Most interest rate speculation is empty wind, but Bill Gross’ opinion comes with a track record:
Pacific Investment Management Co.’s Bill Gross said the Federal Reserve is unlikely to raise interest rates for two to three years as it seeks to keep the economy from slipping back into recession.
Treasury two-year note yields dropped below 0.50 percent for the first time today after the Labor Department said the economy lost more jobs in July than economists forecast. The difference in yields between 2- and 10-year notes is 2.34 percentage points, more than double the average of 1.11 percent for the so-called yield curve over the past 20 years.
“When you analyze that portion of the curve, it says the Fed is on hold for a long, long time,” Gross said today during a radio interview on “Bloomberg Surveillance” with Tom Keene. “When you get down to 50 basis points on two-years, that’s giving you a signal that there’s not much left on the table.”
Gross, manager of the world’s biggest bond fund, has been benefitting from the steep yield curve by buying five-year Treasuries, holding them for a year before selling to pick up capital appreciation as well as interest income.
…
“Hopefully as long as the curve stays steep and as long as the Fed stays where it is, then you produce two- to two-and-a- half returns as opposed to 50 basis points,” Gross said.
Of course, what happened in 1994 was that everybody played that game and results were unfortunate when the music stopped.
There was a fine crop of papers released by the New York Fed today, led by a a Staff Report by Tobias Adrian and Erkko Etula titled Funding Liquidity Risk and the Cross-Section of Stock Returns:
We derive equilibrium pricing implications from an intertemporal capital asset pricing model where the tightness of financial intermediaries’ funding constraints enters the pricing kernel. We test the resulting factor model in the cross-section of stock returns. Our empirical results show that stocks that hedge against adverse shocks to funding liquidity earn lower average returns. The pricing performance of our three-factor model is surprisingly strong across specifications and test assets, including portfolios sorted by industry, size, book-to-market, momentum, and long-term reversal. Funding liquidity can thus account for well-known asset pricing anomalies.
There are some very nice ideas here, but the paper is marred by the authors’ insistence on shoe-horning the model into the antediluvian Capital Asset Pricing Model and their use of regression. Regression? How can you use regression for serious quantitative work? Look, say I have a two stock universe and I’m building a system that swaps between A and B periodically to earn incremental return (it will win when price changes are noise and lose when they’re unexplained signal; the point of the model is to explain as much signal as possible to increase the proportion of your trades that exploit noise). So I trade whenever I think I can get a 1% excess return on capital. Why 1%? Because I’ve tested the system and 1% gives me a better risk/return profile than 0.95% or 1.05%.
So I do the trade and wait. How long do I wait? I don’t know. I wait until I think I can make 1% going the other way, whether it’s three minutes or three years. The condition is met, briefly, after three weeks and I reverse the trade and start waiting again. The regression misses this trade reversal, because it uses fixed time periods of a month. Don’t talk to me about regression.
Still, there are good ideas here which will be incorporated and tested (properly!) in the next quant equity system I build … assuming anybody ever wants a quant equity system that, you know, works. Built one before (in the late ’90’s), I’ll probably build at least one more before I hang up my hat.
The FRBNY also released a staff report by Toni Dechario, Patricia Mosser, Joseph Tracy, James Vickery, and Joshua Wright titled A Private Lender Cooperative Model for Residential Mortgage Finance:
We describe a set of six design principles for the reorganization of the U.S. housing finance system and apply them to one model for replacing Fannie Mae and Freddie Mac that has so far received frequent mention but little sustained analysis – the lender cooperative utility. We discuss the pros and cons of such a model and propose a method for organizing participation in a mutual loss pool and an explicit, priced government insurance mechanism. We also discuss how these principles and this model are consistent with preserving the “to-be-announced,” or TBA, market – particularly if the fixed-rate mortgage remains a focus of public policy.
Their sixth design principle is of great interest:
The design of any successor to the GSEs must take a stand on whether the 30-year fixed rate amortizing mortgage with no prepayment penalty is going to remain a key mortgage product. We assume that U.S. households and policymakers will continue to have a preference for the fixed rate mortgage as a staple of housing finance because it insulates homeowners from fluctuations in interest rates. As a result, securitization will remain an attractive alternative for mortgage originators (because they do not wish to hold such assets on balance sheet against their short-term liabilities or devote capital and liquidity resources to supporting them) and so an active secondary market will be needed to support it.
The TBA market, by the way, is:
The vast majority of agency MBS trading occurs in what is known as the TBA (“to-beannounced”) forward market. In a TBA trade, participants agree on a price to transact a given volume of agency MBS at a specified future date (the settlement date). As the name suggests, the defining feature of a TBA trade is that the actual identity of the securities to be delivered at settlement is not specified on the trade date. Instead, participants agree only on 6 general parameters of the securities to be delivered. A timeline for a typical TBA trade is shown in Figure 2, including three key dates. On the day of the trade, the buyer and the seller establish the 6 general parameters, including the date the corresponding cash and security will actually be exchanged, which may be anywhere from 3 to 90 days later.
There was light trading in the Canadian preferred share market today, with PerpetualDiscounts losing 9bp in a relatively rare pullback. However, FixedResets were able to gain 7bp, taking the median weighted average yield down to 3.40%, just a little above its level of August 4.
| HIMIPref™ Preferred Indices These values reflect the December 2008 revision of the HIMIPref™ Indices Values are provisional and are finalized monthly |
|||||||
| Index | Mean Current Yield (at bid) |
Median YTW |
Median Average Trading Value |
Median Mod Dur (YTW) |
Issues | Day’s Perf. | Index Value |
| Ratchet | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.1177 % | 2,075.1 |
| FixedFloater | 0.00 % | 0.00 % | 0 | 0.00 | 0 | -0.1177 % | 3,143.5 |
| Floater | 2.52 % | 2.13 % | 37,334 | 22.03 | 4 | -0.1177 % | 2,240.5 |
| OpRet | 4.87 % | -4.95 % | 110,794 | 0.09 | 9 | 0.1585 % | 2,362.2 |
| SplitShare | 6.16 % | -2.44 % | 71,520 | 0.08 | 2 | 0.2768 % | 2,252.4 |
| Interest-Bearing | 0.00 % | 0.00 % | 0 | 0.00 | 0 | 0.1585 % | 2,160.0 |
| Perpetual-Premium | 5.79 % | 5.53 % | 100,402 | 5.61 | 7 | -0.0789 % | 1,946.9 |
| Perpetual-Discount | 5.81 % | 5.86 % | 176,575 | 14.01 | 71 | -0.0908 % | 1,865.8 |
| FixedReset | 5.30 % | 3.40 % | 288,626 | 3.41 | 47 | 0.0718 % | 2,234.5 |
| Performance Highlights | |||
| Issue | Index | Change | Notes |
| CIU.PR.A | Perpetual-Discount | -1.29 % | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2040-08-06 Maturity Price : 19.94 Evaluated at bid price : 19.94 Bid-YTW : 5.88 % |
| BAM.PR.O | OpRet | 1.72 % | YTW SCENARIO Maturity Type : Option Certainty Maturity Date : 2013-06-30 Maturity Price : 25.00 Evaluated at bid price : 26.55 Bid-YTW : 2.96 % |
| Volume Highlights | |||
| Issue | Index | Shares Traded |
Notes |
| MFC.PR.E | FixedReset | 52,216 | Nesbitt crossed 25,000 at 26.70. YTW SCENARIO Maturity Type : Call Maturity Date : 2014-10-19 Maturity Price : 25.00 Evaluated at bid price : 26.54 Bid-YTW : 4.20 % |
| CU.PR.B | Perpetual-Premium | 30,700 | TD crossed 30,000 at 25.50. YTW SCENARIO Maturity Type : Call Maturity Date : 2012-07-01 Maturity Price : 25.00 Evaluated at bid price : 25.44 Bid-YTW : 5.66 % |
| BNS.PR.N | Perpetual-Discount | 20,611 | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2040-08-06 Maturity Price : 23.15 Evaluated at bid price : 23.33 Bid-YTW : 5.66 % |
| CM.PR.I | Perpetual-Discount | 20,200 | TD crossed 10,000 at 20.45. YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2040-08-06 Maturity Price : 20.44 Evaluated at bid price : 20.44 Bid-YTW : 5.80 % |
| MFC.PR.C | Perpetual-Discount | 20,000 | YTW SCENARIO Maturity Type : Limit Maturity Maturity Date : 2040-08-06 Maturity Price : 19.00 Evaluated at bid price : 19.00 Bid-YTW : 6.02 % |
| BMO.PR.O | FixedReset | 18,393 | National crossed 13,200 at 27.90. YTW SCENARIO Maturity Type : Call Maturity Date : 2014-06-24 Maturity Price : 25.00 Evaluated at bid price : 27.95 Bid-YTW : 3.20 % |
| There were 17 other index-included issues trading in excess of 10,000 shares. | |||
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