A World No Longer Flat?
Since last December, the yield on the two-year Treasury has frequently exceeded the 10-year Treasury (by as much as 16 basis points on February 16). Interestingly, over the past two weeks, the trend has reversed to the point where 10-year yields now exceed two-year yields by several basis points. Clearly, there’s a whiff of inflation in the air: the National Association of Purchasing Management’s employment index reached a nine-month high; the Institute of Supply Management Index came in far higher than anticipated; and the core personal consumption price index was up by 1.8% during January. Another proxy of potential inflationary pressures could be the recent performance of TIPS (Treasury Inflation Protected Securities) yields. The yield gap between 10-year Treasuries and 10-year TIPS continues to widen.

With a reversal in the “flattening trade,” U.S. companies are increasingly borrowing in the five- to 10-year maturity sector. According to Merrill Lynch, 82% of the $17 billion in corporate debt that was sold in the U.S. last week had maturities of between five and 10 years. This proportion exceeds the five- to 10-year securities that presently represent 40% of the Merrill Lynch Corporate Bond Index. Why the maturity extension? The current Fed funds rate is slightly more than 20 basis points below the two-year Treasury—an historically low spread that has occurred in the face of the market’s expectation of three additional rate increases this year.

There is also a technical factor at work in the recent widening of spreads between the two-year sector and longer maturities. Investors are bidding strongly for current two-year Treasury with the view that there will be a postponement in the March 29 auction. The assumed postponement is ascribed to Congress’ delay in increasing the national debt ceiling. The debt ceiling of $8.1 trillion has now been reached and has necessitated such measures as ceasing contributions into the Civil Service Retirement and Disability Fund.  As evidenced by a sub-1% bid in the repo market, the two-year Treasury appears to be in short supply. 

Proclivity toward Negative Productivity?
For the first time in five years, labor productivity (defined as the relationship between unit labor costs and economic output) declined during the fourth quarter of 2005 by an annualized rate of 0.5%, after increasing during the third quarter by 4.2%. The productivity lapse came on the heels of an increase in unit labor costs of 3.3%, concomitant with a slower rate of GDP growth.

The Fed is likely concerned about waning productivity, amid signs that capacity utilization (from both labor and manufacturing) is also creeping upwards. Echoing this sentiment, the President of the Philadelphia Fed, Anthony Santomero, recently stated, “We have to be careful here as we approach full utilization of our resources… We are hearing from business people in our district… that it is becoming more difficult to find appropriate workers. Indeed, as we make our rounds with member financial institutions, some report, anecdotally, that the year-over-year increase in salaries required to attract quality commercial loan officers may have increased by 40%.”  A confluence of diminished productivity, declining unemployment and rising labor costs, and capacity utilization will not encourage the Fed to let up on the brakes.

The labor market continues to strengthen. February saw a gain of 243,000 non-farming jobs, on top of an increase of 170,000 in January. Furthermore, year-over-year wages increased by 3.5%, the highest level since the third quarter of 2001.

U.S. Fixed Income Yields: Still Globally Competitive?
Relative to yields on other sovereign notes, over the past year, the yield advantage on the U.S. 10-year Treasury has diminished against other English-speaking countries, yet has widened against the 10-year markets in Japan and continental Europe.

Figure 1. One-Year Historical Yield Spread: 10-Year U.S. Treasury vs. 10-Year International Government Bonds

With signs of stronger economic growth, the European Central Bank and the Bank of Japan have indicated some interest in tightening their respective monetary policies. As an example, the Bank of Japan appears ready to change the 0% short-term interest-rate environment that has been in place for over five years, having voted to scale back the amount of funds available to the banking system. Should these signals play out, it’s likely that yield differentials with the U.S. would reverse course.

Potential Effects of a Housing Slowdown
During 2005, median new-home sales prices increased by 7% in the U.S., approximately half the 14% appreciation rate seen during 2004. During January, new home sales fell by 5%, with the number of unsold homes on the market rising to nearly a 10-year high. Housing prices in the U.K. and Australia peaked over a year ago, after having risen at rates in excess of 20%. Perhaps by coincidence, their rates of economic growth were pared by roughly half during the past 12 months. Whereas a deceleration in the increase of house prices should impact economic growth in the U.S., several factors may mitigate the impact of any housing slowdown.

• First and somewhat surprisingly, the rate of housing price increases in the U.S. was substantially less than the rate of increase in many other industrialized countries.
  
  
• Second, mortgagees in the U.S. are overwhelmingly carrying fixed rates. As an example, OECD figures assume that 70% of U.S. mortgages are at fixed rates, where as only 25% of British and Australian mortgages are at fixed rates.
  
  
• Finally, members of the Fed have taken on a mollified tone concerning the effect of housing prices on the overall economy. William Poole, President of the Federal Reserve Bank of St. Louis, recently stated his view that “housing prices are not particularly unreasonable based on housing fundamentals.”  He was also on record as saying that, “A housing price bubble does not exist on a national average basis, but there may be pockets of the country where prices have risen beyond levels that can be justified by economic fundamentals.”  Mr. Poole went on to state his belief that some slowing in the growth of home prices is probable and that the effect on consumer purchases would “not likely be a significant concern.”  Why? “Other economy-wide developments, especially income and employment growth, typically exert a much greater influence on the consumer’s pocketbook and spending habits than does the state of the housing industry.”

Slowing Prepayment Speeds
There is mounting evidence that prepayment speeds on mortgage assets are declining. During January, 30-year conventional mortgage-backed securities posted a decline in prepayment speeds of 23%. This decline, well beyond trading assumptions, was represented across the board, in both discount and premium categories. Nonetheless, 15-year prepayment speeds have largely held at assumed levels. It will be interesting to watch prepayment speeds in the coming months, given assumed declines in cash-out refinancings and forecast future rate hikes.

John Biestman is Director of Business Development at the Federal Home Loan Bank of Seattle.

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