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Fundamentals and Technicals Collide


Last Week in Review: Fundamentals and Technicals Collide

This past week, we watched mortgage-backed securities (MBSs) touch their highest level since late September, meaning the lowest home loan rates. But the good vibes and rate improvement were quickly halted as prices hit key technical barriers. Let's break down what happened.

1. Global Yields Decline

The bond market is global. Meaning there are investors all over the planet in search of yield. So, when these investors look around the globe and see negative-yielding rates throughout many bond markets, it makes our anemic 10-yr Note yield, presently at 1.48%, look attractive. Our low, but outperforming yield, will always attract capital from around the globe and is a major reason why we haven't seen or likely will see a material increase in rates.

This past week rates around the globe moved lower, which pulled our 10-yr Note lower, which in turn helps MBS prices move higher and home loan rates lower. In Germany, their 10-yr Bund moved from – 0.10% to - 0.30% on the notion the European Central Bank will not be hiking rates anytime soon.

There is about a 165bp spread between the German Bund and our 10yr Note which at times narrows and widens but is a reliable figure over the long term. So, when there are problems in Europe and the Bund declines, we often see a similar decline in our yields. The opposite is true.

2. High Inflation Persists, Bonds Don't Care...for now

Inflation is the archenemy of bonds, or so we are taught in economics. Generally, as inflation rises, interest rates must rise to compensate investors for the additional cost of inflation. Today, investors are not being compensated for the negative effects of inflation when purchasing a long-term bond like the 10-yr Note.

The Consumer Price Index (CPI) was delivered on Wednesday. It showed overall consumer prices, which included energy and food, were up a whopping 6.2% year over year, the fastest pace in 31 years.

Inflation this high makes the 10-yr Note, yielding 1.48%, a horrible investment. Who would buy such a bad investment? For one, foreign investors, who are familiar with negative yields. Our Federal Reserve is also a big buyer of our Treasuries every month.

There is a big debate whether high inflation will be transitory. One thing to watch closely is whether inflation expectations are rising. If inflation expectations rise, meaning - if people think or feel prices will rise, they will.

Right now, inflation expectations for the next 10 years are running at 2.63%, the highest in decades. If this number goes higher, it will put pressure on the Fed to speed up their bond tapering program and ultimately hike rates.

3. Technicals Matter

After a sharp decline in rates over the past couple of weeks, many ask, where is the bottom? This is where technicals can be incredibly important. The 10yr Note and the German 10-yr Bund rate decline stopped right at its 200-day Moving Average.

For rates to move beneath this important moving average, it may take bad news which bonds like. At the moment, with inflation rising to the highest level in 31 years, it may be difficult for rates to improve much, if at all from here.

Bottom line: Home loan rates have made a marked improvement over the past couple of weeks. But tough technical levels and another hot inflation reading may limit further rate improvement.