Falling Rates Create New Appeal for Homebuilders

by: Brian Kelly

A sea change is developing in US interest rates. The consensus view is that interest rates are destined to go up – not surprisingly we take a different view.

Greece, the Yuan, and investors reaching for yield in the mortgage market are all conspiring to push rates lower. The 4% level on 10-Year Treasuries is a congestion zone dating all the way back to 2004. The recent sharp rise in bond prices and fall in yields could be the beginning of a bull run in bond prices that could take yields down to 3.30%.

Consensus View – 10 Year Rates To Rise Above 4%

Since 2004, a 4% yield on the 10 year Treasury note has served as both support and resistance. As recently as June 2009, 4% was the apex of a hedging related rally – since then the yield has consolidated and even dropped – despite an improving economy.

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After the 2001 recession, the Federal Reserve waited two years before raising rates and when that campaign began, 4% served as a floor in the market. The point of this history lesson is to illustrate that 4% is an extremely important pivot point.

If breached it is conceivable that rates rise significantly to as high as 5.5% by the end of 2010. On the other hand, if 4% serves as resistance, then rates could drop to as low as 3.30%.

Divergent View – 10 Year Rates to Drop to 3.30%
In our view, 4% is formidable resistance and recent trading in the rates market indicates that it will serve as resistance. We highlighted yesterday our view on the Greek bailout and its impact on US Treasuries. In short, now that Germany is on the hook for the rest of Europe, German Bunds become riskier. In a relative world this makes US Treasuries more attractive to risk averse investors. Moreover, investors only receive 3.18% for a 10 year Bund compared to 3.84% for US Treasuries and with Bunds they are taking on the risk of Greece and the Porcine Pals.

To be sure, the US is not without its fiscal issues but the recent financial bailouts of the GSEs have presented a unique opportunity for investors. Yield hungry investors have been buying Fannie Mae (FNM) mortgage securities in an effort to boost returns. Since Fannie Mae is a ward of the state, the default risk is essentially zero – this unusual situation is supporting a low rate environment in the mortgage market.

The most significant congestion area in 10 year yields over the last 8 months has been ~3.30%. This level has served as both support and resistance since June 2009. Additionally, 3.30% represents a 78.6% retracement of the September to March uptick in rates. We view this area as the most likely target in a declining rate environment.

The Divergent Trade – Buy Home Builders
As the employment situation improves we believe home buying confidence will follow. Given that homes are the most affordable since 1992, the uptick in demand could be significant.

The combination of falling home prices and historically low mortgage rates have pushed the National Association of Home Builders Affordability Index to levels not seen in the history of the index.

Furthermore, the expiration of the tax credit coupled with a fear of rising mortgage rates could conspire to create significant demand during the spring home buying season.

Disclosure: Long Homebuilders