Ian ...but even given what you say we first try to adjust a mortgage basket for duration and then convexity. The result is both remarkably stable over time with the 'adjusted' closely tracking the 10-year. Periods of deviation correlate closely with changes in the bill/ coupon mix. We show this. I must admit I was originally sceptical but the results made me rethink. Also closer testing shows that prior to the GFC, mortgages adjusted to Treasuries. Since, the evidence leans the other way. Moreover, using this spread adjustment, the yield curve behaves as it should. No recession signaled, only a flowing and that should be ending now. We shall see.
One can't compare US Agency MBS securities that are laden with prepayment optionality and negative convexity to a single nominal bullet 10-yr Treasury for a spread comparison. For instance, during the Fed’s QE when most Agency MBS traded at a premium dollar price, the longest option adjusted duration using Sali’s / Citi Yieldbook model (the Sali fixed income folks are impressive!) was 3 years for an Agency MBS 30-yr 2% coupon. 10-year Treasuries usually have a duration of 7-8 years, so any nominal spread comparison is mis-specified due to these duration mismatches when Agency MBS is in a premium price environment.
We usually use OAS analysis that is the excess spread across the entire term structure of Treasuries to arrive at relative value analysis. Agency MBS lower coupons have extended in duration as the market has sold off and now sport a duration in the 7-8 year range (Use ‘TBPF’ screen on Bloomberg). The OAS is roughly 46 bps versus Treasuries, but down from 80 bps last October.
Finally, I’d argue that the Agency MBS market is just as much junk as the US Tsy. Thank you Federal Reserve for buying 35% of the MBS float during QE, but even through QT, they still own 30% plus of the market and really taint the price discovery mechanism for the sector.
Depends whether you view the YC spread as an indicator of monetary tightness or the real yield. I favor the former, so since implicit YC steeper, I figure that conditions easing. Note latest o/p of bank stocks is coming just at the 'correct' time in the cycle. YC should soon steepen
Anecdote - Banks play in the 2Y world and the economy plays in the 10Y world...
Every major economist & strat backtested - it's the two year net bps change in the 10Y yld that drives economic indicators.
if so, and i realize you may not see this as so, isnt the economy dealing with far tighter conditions if the adj10YY should be 100bps higher vs current nominal? thx
It it still 'risk free' from a regulatory point of view, which to most funds is what matters. But for other investors it is an unreliable benchmark and, as the evidence increasingly shows, it is not 'risk free'. Since the problem is not so much 'pay back', but inflation-proof pay back, attention will likely shift towards gold and potentially crypto assets.
If the US Treasury Bond is no longer the risk free asset (and the German Bund is probably in no better shape): will another risk-free asset replace them, or will there be no more risk-free assets?
Ian ...but even given what you say we first try to adjust a mortgage basket for duration and then convexity. The result is both remarkably stable over time with the 'adjusted' closely tracking the 10-year. Periods of deviation correlate closely with changes in the bill/ coupon mix. We show this. I must admit I was originally sceptical but the results made me rethink. Also closer testing shows that prior to the GFC, mortgages adjusted to Treasuries. Since, the evidence leans the other way. Moreover, using this spread adjustment, the yield curve behaves as it should. No recession signaled, only a flowing and that should be ending now. We shall see.
Hmm, I’ll take the opposite tack here.
One can't compare US Agency MBS securities that are laden with prepayment optionality and negative convexity to a single nominal bullet 10-yr Treasury for a spread comparison. For instance, during the Fed’s QE when most Agency MBS traded at a premium dollar price, the longest option adjusted duration using Sali’s / Citi Yieldbook model (the Sali fixed income folks are impressive!) was 3 years for an Agency MBS 30-yr 2% coupon. 10-year Treasuries usually have a duration of 7-8 years, so any nominal spread comparison is mis-specified due to these duration mismatches when Agency MBS is in a premium price environment.
We usually use OAS analysis that is the excess spread across the entire term structure of Treasuries to arrive at relative value analysis. Agency MBS lower coupons have extended in duration as the market has sold off and now sport a duration in the 7-8 year range (Use ‘TBPF’ screen on Bloomberg). The OAS is roughly 46 bps versus Treasuries, but down from 80 bps last October.
Finally, I’d argue that the Agency MBS market is just as much junk as the US Tsy. Thank you Federal Reserve for buying 35% of the MBS float during QE, but even through QT, they still own 30% plus of the market and really taint the price discovery mechanism for the sector.
Depends whether you view the YC spread as an indicator of monetary tightness or the real yield. I favor the former, so since implicit YC steeper, I figure that conditions easing. Note latest o/p of bank stocks is coming just at the 'correct' time in the cycle. YC should soon steepen
Anecdote - Banks play in the 2Y world and the economy plays in the 10Y world...
Every major economist & strat backtested - it's the two year net bps change in the 10Y yld that drives economic indicators.
if so, and i realize you may not see this as so, isnt the economy dealing with far tighter conditions if the adj10YY should be 100bps higher vs current nominal? thx
It it still 'risk free' from a regulatory point of view, which to most funds is what matters. But for other investors it is an unreliable benchmark and, as the evidence increasingly shows, it is not 'risk free'. Since the problem is not so much 'pay back', but inflation-proof pay back, attention will likely shift towards gold and potentially crypto assets.
If the US Treasury Bond is no longer the risk free asset (and the German Bund is probably in no better shape): will another risk-free asset replace them, or will there be no more risk-free assets?