As we mentioned earlier in the week, we expected the markets to be quiet in anticipation of the full employment report that will be released at 8:30 am. While U.S. equities ended the day in positive territory, the action yesterday and all week has been marked by extremely low trading volumes. We talked on Wednesday about how equities are poised to move higher from a technical perspective as the S&P 500 has now closed above the key resistance level of 1110 for four consecutive days. We also talked on Wednesday about how economists and the street are talking down the precision of today’s employment report in light of the abundance of winter storms in February. Consequently, I believe the market has set itself up for a rally barring a disastrous report. A better than expected report should fuel a rally, while a weaker than expected report will most likely be explained away by the weather.
On the treasury front, this has been an extremely quiet week as price and yields are essentially unchanged across the curve, particularly on the longer-end. Shorter treasury yields have actually moved up slightly, resulting in a flatter yield curve. While the slope of the yield curve still remains steep from a historical perspective, the spread between the 2-year and 10-year now sits at 274 basis points, roughly 20 bps below the record achieved a few weeks ago. Rising short-term yields infer that the street believes the Fed might be closer to a tightening. However, numerous Fed governors reiterated this week that monetary policy will remain accommodative for an extended period. Recall that in January, the New York Fed President, William Dudley, defined extended period to mean 6 months. As such, every time a Fed governor references they will keep rates low for an extended period, one can infer that to mean 6 months from that point in time. Consequently, that suggests that the Fed will not raise short-term rates until at least September, at which point we will be getting closer to the Congressional elections in November. And, traditionally the Fed has not raised rates close to the elections, suggesting that a rate hike will not occur until next year.
On the fixed income front, despite the fact that treasuries are virtually unchanged this week, mortgage backed security prices, particularly lower coupon structures, have rallied. Two observations. First, recall that the Fed is nearing the completion of its mbs purchases as they will expire this month. While many have expected this to cause a decline in mbs prices, it has not played out this way. Conversely, it appears that the private sector might appreciate that they will not be competing with the government to buy securities. Recall also that there is a ton of cash and liquidity built up in the system which is not being lent out. This cash appears to be coming back into investment securities. The second observation is the issue surrounding the FNMA and FHLMC loan buyouts. Significant additional cash flows will need to be reinvested as a result of massive prepayments on higher coupon paper. Those cash flows also appear to be reinvested back into lower coupon mbs. From a strategy perspective, it is difficult to determine how to play this trend. Obviously, gains can be taken by selling into the bid side strength as we have had numerous clients play it this way. However, many of our clients remain flush with cash and are looking for investment alternatives. As always, to the extent that you have to buy collateral and are flush with cash, focus on the security selection process. Stick with larger, more liquid pools backed by many loans with good geographic dispersion. This philosophy ensures stability in cash flows and improves liquidity should you sell these pools down the road.