RISR Commentary for April, 2022

April Activity

Interest rate increases accelerated in April, as the 10-year treasury saw an increase of nearly 60 bps. One would have to go back to 2009 to observe a similar jump in interest rates. The reason for the spike in rates is a growing recognition that the Federal Reserve is going to have to tighten monetary policy much more sharply than had been widely anticipated as recently as 6-8 weeks ago. In addition, the yield curve steepened somewhat over the course of the month, which for some market observers meant that odds of a recession had declined. In our view, this is much too fine a parsing of the tea leaves. The US economy is in a very precarious state.

The rise in treasury rates has begun to materially impact other market interest rates, especially for fixed-rate mortgages. During April the national average interest rate for a conventional 30-year fixed rate mortgage jumped from 4.9% at the end of March to 5.42% by the end of April. For an even starker comparison, that rate was a near cyclical low of around 3.25% at the beginning of this year. So, since the start of the year, the monthly payment for a $275,000 30-year mortgage has increased from around $1,200 to almost $1,550, a jump of 30%. It is a safe bet that very few prospective home buyers have seen their monthly incomes rise by 30% since the start of the year. Not surprisingly, mortgage loan applications have plummeted. The softening of the housing market we have been predicting for some time, is well underway.

This is particularly true for refinance applications. The principal reason most homeowners refinance an existing mortgage is to take advantage of a lower interest rates in order to reduce their monthly payment. With the recent rise in mortgage rates nationally, comparatively few homeowners hold mortgages with rates that are amenable to refinancing. Broadly speaking, mortgages originated since 2009 have rates that are lower than current mortgage rates, and so the refinance incentive is greatly diminished. It is true that a portion of refinancings are for home improvement or debt consolidation or other idiosyncratic reasons. But without the ability to obtain a lower monthly payment, we except to see sharp declines in prepayment rates across the country. This will be highly beneficial to RISR.

To re-emphasize, our interest-only mortgage-backed-securities (MBS IOs) receive interest payments for as long as the underlying mortgages remain outstanding. As prepayment rates decline in response to higher market rates of interest, those underlying mortgage remaining outstanding for longer, and we receive those interest payment for a much longer period. That is the primary driver of returns for our strategy.

Much of the debate in the market in April was over how many times the Federal Reserve will raise rates over the remainder of this year and into 2023. A further debate was over whether they might increase rates by 25 bps, 50 bps or even--gasp!--75 bps at one or more upcoming policy meetings.

These are the slightly silly debates that pass for financial reporting and knowledgeable discussion in much of the financial press. Our view is much simpler – interest rates are going quite a lot higher. Whether that happens in 25, 50 or 75 bps steps is ultimately irrelevant, except perhaps as a signal as to how serious the Federal Reserve is going to be about breaking the back of inflation.

Unfortunately for all of us, inflation in the US is utterly out of the Fed’s control. There is no point is replaying the mistakes of the past several years. And to be generous, the Covid pandemic was an unprecedented shock. But the pandemic’s macro-economic impact has been behind us for well over a year. That was when the Fed should have started to remove its extraordinary accommodation.

But we are where we are. Inflation is running above 8% by the broadest measure, and around 6.5% excluding food and energy. The only way to bring these levels down to the Fed’s 2% target, is to raise rates sharply. While we do not make a specific prediction about what the magic number is that will break the back of inflationary trends, we do observe that the contributors to inflation – wages, energy costs as an industrial input, and other factors—will not be reversed easily or in the near term.

The chart below is instructive. It shows the historic relationship between inflation and the 10-year treasury rate since 1990. One notes the generally positive, upward-sloping correlation, as represented by the dashed trend line. The orange dots in the bottom right are of the graph are from the most recent 12 months and show how far from “normal” our current interest rate stance actually is.

This does not necessarily mean that rates have to move all the up to the trend line. But one must expect much higher rates before inflation decelerates. That is the lesson of history. We see no reason for it to be “different this time.” It almost never is.
This message is being heard in the market. During April we saw significant inflow of capital, which increased our AUM to $75.4MM, from around $30MM at the end of March. We will continue to deploy our investors’ capital to assemble a portfolio of MBS IOs that is diversified with respect to geography, coupon, vintage and other key metrics.

Portfolio Applications

We believe RISR provides an attractive, thematic strategy that provide strong correlation benefits for both fixed income and equity portfolios. It can be utilized as part of a core holding for diversified portfolios or as an overlay to manage the interest rate risk of fixed income portfolios. Alternatively, RISR can be used as a macro hedge against rising interest rates with less exposure to equity beta and negative correlation to fixed income beta. The underlying bonds are all U.S. agency credit that are guaranteed by FNMA, FHLMC or GNMA.  There is no financing leverage or explicit short positions that relies on borrowed securities.  Also, timing is on our side as the strategy generates current income if interest rates were to remain within a trading range.

Please contact us to explore how RISR can be utilized as a unique tool to adjust your portfolio allocations in the current inflationary environment.