After the completion of the United Kingdom's exit, Italy will have the third largest economy in the European Union (EU) behind Germany and France. In recent years, Italy's economic growth has been below the average for the EU as a whole, and its unemployment rate has been higher than average. Italy's government is formed through a coalition of its top political parties, and the incoming coalition is proposing some major changes to attempt to address these issues. In particular, it would like to reduce the government spending constraints imposed by EU rules. Investors are concerned that this will lead to an increase in Italy's already large budget deficit and that the risk has increased that Italy could one day exit the EU. The resulting uncertainty has caused investors to shift to safer assets, hurting stocks and pushing global bond yields (outside of Italy) lower.
One source of volatility for MBS prices is uncertainty about the outcome of upcoming elections in several European countries. Investors are most focused on the presidential election in France which will take place on April 23. Polls show a close race between Marine Le Pen and Emmanuel Macron. Le Pen's campaign has been centered on plans for France to leave the European Union (EU) and to stop using the euro currency, while the centrist Macron has run on a more traditional platform. It is not clear what would happen to the EU if France decided to exit. As a result, investors have reacted by shifting to safer assets after news which favors a Le Pen victory and doing the opposite after positive news for Macron. Since U.S. MBS are viewed as relatively safer assets, they have been affected by the shifts in sentiment, causing volatility.
In her semi-annual testimony to Congress, Fed Chair Yellen said that the Fed expects that economic progress will call for "further gradual increases" in the federal funds rate. She also said that it would be "unwise" to wait too long to hike rates. Yellen later added that the Fed will consider in coming months when to begin to reduce the Fed's holdings of MBS. Of note, she said that the Fed will not sell MBS to shrink the holdings, but rather will stop replacing principal reductions. The expected pace of tightening by the Fed increased a little after her testimony, causing MBS to decline.
President Trump today said to expect an announcement about tax cuts in two to three weeks. Mortgage rates moved a little higher after the comment. There are two reasons why tax cuts are viewed as negative for mortgage rates. The first is that tax cuts increase the wealth of the affected individuals or businesses, leaving them with more money to spend. This added spending boosts economic activity, which increases the outlook for future inflation. Mortgage rates rise as expected future inflation rises, since higher inflation further erodes the value of a mortgage’s future cash flows. The second is that tax cuts increase the budget deficit, at least initially. This means that the government has to issue more Treasury bonds to fund the deficit. The added supply reduces the value of Treasuries and similar bonds, including mortgage-backed securities (MBS). A decline in MBS prices leads to higher mortgage rates.
Next Sunday, voters in Italy will decide on a referendum presented by Prime Minister Matteo Renzi which would reform the constitution to speed up lawmaking and to produce a more stable government. If the referendum fails to pass, there is the potential for many troubles to develop in Italy. First, much needed reforms for the Italian banking sector likely would be postponed, which would put many banks at risk of failing. Investors are concerned that this could impact banks throughout Europe. In addition, Renzi has said that he will step down if the referendum does not pass. His resignation would likely lead to a period of political uncertainty in Italy, and it could result in more power for a political group which favors leaving the euro. In the wake of the Brexit vote in the UK, investors would be very concerned if they saw the potential for Italy to exit the European Union. The most recent polls show that it may be a very close vote. Investors have reacted to the uncertainty by shifting to safer assets, including U.S. mortgage-backed securities (MBS). Since mortgage rates are set based on MBS prices, the news resulted in improvement. For the rest of [...]
Anyone watching mortgage rates couldn’t miss the news this week that the Fed will begin to “taper, or cut back on their purchases of MBS and Treasury bonds. All eyes are on the impact this will have on interest rates. Their plan to purchase $10bb less per month signals the Fed’s growing confidence in the economy. Important to note though is that this means they will still purchase $75bb per month in MBS and treasuries for the time being, which still amounts to considerable economic stimulus. Much less publicized, but more immediately significant for interest rates, were two other announcements. The FHFA announced a .1% increase in the guaranty fee for mortgages delivered to Fannie Mae and Freddie Mac, effective in the spring, which amounts to an automatic .1% increase in interest rates. Also, Fannie Mae announced new Loan Level Pricing Adjustments (LLPAs) for loans delivered to them, also beginning in the spring. LLPAs are based on loan characteristics such as credit score, LTV, loan purpose, occupancy, number of units, product type, etc. These adjustments will also increase the cost of borrowing for homeowners. The net effect is that interest rates will likely rise a bit in the near term, [...]