This commentary originally appeared on Real Money Pro at 1:00 p.m. on Jan. 20. Click here to learn about this dynamic market information service for active traders.
Donald Trump's nominee for Treasury Secretary, Steven Mnuchin, had his Senate confirmation hearing yesterday. He was grilled by the chamber on a number of topics, but I think there are three area that are particularly impactful to the bond market and interest rates.
I would argue that this was actually the most-important thing he said. Tax reform is probably more impactful overall, but Mnuchin will probably not be the key voice in crafting that. On the other hand, I don't see Steve Bannon -- or Trump himself -- getting overly involved in government-sponsored enterprise (GSE) reform. It seems that getting Fannie Mae and Freddie Mac out of their current government stewardship is a priority, and it seems that Mnuchin will be driving the bus on that process.
The headlines you'll read are that Mnuchin backtracked from the so-called "recap and release" plan. It would be better for the press to admit that they ran with a vague, off-handed comment made back in November assuming he was for recap and release. All he said back then was that they needed to "get out of government control." I don't know why everyone thought that definitely meant recap and release.
As quick background, the recap and release plan is favored by a set of hedge funds that bought shares in Fannie and Freddie sometime after 2012. Under this plan, the GSEs would sell new common shares to recapitalize the firms. Once they had enough equity capital to survive on their own, they would be spun out of Treasury control. Essentially, they are arguing for an IPO of Fannie and Freddie. I wrote about the flaws of this plan extensively in my Jan. 10 column, so I won't repeat all that here. The short version is that suddenly pulling the plug on government support of the mortgage market risks interest rates spiking. That could cause both economic, and major political, problems.
Yesterday, Mnuchin said emphatically, "my comments were never that there should be recap and release." But he went further than that. He said the GSEs are "very important entities to provide necessary liquidity for housing finance."
What Mnuchin is talking about is the so-called "to be announced" (TBA) market, which is where mortgages that haven't even closed can be pre-sold to investors. It allows banks to know what rates they can lend at without forcing borrowers to settle on their mortgage right away. TBA also allows banks to hold mortgages on their own books, and quickly sell them if they need liquidity. Don't forget, Mnuchin was not only the head of a mortgage bank, but he was also once a mortgage trader at Goldman Sachs. He knows how important TBA is to how mortgage finance works.
On a related topic, Mnuchin also said twice that he wanted to find a bipartisan solution. I really think this is a reference to the Johnson-Crapo bill that made it through the Senate Banking Committee two years ago. I don't know if Mnuchin favors this bill specifically, but I think it fits with what Mnuchin outlined during the hearing. Mortgage finance is left pretty similar, but the end risk is distributed to investors, not tax payers.
It blows my mind that FNMA and FMCC stocks weren't down more. They dropped about 10% before recovering to about -5%. Today they are up about 2%. I don't like this trade at all.
2. Tax Reform
We have a long way to go before tax reform becomes a reality, but I think it is highly likely that some kind of tax reform will happen. As I said above, Mnuchin will be highly influential in this process, but there will be a lot of cooks in this kitchen. So it is hard to know what the reform will look like and how it might impact economic growth.
One interesting wrinkle that Mnuchin mentioned yesterday is that he aims for tax reform that is deficit neutral. Now this will include so-called dynamic scoring that gives credit for lower taxes causing faster growth. And who knows if Congress/Trump agrees. But even with dynamic scoring, if they are trying for deficit neutral, it changes the nature of what those tax cuts can look like. The tax plan Trump had on the campaign trail is not deficit neutral -- no matter how dynamically you score it. And for sure, it would leave no room for big infrastructure projects.
This matters quite a bit for the Fed. Their economic model will indicate that deficit spending is inflationary, unless it soaks up economic slack. If the tax plan is basically deficit neutral, the Fed is going to be less aggressive. In fact, if tax reform just results in a less-complicated, more-efficient tax code, that's probably deflationary, because it would enhance productivity.
A steady deficit would also prevent a big jump in Treasury bond issuance, which is one reason why longer-term bonds underperformed right after the election.
There's a long way to go before we know what the tax package looks like, but this should serve as a reminder that the ultimate outcome might not look much like what we're assuming now.
3. Dodd-Frank Reforms
Another key issue the Treasury Secretary will wind up dealing with is banking regulation. While Mnuchin said he wanted to roll back parts of Dodd-Frank, he said he supported the Volcker Rule. This prohibits investment banks from engaging in proprietary trading. Or put another way, banks are not allowed to buy and sell securities with their own capital -- unless it is part of market making.
I believe this has been a key reason why bond market liquidity has declined over the last few years. The line between market making and prop trading was pretty blurry prior to the Volcker Rule.
If you buy a bond at $100.5 thinking that some other customer will buy it at $101, that's market making. If you buy a bond at $100.5 because the market is dropping but you think it will rebound and you'll be able to sell the bond at $101 later, that's prop trading. But of course, in real life the difference isn't so easy. If a large block of municipals are out for the bid, that puts downward pressure on the market, generally. If a dealer bids on those bonds, are they market making?
Since you can't draw clear lines, banks have instead just put more-restrictive limits on how much traders are allowed to trade, and who they can trade with. It sounds like that system will stay in place under Trump.
That matters not just for us bond geeks, but it also makes bond trading less profitable for investment banks. They had pretty good trading this past quarter, but it is going to be hot and cold over time.