Continued Brexit Uncertainty Lifts Treasuries

Oct 23, 2019
Boris Johnson in House of Commons

The U.K. House of Commons voted yesterday to enact legislation fulfilling the E.U. Withdrawal Agreement negotiated by Prime Minister Boris Johnson. That represented the first time Parliament voted for Brexit. That was the good news for BoJo. Parliament then voted down a fast-track provision that would have enacted the legislation by October 31.  Boris Johnson, despite protestations to the contrary, will now ask the E.U. for an extension beyond October 31 while Parliament works up the legislation enacting the withdrawal agreement, (and you can expect that to not be exactly what BoJo wants).  One E.U. diplomat said leaders there will most likely grant an extension up to January 31, with an exit clause allowing the U.K. to leave earlier in the unlikely event Parliament managed to pass legislation before that time.  The British pound has declined slightly versus the dollar (-0.64%), while Treasuries have rallied a bit on the news (10yr at 1.732%). The market took the conflicting votes in stride yesterday, probably because it leaves the Brexit matter unresolved and that uncertainty will continue to weigh on risk assets and provide a bid in Treasuries. It seems the beat goes on.


newspaper icon  Economic News


There’s no surprise that the data lately has been somewhat bifurcated. The manufacturing and factory sector has been in contraction, if not recession, from a combination of the global growth slowdown, tariff/trade war uncertainty and geo-political headwinds. On the other hand, with lower rates, and moderate wage gains,  housing has been showing signs of gathering momentum.


It’s with that backdrop that yesterday’s releases were expected to confirm continued strength in housing and weakness in manufacturing, but alas, the results only added to the confusion regarding the direction of the economy.  Instead of showing strength, September existing home sales came in below consensus forecasts at 5.38 million units sold annualized versus the 5.45 million expectation and 5.50 million in August.  On a month-over-month basis, this equates to a drop of -2.2% versus the more slight -0.7% projected and the 1.5% gain in August.


On a positive note, the overall inventory-to-sales ratio was 4.1 months which is the same as the 3-month moving average indicating inventories aren’t outpacing sales despite the recent moderation in sales.  Realtors see anything below 5 months as a tight market but we’ve been in that position since November 2015. In addition, median prices increased 5.92% on a year-over-year basis. the highest level since January 2018.  So while sales activity was slightly weaker than expected, limited inventory is helping to keep home prices appreciating and those home price gains are limiting additional sales. If mortgage rates head higher the combination of higher prices and rates will further weigh on sales activity.


On the manufacturing side of the economy, the lightly followed Richmond Fed's Manufacturing Index for October printed well above expectations at 8 versus the -7 expectation and that represents a decent bounce from -9 in September. This is the highest reading since April.  On one level this may indicate some stability in the factory sector, as all subcomponents returned to positive territory, but as a single data point we’ll await confirmation from other regional Fed surveys, and, of course, the all-important ISM Manufacturing Index before announcing that weakness in the factory sector has ended. The preliminary Durable Goods Orders numbers for September are due tomorrow and that will be another tell on the manufacturing side. Expectations are for a somewhat weak showing.


line graph icon  Investment Recommendations — The Hedging Benefits of a 2.5% Coupon 20yr MBS


About a month ago, we recommended 3.5% coupon 20yr MBS as providing a good yield with the coupon a good compromise between prepayment protection and limited duration extension. That’s not to say other coupons in the stack can’t provide useful performance characteristics when considered in conjunction with the entire balance sheet. Today, we discuss the positive attributes of the 2.5% coupon 20yr MBS and why it can be a useful hedge for many banks.


Of our 112 asset-liability clients, 80% are asset-sensitive. That is, as rates rise net interest margins (NIM) increase but when rates fall, those margins decline. The balance sheet positioning of our AL clients is probably very similar to community banks across the country. Thus, in an environment where the Fed has cut rates 50bps, and is likely to cut 25bps next week, combined with global growth rates being taken down, NIMs for asset-sensitive banks are at varying degrees of risk in a lower rate scenario.  As such, 2.5% coupon 20yr MBS bonds can offer nice hedging characteristics for asset-sensitive banks.


First, the 2.5% coupon 20yr MBS can be purchased at near par so increased prepayments won’t detract from the bond’s yield as opposed to premium coupons that will see more significant yield declines. Thus, the bond acts as a hedge to the performance of most other bonds in portfolio and to an asset-sensitive balance sheet in a lower rate scenario. Second, in a higher rate environment, the bond does extend but for asset-sensitive balance sheets NIMs are likely to improve. Third, many portfolios do not own the 2.5% coupon so it does increase diversification across the coupon stack which can prove useful in a lower-for-longer interest rate environment. A current offering is shown below via Bloomberg’s YT Screen.


If your bank is asset-sensitive and you are looking for an investment that hedges some of that risk but with a decent yield consider a 2.5% coupon, 20-year MBS pool. If you have an interest, please contact your CenterState representative.


Investment Recommendations



bar graph iconAgency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 1.87 1.97 2.06 2.14 2.47 2.72
0.50 1.79 1.90 1.99 2.08 2.42 2.67
1.00 1.65 1.77 1.87 1.96 2.32 2.57
2.00 - 1.57 1.68 1.79 2.19 2.43
3.00 - - - - 2.05 2.33
4.00 - - - - 1.95 2.25
5.00 - - - - 1.87 2.18
10.00 - - - - - NA


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