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The market reaction went a little “too far, too fast” in regard to the Fed policy pivot. We witnessed the coupon stack (i.e., the price spread between TBA coupons) decompress in more than a trivial manner in a short period. However, the primary mortgage market has been largely reluctant to follow the Treasury rally, and mortgage rates have ultimately not dropped by the same amount as Treasury yields.
The FOMC raised its benchmark rate by 25 basis points to a new range of 4.75%-5.00% on Wednesday, a middle ground policy move made in the hope of tampering inflation without further harming the banking system. The raise marks the 9th consecutive rate hike since the Fed began hiking in May of last year and brings the target fed funds rate range to the highest level since September 2007. While the central bank’s monetary policy has been aimed at correcting inflation, it has also revealed hidden weaknesses (e.g., entities whose balance sheets relied on low interest rates).
Next week will reveal the Fed’s resolve on continuing to beat the drum on their aggressive inflation fight. The word until now has been that the central bank will keep hiking interest rates until inflation is under control.
Events this week likely will lead to a higher peak interest rate than investors had been expecting just weeks ago. Central bankers appear worried about a cycle in which workers seek higher pay to offset inflation’s bite, and in turn trigger more price increases. In fact, inflation remains high because people have jobs and earn enough income to cover stubbornly expensive housing costs. Robust hiring is good for the economy and workers, but elevated pay growth puts added pressure on the Fed to bring down earnings.
The week after the jobs report is generally pretty data-light, and this week was no exception. With a dearth of data, market movement hinged on “Fed speak” and consumer sentiment. We saw some volatility return to bond markets as investors built in expectations for a more hawkish Fed. As a reminder, the Fed raised its benchmark rate last week to a range of 4.5% to 4.75%. Let’s run through what we’ve learned in the wake of that decision and a robust U.S. payrolls report that took some wind out of investors’ sails that had hopes for rate cuts by summer.
As strong as economists may have thought the job market was, it’s even stronger. In addition to headline non-farm payrolls in January (517,000) beating estimates by around 300,000, employment numbers were revised higher for the past two months. Yes, a tight labor market is anathema to any sort of quick stop to the Federal Reserve’s rate hiking cycle, but the growth rate in average hourly earnings is declining, which will be welcome news to Fed Chair Powell and his colleagues. There exists a raging debate among economists over whether we’ll need a sharp rise in unemployment to keep inflation low.
Have you heard? Inflation was so 2022. All jokes aside, after we learned last week that U.S. inflation cooled for the sixth consecutive month (the consumer price index dropped 0.1% in December compared to the month prior), expectations are now that the Federal Reserve is likely to downshift rate hikes to 25 BPS going forward, beginning at next month’s FOMC meeting.
In addition to raising the overnight Fed funds rate, the Fed is exiting the MBS and security purchase space as it wraps up QE4. The Fed will reduce its asset holdings by not reinvesting the funds received from maturing securities into new securities as it has been doing over the past two years. The MCT Review this week examines the Fed’s plans and the ultimate impact on a volatile bond market.
We have seen steady day-over-day TBA hedge supply, but some volatility after the ECB announcement. There have been intraday reprices throughout the week as mortgages moved wider and tighter. Rolls closed lower with lighter bank flows not enough to offset real money selling. Spec origination has been busy, highlighted by Class B and G2 custom lists. 15-year pools traded just a touch behind last month’s levels, performing better than 30-years, as investors remain focused on shorter paper. Customer interest is muted ahead of the FOMC next week. Custom pools traded fairly well, mostly holding up to recent clearing levels.
Origination volume has been just short of Fed purchases, and the Fed’s biggest purchases are in 4s. The Fed plans to conduct approximately $16 billion in its reinvestment purchase operations over the next two weeks. Secondary selling has come from a mix of MMs and HFs. Notable BWICs include more than $69 million FN/FR 30yr Semi-Seas Investor 2.5s, more than $17 million G230 Seas Mixed Spec 4.5/5.0, and more than $9 million G230 MJM 2.0-4.0.
