BofA Sees June Rate Hike As Fed Shifts Focus To Inflation

Among all the sort-of-hawkish takes on the Federal Reserve’s policy statement yesterday, Bank of America Merrill Lynch says it hasn’t changed its expectation that the Fed will start  raising rates next June, if not later. BofA joins many strategists who stop short of calling the statement hawkish, calling the Fed “still dovish, but less than expected,” and saying it sees signs that the Fed is shifting its focus from the labor market to inflation. From BofA rates strategy team:

[The Fed] made several changes in the statement that were less dovish than some in the markets were anticipating, based on the price action immediately after 2 PM. We see the main focus of attention on the FOMC shifting from the labor market to inflation, even though they did not materially change their inflation outlook at this meeting. Stepping back, today’s meeting did not change our view that the Fed will remain very patient and gradual in removing policy accommodation. Our base case remains a June start to a very slow hiking cycle, with risks skewed to a later liftoff.

BofA examines the Fed’s comments on inflation, and says we might see more talk of inflation concerns in the Fed minutes than we saw in the statement itself:

Based on speeches ahead of the October meeting, there was some expectation that the FOMC would indicate more concern about downside risks to inflation. Relative to the September statement, the Committee noted the drop in breakevens but also stated that “survey-based measures of longer-term inflation expectations have remained stable.” They also that “lower energy prices and other factors” could lead to lower inflation “in the near term,” yet they still saw the risks of persistently below-target inflation as having “diminished somewhat since early this year.” A hawkish interpretation would be that the FOMC passed up a chance to sound more concerned. Our view is that the Fed doesn’t want to overreact, but acknowledges that some of the inflation indicators have softened. Outside of Kocherlakota’s dissent, their concerns haven’t reached the point of changing their inflation outlook, but we would not be surprised to see more concern expressed in the minutes in three weeks’ time.

Uptick In Mortgage Rates Triggers Plunge in Jumbo Refinancings

Mortgage rates followed Treasury yields higher last week, but the average 30-year mortgage rate remains right around 4% and close to a 16-month low. Still, the slight uptick was enough to cause a plunge in refinancings among jumbo borrowers last week.

The average 30-year fixed-rate mortgage rate rose to 3.98% in the week ended today, per Freddie Mac‘s (FMCC) latest Primary Mortgage Market Survey. That’s up from 3.92% a week ago, which had been the lowest rate seen since June 2013. An equivalent 30-year average rate measured by the Mortgage Bankers Association’s latest weekly survey also rose to 4.13% from 4.10% a week earlier, which had been the lowest level recorded since May 2013. The MBA’s survey showed the average rate for jumbo loans of more than $417,000 rose to 4.17% from 4.03% a week before, which had also been a 17-month low.

The MBA survey also said mortgage applications decreased by 6.6% in the latest week, while refinancings fell by 6%. Mike Fratantoni, chief economist at the MBA, says refinancing volume for jumbo borrowers has been particularly volatile in recent weeks as interest rates have gyrated.

“Borrowers with jumbo loans tend to be most sensitive to changes in rates, and that sensitivity has been clearly apparent in the past few weeks with double and even triple digit percentage changes in refinance application volume for jumbo loans,” Fratantoni said in a statement.  The MBA said the average loan size for refinance applications decreased to $263,600 in the most recent week from an all-time high of $306,400 the previous week, driven by a 41% drop in refinance applications for loans greater than $729,000 which had surged almost 130% the week before.

The rise in mortgage rates comes after the 10-year Treasury yield – which mortgage rates tend to track – has risen over the past two weeks after it hit its own 16-month low of 1.865% on Oct. 15.

The average 30-year mortgage rate hit an all-time low of 3.31% in November 2012 and nearly equaled that low in May 2013 when it dipped to 3.34%.

Is Fed Statement Hawkish, Or Just More Data-Dependent?

Markets have been reading the Fed’s latest policy statement as kind of, sort of hawkish-ish, describing a strengthening economy that requires less support without being effusively upbeat. But maybe the Fed is just incorporating its longstanding data-dependent stance into its policy statement more explicitly than it has before.

Today’s statement didn’t change any wording from previous ones regarding a time frame for a first rate hike, but its more forceful phrasing on the strength of the labor-market recovery has many observers claiming to see hawks circling. Shorter-dated bond yields rose today as a result, while several strategists settled back into predictions that the Fed’s first rate hike will probably arrive in the middle of next year, after such expectations had been pushed back by the global growth worries and market gyrations earlier this month.

Still, a lot of strategists hesitated to flat-out call the statement hawkish.

“On balance, we see these changes as tilted slightly hawkish – not necessarily hawkish to the prospects for a June tightening,” writes RBS economist Michelle Girard.

“We emphasize that this is all relative; more hawkish may be too strong a term,” writes David Ader of CRT Capital. “Better would be less dovish or more optimistic, but hardly hawkish.”

Adrian Miller of GMP Securities says the statement’s upgraded take on the labor market, and its slight nod to the possibility of an earlier rate hike, means “one can interpret the policy statement as being somewhat more hawkish than initially thought.”

Instead of straight-up hawkish, maybe the Fed’s statement simply codifies what Fed officials have been saying for months, in speeches and press conferences and policy meeting minutes: that all policy moves depend entirely on incoming economic data. Today brought that stance explicitly into the official policy statement for the first time, by way of this new pair of sentences following the Fed’s now-boilerplate “considerable time” rate-hike time frame:

However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

“The Fed has not chosen to put it into the statement until now,” says Erik Weisman, bond portfolio manager at MFS Investment Management. “It’s one thing to say it, it’s another thing to put it in the statement.”

Weisman points out that two of the FOMCs’ more hawkish members, Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher, dissented from the September statement but signed off on the October statement, and the new lone dissent came from Minnesota Fed President Narayana Kocherlakota.

“The two hawks who dissented are now on board, and one of the doves is not on board,” Weisman says. ”I think that’s quite meaningful. The risk is that when we see the [policy committee meeting] minutes, we might see that there was a little more horse trading going on at the meeting, and we could see more hawkish minutes.” The Fed will publish those minutes in three weeks.

Bon Voyage, QE3: Fed Ends Bond Buys; Keeps ‘Considerable Time’ Language

The Federal Reserve’s latest policy statement is out, and as expected it formally ends the Fed’s bond-buying program that was due to conclude this month. The Fed also kept its “considerable time” language defining the gap between the end of quantitative easing, which is now, and the first Fed rate hike.

In terms of changes, the Fed significantly upgraded its assessment of the labor market and even said inflation looks better than it did earlier this year. Some excerpts:

Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing….

The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year.

The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability.

Treasury yields continue their climb today with a quick jump higher following the statement’s release, with the 2-year yield now up to 0.473% and the 10-year note yield up to 2.350%, per Tradeweb data. The dollar is strengthening against the euro so far.

The particularly differs from the last one in the roll call of dissenters. Gone are the two hawkish dissents of Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher. In their place is a sole (somewhat dovish) dissenter, Minnesota Fed President Narayana Kocherlakota. From the new statement:

Voting against the action was Narayana Kocherlakota, who believed that, in light of continued sluggishness in the inflation outlook and the recent slide in market-based measures of longer-term inflation expectations, the Committee should commit to keeping the current target range for the federal funds rate at least until the one-to-two-year ahead inflation outlook has returned to 2 percent and should continue the asset purchase program at its current level.

From our colleagues at the Wall Street Journal’s Real Time Economics blog, here’s the word-by-word comparison between the Fed’s last statement and the current one.

Weak 5-Yr Auction Compounds Treasury Slump Ahead Of Fed

Bonds continue to have a lousy day in the lead-up to the Fed’s big announcement in under half an hour. An auction auction of $35 billion worth of 5-year notes found pretty weak attendance, according to several market participants, with the notes yielding 1.567% compared to a 1.549% bid right before, leading to a long 1.8 bp “tail” (long tails generally mean poor auction results). David Ader of CRT Capital explains:

The auction tailed a lot.  At 1.8 bp this is the longest tail since Dec which in turn was longest tail since June ’12. Dealers got more than they bid for, so to speak, with the largest outright take since $21.8 bn in Dec.

Here’s Adrian Miller of GMP Securities with what the auction means coming just before the Fed statement:

The cool reception to the auction was basically the result of the proximity to the Fed’s decision. However, of those who did attend the auction its clear institutional investors are comfortable with the prospect of a dovish policy statement. At the same time indirect bidders have more options for their 5-year tenor allocation now that the ECB is buying bonds and the AQR is over. Additionally, the drop in aggregate demand as represented by the lowest bid-to-cover since July 2009 (1.92x) is likely due to the auction’s low stop which offers little in the way of value especially with rates expected to back up modestly over the near term even with a dovish Fed statement.

Treasury Yields Creep Higher Ahead Of Fed Statement

The bond market seems a little less certain of a dovish Federal Reserve this morning than it did yesterday. While everyone’s waiting for the Fed to release its latest policy statement this afternoon, bond yields have been stealthily creeping higher this morning, putting a further dent in the gains seen earlier this month.The ten-year note is down 8/32 in price to yield 2.312%, per Tradeweb data, the first time its yield has risen above 2.3% since Oct. 10. The 30-year bond is down 14/32 to lift its yield to 3.081%, the  highest intraday yield since Oct. 9.

The yield on the two-year note, which fell as low as 0.244% on Oct. 15, is back up to 0.434%, also the highest since Oct. 10. That particular note’s yield is seen as the best indicator of market expectations regarding Fed rate hikes. After reaching a 2014 high of 0.591% on Sept. 24, it dropped like a rock for the next couple of weeks amid intensified worries about global growth. But it’s been on the rise again for the past two weeks, as the stock market has recovered and recent economic indicators paint a pretty decent picture.

The upcoming Fed statement is expected to formally declare an end the central bank’s current quantitative easing program, but it’s still unclear whether the Fed will make any change to the subsequent “considerable time” interval for when it might raise interest rates, or if the Fed will change any language related to job-market slack.

After Muni Volatility, Some Buying Opportunities Return

“Volatile” and “municipal bonds” aren’t terms you’d pick to pair together, but lately munis have been through an exceptionally volatile period (by muni standards, anyway), and the risk of occasional turbulence may persist. The good news is that some munis went from looking broadly overbought mere days ago to looking like decent values again, creating new buying opportunities for certain maturities.

Citi muni strategist George Friedlander says the whipsaw that’s occurred over the past two weeks caused long-term high-grade muni yields to drop by nearly 35 basis points before giving most of that gain right back, pushing muni volatility near its peak for this year and resulting in a “significant underperformance” and cheapening versus Treasuries. Friedlander sees a silver lining:

Over the past week, the upward adjustment in yields was the largest in a single week in nearly two years, since rates bounced from historical lows around the end of November 2012….

As had been the case the last time we were near current levels, in late 2012, many participants were actually relieved to see munis back off significantly. Yields down near historical lows tend to be a lousy place to start a new year, so that many traders were not all that disappointed to see a back-off. In addition, yield levels were getting so low as to make the long end of the curve less than compelling, or even downright scary, to many potential investors. Furthermore, after the absolute and relative yield adjustment… munis were in a lot better position to track Treasuries, so that hedged positions no longer appeared to be so severely at risk. So, while a number of firms took bad hits as the market corrected, other market participants were actually relieved to see yield levels back closer to rates that seemed more “normal.”

That is not to say that the muni market is necessarily out of the woods as yet. One key concern on the long end is that further weakening, if it occurs, would almost certainly be accompanied by negative fund flows. For the week ended 10/22, long-term muni fund flows according to Lipper/AMG were in significant negative territory for the first time since the first week in August. While direct retail clearly picked up on the yield rebound, there is a maturity mismatch: direct retail is buying in a lot shorter maturities, on average, than funds would likely be selling.

Matt Fabian of Municipal Market Advisors says longer-dated munis look attractive again:

Regarding near‐term performance expectations, last week’s re‐pricing re-allocated value across the curve. Positions longer than the 10yr are reading as cheap for the first time in weeks. However, continuing negative momentum also encourages caution and more careful security selection. The earlier curve—2yr‐10yr—appears overbought but is showing strong positive price momentum, implying a reallocation into shorter-maturity bonds and more bullish retail bid. This would be a solid choice for asset preservation.

The iShares National AMT-Free Muni Bond ETF (MUB) has had a seesaw month but is now basically unchanged from where it was three weeks ago, trading at $109.98 at latest check.

Puerto Rico Facing ‘Narrowing Liquidity’ – Moody’s

Moody’s Investors Service today says Puerto Rico faces “narrowing liquidity” as its cash dwindles, saying the commonwealth’s financial position “remains vulnerable, and reliant on continued bond market access, even as lenders impose increasingly onerous terms and punitive borrowing costs.” The rating agency’s report comes ten days after the Government Development Bank for Puerto Rico published a revised projection that its available cash will fall as much as 22% below previously forecast amounts without a new bond offering to refinance debt that’s owed by the Puerto Rico Highway and Transportation Authority. The Moody’s report doesn’t take any rating action.

Moody’s says Puerto Rico government officials have been discussing plans to refinance HTA’s loans, which account for about 21% of GDB’s loan portfolio, as part of their efforts to replenish and maintain GDB’s cash levels. The rating agency expects the financing to be announced on October 29, and says failure to execute the financing “would put GDB on a path to insufficient reserves at a time when it will face mounting pressure to meet its own obligations.” More from Moody’s:

GDB maturing note principal totals $481 million in fiscal 2015, and jumps to $876 million in fiscal 2016. Depletion of GDB’s cash position, which serves as a proxy for that of the commonwealth, could lead the commonwealth and GDB to resort to budgetary payment deferrals and other cash management tools in order to pay debt service, which would increase the risk of default and place negative pressure on the rating of the commonwealth and its related entities.

While such a scenario, with heightened default probabilities, would indicate growing credit pressure on the ratings of the commonwealth and related entities, we believe it is unlikely. The commonwealth’s small group of willing lenders probably will allow completion of the HTA loan financing, although subject to punitive interest costs and strict provisions on legal jurisdiction. Assuming a $1 billion infusion after completion of the transaction, GDB’s quarter-end liquidity would rise about 72% above previously projected sums, reaching almost $2 billion on June 30, compared with $1.1 billion under the March forecast.

Puerto Rico’s 21-year bonds that were issued in March at 93 cents on the dollar are trading between 86 and 89 cents on the dollar today, per the MSRB’s EMMA website. The bonds have become widely held by hedge funds betting on the commonwealth’s ability to refinance its debt and get its fiscal house in order. Puerto Rico municipal debt is widely held among muni-bond funds nationwide because the bond interest is tax-exempt at the federal, state and local level.

Bonds Slip As Confidence Rises, Fed Meeting Begins

A couple of decent readings on domestic economic data are undercutting bond prices on Tuesday, just as the Federal Reserve’s latest two-day policy committee meeting is getting underway. Consumer confidence jumped in October, with the Conference Board reporting that its consumer confidence index rose to 94.5 in this month from 89.0 in September. The Richmond Fed’s manufacturing index rose to 20 in October from 14 in September.

The 10-year Treasury note is currently down 6/32 in price to yield 2.278%, per Tradeweb data, down in from an intraday high 2.296% around mid-morning shortly after the confidence reading came out. The 30-year bond is down 13/32 to yield 3.054%, and the 2-year note is marginally lower in price, yielding 0.390%.

David Ader of CRT Capital calls the morning’s reports “a strong duo… with Confidence the more important and showing an improvement in labor conditions with a gain to the labor differential and higher expectations for incomes and inflation. Richmond Fed is second tier, but stronger nonetheless and in the same components vis a vis labor.”

Rates Fall Further Ahead Of Fed Meeting

Bonds have picked up some early-week momentum heading into the start of the Federal Reserve’s latest two-day policy meeting that gets underway tomorrow. The 10-year note is up 6/32 in price to trim its yield to 2.252%, per Tradeweb data, and the 30-year bond is up 15/32 to yield 3.026%.

The 2-year Treasury note yield, which has become the market’s bellwether indicator regarding the expected timing of the Fed’s first interest-rate hike, climbed a bit last week but stands at 0.382% today from 0.591% barely over a month ago. That drop comes as weak inflation readings and fears of a Europe-led global slowdown have investors pushing back their expectations of when the first Fed rate hike will happen.

When its meeting wraps up on Wednesday, the Fed is going to have to make at least a minor tweak to its policy statement language to acknowledge that its bond-buying program is slated to end this month. Still, Bank of America Merrill Lynch‘s rates strategy team doesn’t expect many changes beyond that. From BofA rates strategists Priya Misra, Shyam S. Rajan, and Brian Smedley:

We expect few changes to the statement, which could disappoint equity markets in the context of last week’s bounce in risk appetite, as this was at least partly attributable to President Bullard’s rekindling of QE hopes. We see minimal chances that the Fed will heed Bullard’s suggestion to delay the end of QE3 but hike rates in Q1 2015. Instead, we believe QE3 is highly likely to conclude at the end of October, as has already been telegraphed in various FOMC communications. The FOMC is much more inclined to wrap up asset purchases and refocus on rates and forward rate guidance.

The committee’s characterization of the labor market and inflation risks will also be in focus. We expect the “significant underutilization” language to remain in place — although we see a modest chance that language is downgraded to, say, “elevated underutilization.”