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Commentary
"There is nothing wrong with change, if it is in the right direction."–Winston Churchill
The Return of Volatility?
In the wake of recent weeks’ headlines, it’s interesting to ponder whether the financial markets have indeed become more volatile. There clearly seems to be a global move to adjust the premiums of risky assets, be they sub-prime mortgage pools or emerging market stocks. Recent unsettled conditions were precipitated by myriad sources: remarks from a retired Fed chairman, a large drop in U.S. durable goods orders, and talk of increased securities market regulation in China. In any event, as the risk premiums of high-yield debt, credit default swaps, emerging market bonds, and other assets widened relative to treasuries, we're reminded that, when conditions are ripe, financial asset prices can indeed be quite volatile.
Over the past several years, market volatility has been relatively sedate. Perhaps it’s due to increased market efficiencies spurred by the growing role of hedge funds (which are seldom in the business of hedging) and financial structures, such as credit default swaps and collateralized debt obligations, that facilitate true hedging on one side (and speculation on the other). Still, the fact that global markets can almost instantaneously adjust risk premiums and prices, presents the analogy of the occasional temblor on the proverbial fault line. That is, today’s financial markets have been witnessing long stretches of placidity, interspersed with short moments of sheer terror!
Nevertheless, it’s interesting to measure volatility through different time horizons and different markets. Consider the market for five-year interest rate options. Figure 1 depicts interest rate option volatility over the past six years. Other than the deflationary prospects presented in the 2003 – 2004 timeframe, things have been relatively quiet.
Figure 1. Volatility of 5-Year Interest Rate Options: 1/1/2000 – 3/9/2007
Source: Bloomberg 3/9/07
Figure 2 presents interest rate option volatility over the past six months. Last December, we witnessed an increase in volatility due to some concern about frothy inflation measures. Over the past few weeks as well, we saw volatility percolate due to perceived economic softening as measured by sub-prime mortgage defaults, weaker GDP growth, and soft factory orders. Still, by historical standards, interest rate volatility remains low. In fact, cap volatility has been gravitating toward low levels in recent days.
Figure 2. Volatility Trend of 5-Year Interest Rate Options: 9/1/2006 – 3/9/2007
Source: Bloomberg 3/9/07
What does this mean to a manager of a financial institution? First, from a historical perspective, interest rate options are inexpensive. All other variables being equal, there appears to be more value derived from purchasing, as opposed to selling, an interest rate option. This would imply that, historically, you would have been better off with an advance containing an interest rate cap or floor as a contractual feature. Second, the desire to improve net interest margins is often a primary motivator that can override the aforementioned historical observations. As such, if you are looking to sell an interest rate option, it may be best to do so immediately after the earthquake. Finally, for those that are inclined to sell interest rate options, (again all things being equal and not taking into account individual balance sheet characteristics), we’re inclined to recommend shorter lock-outs and maturities on convertible/putable advances, along with at-the-money or in-the-money knock-out advance structures.
Slower GDP Growth, An Enduring Consumer… So Far
The latest calibration of fourth-quarter 2006 GDP growth resulted in a large downward revision, to 2.2%, from the previously reported level of 3.5%. Why the slower growth? Much was due to inventory corrections, along with a drop in business spending and residential construction. The good news portion of the announcement concerned a slight decline in core inflation (from 2.1% to 1.9%).
Back to reduced business spending… Durable goods orders for January (excluding orders for military equipment) fell by 7.8%, largely due to reduced levels of capital spending over a large range of categories, including: software, aircraft, motor vehicles, computers, primary metals, and communications equipment. The January factory orders number fell by the largest amount in over six years.
For now, the consumer appears oblivious to the cloudy capital spending picture. As an example, the Conference Board’s latest consumer confidence index increased month-over-month, to 112.5 from 110.2. The index was widely expected to have decreased. To be sure, the consumer is facing some significant headwinds, and they’re largely blowing in from the housing sector.
The Fed’s March 7 Beige Book remained relatively upbeat, but did acknowledge some softening in four of the 12 districts—Boston, Dallas, New York, and St. Louis—particularly in the area of investment spending. All districts continued to report slight increases in wage pressures and a continued “tight supply of skilled and professional workers.”
Speaking of Payroll…
The growing momentum of the slower economic growth scenario was dealt a small blow by a better-than-expected increase of 97,000 in non-farm payroll. Moreover, January’s payroll increase was revised up, to 146,000, from 111,000. Additional signs of strength: a dip in the unemployment rate, to 4.5%, and an average hourly earnings increase of 0.4%, compared with 0.2% in the previous month. Still, a few clouds appeared: the gain in private employment, 58,000 workers, was the smallest in over six months.
The Impact of Sub-Prime
As of December 31, 2006, approximately 10% of all sub-prime mortgages were more than 60 days delinquent or in foreclosure. That’s almost double the level of mid-2005. Sub-prime mortgages, according to the Mortgage Bankers Association, equaled approximately 20% of all mortgages originated in 2006. According to Inside Mortgage Finance, the sub-prime mortgage market comprises approximately 13% of home loans that are currently outstanding.
Clearly the state of the sub-prime market is already having an impact. The most recent rough patch in the housing market began in July 1989 and continued for 18 months. During that time, new home sales declined by 45%. We are now six months into a housing slowdown, in which new home sales have dropped by 28%. For every new sub-prime lender that shuts its doors, the likelihood of continued contraction in home sales increases. In a March 9 speech before the Charlotte Branch Enterprise Risk Management Conference, outgoing Federal Reserve Governor Susan Bies had this to say: "What's happening is the front end of this wave of teaser-rate loans that are coming into full pricing. So what we're seeing in this narrow segment is the beginning of the wave. This is not the end, this is the beginning." Her observation is significant, especially given the hitherto absence of deteriorating payroll numbers or slowing of wage growth. It appears, at this time, that the weakness in the sub-prime markets is predominately related to underwriting, as opposed to the broader condition of the economy.
Prospects for Short-Term Rates
In the wake of last week’s stronger-than-expected employment situation report, the odds of an interest-rate cut by summer, as measured by the futures markets, decreased from approximately two-thirds just before the release, to a current level of less than one-quarter. The forward markets currently forecast an overnight rate of 5.03% by September, and 4.81% one year from now. During the February 27 equity market rout and treasury rally, the spread between two-year and 10-year treasuries narrowed to an inversion of only two basis points. Since, that time, however, the inversion has widened slightly to four basis points.
John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.
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