Rates dropped as mortgage bonds rallied big and stocks were flat on a Fed pledge to keep overnight rates near zero through 2014, iffy New and Pending Home Sales, weak GDP, and doubts about investors in Greek debt to agreeing on losses they’ll take.

Greek debt negotiations will dominate market action early this week.

The latest looks like a deal where Greek bond investors exchange outstanding bonds for new ones with coupons as low as 3.6-3.75%, and take 50-70% losses in the process. If most private investors don’t agree, it could trigger credit default swaps (CDS) on these securities, leading a European bank liquidity issue, which is really a global issue, and U.S. rates could drop further in this scenario.

The week also begins with an EU summit that will focus on tighter fiscal union across Europe. But short-term, most sentiment hangs on the Greece deal.

Volatility will reign, with most probable scenario being low rates hold as investors focus on U.S. mortgage and Treasury bonds.

The week’s data breaks down like this:

Monday we’ll see the Fed’s preferred inflation measure, the Personal Consumption Expenditures Index (PCE), which is likely to be flat. Tuesday brings November’s Case Shiller home price report where we’ll find out if a losing streak extends into a third month or turns positive. Wednesday and Friday bring ADP and BLS jobs reports for January. Expectations are wide for both after blowout ADP (+325k private jobs created) and much better BLS (+200 nonfarm jobs created) for December. Also Wednesday is ISM Manufacturing for January which may show an improving trend extending into its 30th month. Plus 4Q earnings season rolls on all week.

Here I preview each item for those who want more details.

Looking at stocks, the S&P 500 closed last week at at 1316, flat on the week and well above its 200-day and 50-day moving averages of 1257 and 1255. Seems stock investors are awaiting signals out of Greece before committing further or pulling back. A possible deal impasse and/or CDS spiral on Greek debt could push the S&P 500 down to its 50 and 200-day averages. But given this unpredictable macro environment, analyst Robert Sinn put it best in his 1/28 Weekly Letter:

You can expect to hear people mention S&P 500 levels less often as they speak more in terms of individual names and in which sectors they want to be invested.

Looking at mortgage bonds (MBS), the 3.5% Fannie Mae coupon – a key benchmark lenders use to price consumer rates – rose a whopping 103 basis points last week to close at 103.69. MBS are now a comfortable 88 basis points above 25-day moving average and 125 basis points above their 50-day moving average.

Rates drop when bond prices rise like this, but rates only dropped .125% because lenders didn’t price all these gains into rate sheets until they see whether the rally holds—which again, is dependent largely on Greece to start the week.

The tricky balance is that U.S. data could continue its modest improvement this week, so if the EU situation stabilized even slightly, MBS would sell, pushing rates up. And lenders don’t want to get caught in that reversal so they price conservatively.

I’ll repeat my outlook for last week since the Greek deal is dragging on:

MBS and rates will hold or improve slightly if the Greek debt deal goes sideways. But if it’s reasonably clean -meaning there’s no event that triggers claims on credit default swaps and squeezes banks – then we could see U.S. rates rise short-term as investors shift out of MBS and Treasury safe havens into riskier assets.

BOTTOM LINE: Rates are absurdly low. Only a meltdown in Europe will cause U.S. rates to go lower near-term.

If you’ve been waiting for a rate bottom, this could be your week.
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Related:
-Refi Roadmap: A Locked Rate Isn’t A Closed Loan
-Stat by Stat: Recap Jan 23-27, Preview Jan 30-Feb 3

Could this relative price movement change direction?

Sure. Some broker-dealers believe that a sustained selloff in the rates market that will take the 10-year Treasury to 2.5% or above would be the most likely scenario in which MBS spreads would widen significantly. This is due to a number of factors, including a prediction that, assuming a selloff is caused by improving fundamentals of the US economy, the probability of Fed’s QE 3 involving agency MBS should diminish significantly in a rates backup scenario.

On top of that, IF rates were to see that big of a move, it would mean that volatility has increased – rarely a good thing for MBS’s. And when that happens, “convexity hedging” related selling from servicers and originators would probably lead to a sudden increase in the supply of agency MBS in this scenario, resulting in even more selling.

Lastly, domestic banks have been providing a very strong bid for agency MBS over the past 5-6 months, and in a rates backup scenario, their deposit growth is likely to be lower, meaning that banks would be unlikely to grow their holdings until rates stabilize again. Simple!

For 2012 fixed-income traders seem focused on the U.S. election and continued bickering, more regulation in the U.S., Europe and its eventual endgame, where U.S. data shows the economy is headed, will the Middle East ever be stable, and what will happen to China. They are pretty much the same things as a year ago.

So where is the economy, and rates, going?

Freddie Mac forecasts that U.S. economic growth would likely climb to 2.5% over 2012, and that mortgage rates would stay at record lows. Frank Nothaft, Freddie’s chief economist said:.

“While the headwinds remain strong going into 2012, there are indications the economy and the housing market are gaining ground, albeit slowly,”

The company said that mortgage rates would stay low, with 4 percent for the 30-year fixed-rate mortgage leading the way recently. Nothaft forecasted that recent modifications to the Home Affordable Refinance Program would increase refinance originations by more than $100 billion over the next year, giving a lift to purchase-money biz but letting single-family originations enter a shortfall over the next year.

Another forecast from from Keefe, Bruyette & Woods, Inc. said:

“We expect 2012 to be a fairly similar year to 2011 for the mortgage market. While we expect a decline in residential mortgage volume (forecast a moderate decline in mortgage origination volume in 2012 to $1.1 trillion from an estimated $1.2 trillion in 2011) as refinance activity tapers off, originations should get support from still low rates and implementation of HARP 2.0. The lower volumes will likely lead to weaker mortgage production margins. Mortgage credit is likely to remain stable although we expect increasing delinquency rates on FHA loans. We expect little mortgage market reform through Congress, but there could be some changes driven by the regulators such as the release of a definition of a Qualified Residential Mortgage (QRM) and the introduction of a GSE risk-sharing pilot program.”

Fannie Mae’s chief economist, however, is warning that the United States has a 40% chance of slipping into a double-dip recession in 2012.

Recently Doug Duncan predicted a 50% chance of a double-dip recession next year, due to persistently high unemployment and the ongoing housing slump. But an uptick in job growth and stronger automotive and retail sales forced Duncan to revise his dour forecast slightly upward. He does not anticipate the housing market to fully rebound before 2015. And he expects to see plenty of contagion from Europe. One of the major problems is the housing market, he says. In past downturns, home sales have led a recovery, but this time around low interest rates have not pulled mortgage lending or consumer sentiment out of the doldrums. Chronically high unemployment over the next decade and weak income growth will continue to expert pressure on housing prices, he says:

“Until employment picks up, you won’t see any improvement in housing.”

Rarely do forecasts come true 100% of the time, however, and there were some from last year that did not.

There was no double-dip recession in 2011, and the year is ending on a positive note with the U.S. economy is growing at an estimated 3.5-4% annualized pace in the fourth quarter.

The European currency union did not come apart in 2011, although it had a few near-death experiences requiring multiple summits. The 11 countries that hitched their wagon to the common currency in 1999 and the 6 that joined subsequently are still together.

About a year ago banking analyst Meredith Whitney’s forecast of a large number of municipal defaults failed to materialize, fortunately, with less than $2 billion going into default according to a report from Bank of America Merrill Lynch. In fact, the U.S. Census Bureau just reported that state and local government tax collections rose 4.1 percent in the third quarter from a year earlier, the eighth consecutive increase.

But disaster is always on the minds of many, and the Federal Reserve issued proposals intended to prevent the collapse of major financial firms. A Fed statement said:

“The proposal would create an integrated set of requirements that seeks to meaningfully reduce the probability of failure of systemically important companies and minimize damage to the financial system and the broader economy in the event such a company fails.”

The Federal Reserve released a draft proposal that outlines a change to the liquidity capital ratio (LCR) tests that are included in the Basel III reforms. It is important to note that the treatment of conventional and Ginnie Mae MBS was only one small part of the Fed’s proposal, titled “Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies.”

Under the Fed’s proposal, Fannie and Freddie securities would be classified as “highly liquid assets,” the same liquidity treatment as Ginnie Maes.

This makes agency MBS more appealing for purposes of attaining liquidity benchmarks. Remember that liquidity capital is not risk-based capital – the 20% risk-based capital weighting for Fannie and Freddie MBS is not going away, which means that the more restrictive capital requirements will remain untouched. For the purposes of risk-weighting, Ginnies are still classified as “Level 1″ assets, while conventional MBS are labeled as “Level 2.”

The risk weighting assigned to any asset is determined by the Basel Committee for Banking Supervision – not the Federal Reserve. And overseas investors buy Ginnie MBS’s for reasons that have little to do with the Basel III capital requirements. For these investors, the liquidity test is far less relevant than the presence of a full US government guarantee – something that is not going to change any time soon. All this is open to comments for the next three months.

One CEO wrote:

“The Basel III regulations show that ultimately I don’t think that the United States banks can say to the world that they don’t have to follow the same rules as everyone else. They can’t say, ‘Hey world, don’t worry about us and residential lending- we know what we are doing.’ The main contention for the Clearing House around Basel III is that it caps tier 1 capital reserves for MSR at about 10% (if my research is correct). This means that a bank like Wells Fargo that has $125 billion in Tier 1 capital would be limited to $12.5 billion in MSR (mortgage servicing rights). Depending on where the MSR is marked (say 4x servicing values, for example, on a Fannie Mae MSR although I think the norm is about 86-100 bps right now), and assuming that the strip is .25%, then the total amount of servicing that Wells Fargo could hold would be somewhere in the neighborhood of $1.25 trillion. This has huge implications. Think about the fire sale of servicing or reduction in production by the larger banks that has to occur between now and 2018 (when Basel III is slated to go into effect). We are already seeing servicing values reflect this uncertainty.”

He continues,

“Does it matter that the large aggregators are going to be reducing their holdings of MSR due to Basel III? Why is this good or bad? It will allow free flow of capital from foreign markets because we are all on the same ‘regulatory path’- something we will need for our recovery. This is also the intention behind Dodd Frank of course. It will allow the aging western civilization to match cash flows that suit their lifestyle with something other than treasuries and still have some relative notion of safety – even as credit widens because the concentrated risk in one institution would be much smaller. More players, in the mortgage lending part of banking, mean more competition. This drives cost to the consumer down and it also reduces systemic risk. The servicing value attributed to MSRs is in direct correlation to what a small aggregator can reasonably put on its books. Basically, if someone is out “buying the market” with higher servicing multiples, due to business a differing business strategy or overhead, then this would keep smaller servicers from being able to acquire the best quality loans at a reasonable price.”

Matt Ostrander, CEO, Parkside Lending responds:

“But if banks need to make higher yields they are invariably going to chase higher risk assets to do so. The markets ‘are what they are’ and they will need to do this – they can’t just inflate margins on commodities- it will only work in the short run. Too much regulation could lengthen the recession. It could stifle growth of our largest banks and this is not good for a large economy like ours- we need supersized banks to handle massive sized projects that we have in the United States- it’s what makes our economy so incredible. Money center banks are important and we need them to stay relatively large.”

The root cause was and continues to be EU concern. There will be no resolution of EU debt soon, and that will continue to drive US Treasury yields and mortgage rates even lower in 2012.

Mortgage rates aren’t tied to the 10yr note, they’re tied to mortgage bonds—right now most lenders use Fannie Mae 3.5% coupon to price rates—but mortgage bonds track the 10yr note medium and long term. So if Pond is right, rates would rise .375% or more. As of Friday, rates had already risen .375% over the past two weeks, then regained .125% yesterday—so we’re up .25% from record lows. So could they go more from here?

Pond’s views are outside consensus but he has a point when he says the Fed is distorting rates by pushing them lower than is justified by fundamentals. He said rates can remain distorted for awhile but ultimately money will go where it should.

So it’s a question of defining “ultimately”.

I think the forecast is extreme because the Fed will continue buying mortgage bonds, and I’ve discussed in detail how that lowers rates.

I agree that market prices for securities ultimately revert to levels driven by fundamentals, the Fed plus Eurozone debt crisis and U.S. fiscal policy paralysis will outweigh fundamentals near-term.

Because of this, I think rates remain in their current range +/- .25% by year end.

This rate rise comes as headlines scream record low 3.94% rates. Below is what consumers must know about rates, last week’s recap and next week’s outlook. Reminder: bond markets closed Monday.

Rate Headlines vs. Reality
The 3.94% record lows reported throughout the press are from a Freddie Mac survey released Thursdays.

The survey is for single family home loans up to $417,000, it includes 0.8% in points (aka extra fees on top of normal closing costs), and is for rates in the 3-4 business days before the day they’re reported—so those rates are expired as you read them, and here’s more critical fine print on rate headlines.

Recap Market Week Oct 3-7
Rates rose last week mostly because of these reports:

-ISM Manufacturing: September manufacturing activity measured by an Institute for Supply Management survey showed a slight expansion. The survey index was at 51.6 with 50 being the dividing line between expansion and contraction.

-Jobless Claims: Initial claims for unemployment benefits were 401,000 for the week ending October 1, up 6,000 from previous week’s revised 395,000 (was 391k). This was the second week at or below the 400k threshold—readings below 400k suggest an improving jobs picture. Still the 4-week moving average was 414,000.

-BLS Jobs Report: The Bureau of Labor Statistics reported that 103k nonfarm jobs were added to the economy in September: 137k private sector jobs added, 34k government jobs lost. Expectations were for 60k jobs created. More on jobs report.

This less-bad data led to more stock optimism and net bond selling. None of the data suggest meaningful nor sustained U.S. economic improvement, but markets continue their desperate search for anything positive.

Preview Market Week Oct 10-14
Here are next week’s economic calendar highlights with rate impacts:

September 21 Fed meeting minutes Tuesday: This may remind markets just how bad the Fed thinks the economy is, and also remind us of their commitment to buy mortgage bonds using cash flows they get from their roughly $1 trillion in mortgage bond holdings resulting from their QE1 buying from January 2009 through March 2010. Rates even to down.

$66b New Bond Supply: $66b in new Treasury securities will be auctioned into markets as follows: $32b 3yr notes Tuesday, $21b 10yr notes Wednesday, $13b 30yr notes Thursday. Given Operation Twist’s objective of shifting government debt into longer durations, the 3yr auction could be weaker but the longer durations should be ok. Rates net even on auctions.

Retail Sales Friday: Estimates for September retail sales range from 0.6% to 1.2% and the August figure was unchanged at 0.1%. This figure could be more of the ‘better but really just less-bad’ data we got last week. Rates even to up.

Europe Is Biggest Rate Factor: Rates will continue to rise and fall on each little development in the European debt crisis. The latest is that France wants to draw on Europe’s TARP-like fund to recapitalize banks and Germany wants individual Eurozone governments to lead. This misses the point that Eurozone defaults are imminent. Bank liquidity moves won’t stop defaults, they’ll just help manage liquidity problems when defaults come. But political paralysis in Europe can’t even figure out how to create a safety net. Nevertheless, next week will likely start with rates up slightly on perception of progress in Europe, then fade. Rates even.

Bottom Line For Rates:
Rates should be about even next week, perhaps slightly down if markets realize that Europe’s leaders haven’t really accomplished anything yet.

Retail Sales
-ISCS-Goldman Store Sales, Week/Week: +0.1%
-ISCS-Goldman Store Sales, Year/Year: +3.7%
-Redbook Store Sales, Year/Year: +4.1%. Previous was +4.2%.

Techs
Our call was for a technical objective of a 1.47% 10-year yield. We are still headed in that direction. The Dow is suffering a technical correction and its first stop on its downward path should be 10,000.

Treasury yields are up slightly is early trading. Recall that a little over a month ago, we pointed to a technical objective of 3.0% on the 30-year and 1.5% on the 10-year. The 30-year overshot that and the 10-year has another 0.25% to go.

PPI (Wednesday), CPI (Thursday) and Industrial Production (Thursday) headline. The 500 pound gorilla is still the Greek debt issue. A default will seriously hurt banks in France which hold the debt and U.S. banks which hold the credit default swaps. If this happens we will likely see a massive equity selloff and flight-to-quality buying of U.S. Treasuries.