2024 Mid-Year Commentary & Outlook

Published July 2024

First Half 2024 Grander Update:

The first half of 2024 has been dominated by Fed speculation – when will they drop rates? How quickly will they do so? – but the real story in mortgage markets was the ongoing lack of supply and continued resilience of mortgage rates. For MSR investors, the news has been terrific – unless you are trying to source more products at cheap valuations. For fixed income markets as a whole, however, this steady picture and the range-bound market associated with it is starting to show signs of change.

Fixed Income Markets

Long term rates have traded in a 75-bps range since the beginning of the year, after starting the year just south of 4%, rates peaked in late April around 4.60% and have traded down to the current 4.25% range. The trading range has been unconvincing; small perceptions of future risks (the potential for a Republican sweep of the White House, Senate, and House, for example) has been enough to create outsized moves. Supply – demonstrated by repeat “biggest ever” note and bond auctions by Treasury – remains robust, with rate pressure further strengthened by Fed portfolio shrinkage and the beginning of the baby boomer retirement drawdown trade. The bias remains towards higher long-term rates, in other words, although it will likely require more news to convincingly break out one way or another.

 2023 Year End Commentary and 2024 Outlook

On the shorter end of the curve, two-year rates remain locked in a 4.25-4.50% range, as Fed speak almost immediately counteracts any suggestion of sooner or faster rate reduction. Chair Powell and the other governors have been remarkably consistent in their verbiage, and similarly all on message that rates will only be lowered with clear evidence of reduced inflation within their range – and as long as headline CPI and core have a 3% handle, that evidence is lacking. Moreover, until consumer confidence worsens, or unemployment rears its head, the Fed has no real push to drop rates.

Spread product has been largely range-bound, although markets are starting to differentiate between what are seen as “low risk” spread product – investment grade credit, conforming and guaranteed mortgage paper – and “higher risk” product such as CMBS and non-dollar bonds. Supply is modest YTD, but large corporate issuance in 2019-2021, driven by low rates and cash hoarding in the pandemic, should result in significant rollover activity and pre-positioning in the second half of the year.

Mortgage and MSR Environment

Long term rates have traded in a 75-bps range since the beginning of the year, after starting the year just south of 4%, rates peaked in late April around 4.60% and have traded down to the current 4.25% range. The trading range has been unconvincing; small perceptions of future risks (the potential for a Republican sweep of the White House, Senate, and House, for example) has been enough to create outsized moves. Supply – demonstrated by repeat “biggest ever” note and bond auctions by Treasury – remains robust, with rate pressure further strengthened by Fed portfolio shrinkage and the beginning of the baby boomer retirement drawdown trade. The bias remains towards higher long-term rates, in other words, although it will likely require more news to convincingly break out one way or another.

On the shorter end of the curve, two-year rates remain locked in a 4.25-4.50% range, as Fed speak almost immediately counteracts any suggestion of sooner or faster rate reduction. Chair Powell and the other governors have been remarkably consistent in their verbiage, and similarly all on message that rates will only be lowered with clear evidence of reduced inflation within their range – and as long as headline CPI and core have a 3% handle, that evidence is lacking. Moreover, until consumer confidence worsens, or unemployment rears its head, the Fed has no real push to drop rates.

Spread product has been largely range-bound, although markets are starting to differentiate between what are seen as “low risk” spread product – investment grade credit, conforming and guaranteed mortgage paper – and “higher risk” product such as CMBS and non-dollar bonds. Supply is modest YTD, but large corporate issuance in 2019-2021, driven by low rates and cash hoarding in the pandemic, should result in significant rollover activity and pre-positioning in the second half of the year.

Outlook

With July 4^th behind us in a presidential election year, all focus will now be on November and the election. We are not political prognosticators here at Grander, but the markets are viewing signs of a Republican sweep with some worry: one political party holding the House, the Senate, and the Oval Office tends to lead towards higher deficits and more extreme macroeconomic policies. In an environment where the Fed is still worried about overheating in the economy, which would tend to suggest higher rates on the long end, wider spreads, and more volatility. For MSR holders, that should be to the good – cash flows should remain robust, and both voluntary and involuntary prepayments should remain muted – but the uncertainty can affect trading and valuation spreads. We will have more to say once we get past Election Day.

2023 Year-End Commentary and 2024 Outlook

The last few months of 2023 saw a rapid reversal of the prior six months, which had seen long term rates move rapidly higher along with a noticeable increase in volatility costs. The 10-year dropped from a high print of just over 5.0% to a year end level of just below 4% – a significant drop, matched by an easing of par origination rates on new mortgage of just over 100 bps, from 7.70% to 6.62% to close the year. The parallel drop-in rates and in volatility helped nearly every fixed income market show good performance – in particular prepayment sensitive markets such as agency MBS and callable paper – but with Fed Funds over 5.25%, leveraged investors continued to struggle to beat cost of funds driven performance hurdles. Those higher rates also high commercial real estate investors hard: with vacancies continuing to trend higher post-Covid, and refinancing rates higher than any time since the early 2000s, huge swathes of office and retail space built over the past two decades are facing significant valuation events. While this story will play out largely in 2024 and 2025, fixed income markets have already reflected this in reduced CMBS liquidity and higher demand for non-commercial assets. Diverging performance in the credit market could also be seen, with lower quality high yield names seeing significant spread expansion as investors focused on investment grade, high cash flow credits. While the first part of the year drove exceptional MSR performance due to increasing par origination rates, the last three months continued that performance as volatility costs embedded in MSR discount rates dropped. Volumes, however, were light, as sellers saw the trends and largely let the market reprice. Grander’s funds saw another quarter of solid performance, although year end marks were lower than expected as third-party models were unable to reflect active pricing in secondary markets, and low prices on current origination coupons outweighed the continued slow prepays seen in older vintages.

The past year saw a continuation of the volatility we’ve seen in fixed income markets since the turbulent early days of the Covid epidemic, although in this case, the year-on-year volatility was largely a washout, at least on the longer end of the curve. The story was driven by a tense dynamic between the Fed – signaling it would keep tight monetary policy for as long as the economy was not solidly back to a 2% inflation rate – and markets, desperate for cheaper money to support more leverage, kept trying to convince itself that the economy would worsen, and the Fed’s hand would be forced. In a nutshell: The Fed won. The economy remained strong, with real GDP running at 3%, unemployment remaining at post-crisis lows accompanied by real wage growth of almost 2%, and inflation remaining cloying above its 2% target. If you looked just the year end prints on the 10 year, you’d think nothing had happened – but actually the long end traded in a 150 basis point range, as low as 3.40% in the spring and as high as 5.00% in the fall. Markets first leaned against the Fed speak and rallied, but increasing signs that inflation was not dropping fast enough or broadly enough caused rates to back up in the fall, before improving data allowed the curve to fall back to a 4% range by year end, where it remains today. Corporate credit spreads were largely directional with term rates, although the brief banking crisis in the spring – capped by the failure of Silicon Valley Bank and First Republic – led to broad initial spread expansion which largely cleared out as the year went on. In contrast, however, real estate lending tightened up during the year, with significant fears continuing to haunt spreads and liquidity – especially in commercial markets – throughout the year. Mortgages – which is Grander’s focus – saw varying performance, but residential markets closed the year showing signs of real life. The 30-year conforming rate rose steadily from 2022year end into September, peaking with a Freddie survey rate top of 7.72% before falling back to 6.69% at year end, while non-QM markets saw origination rates soar from roughly 8% at the beginning of the year to well north of 10% for super jumbo and low doc loans before settling back to 8.5-9.0% rates at year end. Prepayments were predictably glacial, with 2021 and 2022 production seeing all-in CPR rates below 4%. With such massive incentives to stay put, borrowers also performed well, with delinquency and buyback rates also trending at post-crisis lows. New production was limited almost entirely to purchase originations, and with home construction and existing home sales still somewhat quiet, 2023 will go down as one of the smallest origination years since the collapse in 2008 and 2009. The place to be in 2023 (at least in fixed income) really was MSRs: with low production, servicers slowly bid up MSR purchase multiples and tightened bid spreads for secondary product, while the same dynamics meant little flow product emerged – and at such high coupons that secondary buyers like Grander had little interest. With CPRs low, and with forward curves predicting a long and slow easing cycle not expected to begin until mid to late 2024, cash flow on existing pools was very good, certainly much better than models at origination would have suggested, and embedded value in escrow balances rose significantly through the year. Looking forward, we expect continuing low CPR rates as the Fed focuses on getting “the last mile” out of the inflation battle. In addition, with the Fed, we share the view that long term normal rates will now be comfortably above the zero-rate environment that persisted post-crisis for more than a decade. That should support par origination coupons for conforming product in the 5.5%-7.0% range for the foreseeable future, keeping the 2.75-4.0% average coupons targeted for Grander’s MSR portfolios deep in the money. Moreover, those higher long term normal rates will necessarily flush out a lot of marginal borrowers in commercial real estate and corporate markets; we expect 2024 to be another good year for MSRs (although more of a normalized year compared to 2023’s stellar results), and a better year for residential MBS investors overall. Grander’s portfolio performed well yet again. GMOF I closed in September, capping off quite possibly the best investment window (Q3 2021 to Q3 2023) that could have been hoped for. Performance since inception is almost 38%, or 17% annualized, during a period when the fixed income markets – and alternative fixed income in particular – were down across the board. As always, we thank our investors for their ongoing support, and we have been pleased to show such strong performance for their investments with us.