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Are investors too complacent?

By Greg McBride, CFA · Bankrate.com
Monday, April 12, 2010
Posted: 2 pm ET

Something caught my eye over the weekend. The Chicago Board Options Exchange Volatility Index, referred to as the VIX and often considered a "fear gauge" for investors, is at its lowest point since Oct. 2007. Hmmm, Oct. 2007. That is when the bond market was exhibiting stress as the credit crunch clutched on with both hands all while stock prices powered to record highs. In hindsight, the stock market and the fear gauge gave no clue about what was to come. Today, the S&P 500 is still 24 percent below that record level.

With the Fed having completed their mortgage purchase program at the end of March, the spread between mortgage rates and Treasury yields remains surprisingly (surprising to me anyway) tight. We haven't seen spreads this tight, for this long, since 1998.

The low level of the VIX and the narrow spreads between mortgage rates and Treasury securities both indicate a complacency I find troubling. We're entering corporate earnings season, which is often a ripe time for market volatility. There are of course the concerns about not just Greece but also Portugal, Spain, and to a lesser extent Ireland and Italy. And recently, investors have been willing to settle for a lower yield on a ten year swap with a private counterparty than on a 10-year U.S. Treasury note. So there are some caution signs in the market.

Also, those mortgage spreads could yet still widen. A key reason they haven't thus far is the surge in volume of mortgage bond purchases by yield-starved investors or institutions needing to recalibrate with their respective indexes. But if this pent-up demand begins to taper off, spreads could begin to expand.

Spreads could also widen if long-term interest rates resume a move higher. There is a higher likelihood of mortgages with higher rates being later refinanced. The risk a loan gets called away from the lender or investor via a future refinancing is reflected through wider spreads as rates rise, in contrast to narrower spreads as rates fall.

Should investors' complacency be replaced with nervousness, it would rattle the prices of stocks and even those of mortgage bonds, resulting in another upswing in mortgage rates.

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