The ten-year bond is the basis for all mortgage pricing
Long-term interest rates are priced off the benchmark long-term bond, which is the ten-year Treasury. These days, the ten-year bond reacts to economic data through the Federal Reserve’s asset purchase program, also known as quantitative easing (QE). As a general rule, economic data that shows weakness is bond bullish (positive). However, data that shows strength isn’t necessarily bond bearish (negative).
The week in review
Last week was extremely heavy data-wise. On Monday, we got the latest budget numbers out of the Federal Government, showing we had a $98 billion deficit for the month of July. On Tuesday, the NFIB Small Business Optimism Index showed small business is still depressed compared to the big S&P 500 names with international exposure. Import prices were well behaved—probably a little too well behaved for the Fed’s tastes. Headline retail sales were lower than expected due to autos, but the ex–auto and gas numbers were in line with expectations. On Wednesday, the Mortgage Bankers Association reported applications fell, and the Producer Price Index showed no inflation at the wholesale level.
Thursday was a huge day data-wise, with a good initial jobless claims number, a so-so Empire Manufacturing number, and benign inflation at the consumer level. The Treasury International Capital Flow report showed foreign investors dumped U.S. financial assets, and the Bloomberg Consumer Comfort index fell slightly. And for good measure, we had a number of huge industrial reports, with a disappointing industrial production number (-0.1 versus the +0.2 expected) and a drop in capacity utilization. Homebuilder sentiment was the strongest it has been since the glory days of the bubble, and manufacturing decelerated in the Philly region.
Finally, on Friday, productivity and unit labor costs were better than expected, while housing starts disappointed slightly. The preliminary numbers for Michigan Consumer Confidence dipped, but last month was a six-year high.
The ten-year bond broke out of its recent trading range on Thursday, and continued its sell-off on Friday. While the economic data was generally a mixed bag, bond investors were spooked enough to continue to let go of paper.
Implications for mortgage REITs
Mortgage REITs, like Annaly (NLY) and American Capital (AGNC), are driven by interest rates. The mortgage REITs have been crushed as the ten-year bond has sold off, but they’ve been trying to form a bottom here. For REITs, it’s all about the Fed’s exit of QE. The sell-off in bonds and MBS sent the mortgage REIT ETF (MORT) down over a buck (5%) in sympathy.
Implications for homebuilders
Homebuilders, like Lennar (LEN), KB Home (KBH), and Standard Pacific (SPF), are more sensitive to general economic strength. They will take comfort in the good consumer confidence numbers, but the industrial production numbers and the Fed manufacturing numbers are flashing warning signs. Investors are going to be cautious with the builders until they’re confident that the increase in rates isn’t killing traffic.