout/renegotiation requests. That can be tough for capital markets teams, especially when rates are still rallying and early payoff speeds are still on the rise. Liquidity just doesn't move down the coupon stack that quickly. But eventually we see the shift.

What about this ornery yield curve? Short term rates have gone up this year relative to long-term rates. And if the Fed raises its overnight Fed Funds rate, and Discount Rate, a few times next year, so even if short term rates head higher, we could still see long term rates not move as much, leading to a flatter yield curve. The “flat yield curve” is a yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality. This type of yield curve is often seen during transitions between normal and inverted curves. Put another way, an easy way to think of it is if the Fed raises rates and 30-year mortgage rates don’t budge.

Sometimes, when inflation is less of a concern, the spread (difference) between short term rates (less than a year maturity) and long-term rates (10 years and beyond) can narrow. But as 2021 moved along, we were reminded that a flattening can also occur in anticipation of slower economic growth. And sometimes, the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates, and that is what is happening now.

Lenders could see a rate situation where adjustable-rate mortgages (ARMs) and 30-year fixed-rate mortgages have similar coupons. Those are interesting discussions for experienced, and inexperienced, LOs to have with borrowers.

Turning to the bond market, and therefore interest rates, theoretically bonds are trading today. But there is an early close, and most traders and investors have closed their books for the year and are taking the day off. U.S. Treasuries (but not mortgage-backed securities) ended Thursday on a higher note that helped reclaim some of Wednesday's losses. The rebound pressured the 10-yr yield back below its 50-day moving average (1.521%). The 10-year note closed 1/4-point higher on the day but UMBS30 prices fell 2 to 3 ticks (32nds) with limited Fed support and supply increasing somewhat over the past couple sessions.

The weekly initial jobless claims included the usual continuing claims, and this four-week moving average for initial claims (199,250) is the lowest it has been since October 25, 1969, which reflects the tightness of the labor market.

Thursday the benchmark 10-year note settled just off the session highs to yield 1.52 percent. If anyone cares about rates today, this New Year’s Eve session contains no data or Fed purchases with futures settlement at 1PM ET with cash closing at 2PM ET. In an illiquid market we find the 10-year’s yield down to 1.50 percent and current coupon Agency MBS prices worse/down a few ticks.