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.
Even with the most aggressive pace of rate hikes in over a generation during the past year, recent data suggests that there’s still a path to a “soft landing” for the Federal Reserve. The U.S. economy posted the kind of mild slowdown in the last quarter of 2022 that the Fed wants to see as it attempts to tame inflation without choking off growth. Gross domestic product beat expectations to rise at a 2.9% annualized pace, down from 3.2% in the third quarter and a long way from a recession.
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.
Pay attention to the bond market rather than the Fed. That’s what I’m hearing as we learned this week that inflation continued to ease in December, though much focus was also on Wells’ exit from the correspondent space and its ramifications. The headline CPI (-0.1% month-over-month, +6.5% year-over-year) posted the slowest inflation rate in more than a year and core inflation (+5.7% year-over-year), which excludes food and energy, also posted the smallest advance in a year.
While it’s back to business as usual, it was a fairly quiet week as we settled into the new year. Fast inflation and high interest rates dominated the narrative and upended markets across the world last year. When the dust settled, 10-year Treasuries were 200+ BPS higher than the start of the year, the curve inverted in a bearish fashion faster and farther than ever, implied volume spiked, and mortgage spreads were pushed from stubbornly rich to suddenly cheap. The result was an entire trade-able universe moving out of the money, originations grinding to a halt, and duration becoming a function of illiquid trade flows.
There is never much going on in the bond markets the week between Christmas and New Year’s, so I won’t waste your time with filler. MBS MARKET COMMENTARY
MCT would like to wish everyone a Merry Christmas and Happy Holidays. Talk to close the year has been dominated by the Federal Reserve’s most aggressive policy tightening in four decades and its impact on the economy, and for us the residential housing market.
Consumer-price increases have begun a more pronounced slowdown from their 40-year high earlier this year as the Fed slowly gains ground against inflation. U.S. short-term inflation expectations, which the Fed does take into its calculus, eased again to the lowest level in more than a year, helped by falling gasoline prices. CPI came in at 7.1% on Tuesday, below expectations, however the Fed became more hawkish, which is a signal that it is too early to take a victory lap.
The Fed is in its blackout ahead of next week’s FOMC events, and though the central bank has been telegraphing that it will eventually be shrinking the size of its rate increases, better than expected data has fueled speculation the Fed will keep rates higher for longer in the fight against inflation.
ederal Reserve Chair Powell tried to walk the tightrope between stressing that the central bank’s inflation fight is far from over and telegraphing that policymakers could downshift from their rapid pace of tightening as soon as the December 13-14 FOMC meeting. The Fed’s publicly preferred measure of inflation, the PCE Core Price Index, which excludes food and energy, was expected to increase 5% year-over-year, but increased 6% (not exactly a downward trend). And the economy added 263,000 jobs in November, which was better than 200,000 estimates as wage inflation continues to increase; average hourly earnings rose 0.6%, faster than in October.
As we enter the holiday season, everyone in the mortgage industry has the same problems: lower volume, lower pricing and gain on sale margins. With less emphasis on growing volume, due to a lack of borrower demand from currently high mortgage rates and a lack of seller demand from being locked into low mortgage rates, a much greater focus for companies in the mortgage industry has been on lowering costs and increasing profitability.
We were reminded this week that the U.S. labor market is still on solid footing, aiding to speculation that the Federal Reserve will continue its aggressive rate hiking path beyond Wednesday’s 75 BPS rate increase. Today, we learned that October payrolls beat expectations (the headline figure came in at 261k, and there was a positive back month revision of 29k), which further complicates Fed’s job and lowers the odds of the mythical “soft landing.”
We still seem to be a ways off from the point an actual FOMC voter says “let’s wait and see” when it comes to hiking rates. Until that occurs, bond prices continue to fall and the Fed (and others) will continue to incur paper losses on massive bond holdings accumulated during pandemic rescue efforts.
We are beginning to see the Fed’s policy moves take hold, with slowing productivity growth, marginal gains in labor force participation, and home builder sentiment continuing to drop as higher interest rate costs price out a large number of prospective buyers.
The pace of the Fed’s rate hikes and winding down of QE4 have introduced heightened volatility to the bond market. The Fed has raised its benchmark interest rates five times this year, including three consecutive 75 BPS rate hikes, increasing the cost of borrowing money in the hope that more expensive loans will result in less investment, less business expansion, fewer jobs, lower pay, and ultimately less inflation.
Interesting (read: disheartening) times in this rollercoaster of a bond market, huh? There’s the highest volatility in at least five years, colossal bid-ask spreads, scant liquidity in coupons above par, falling bond prices that have banks sitting on their hands, and a central bank that is still uncertain on how long and hawkish it plans to remain in tightening mode (don’t forget fear of a global recession, escalating geopolitical tensions thanks to Russia’s war on Ukraine, the UK’s tax-cut fiasco, and the potential for further defaults by developing nations). A year ago, 2-year Treasuries yielded 0.2%. They were 1% in January of this year, but today yield more than 4%.
The phrase “Don’t fight the Fed” was first introduced in the 70’s (a lovely time for inflation lovers) and for most of the last few decades, the phrase meant that the Fed has the market’s back and investors are rewarded for keeping their feet on the gas pedal as the Fed injects liquidity, dampens volatility, and drives outsized returns. But fighting the Fed cuts both ways, and Fed officials are now intent on taming prices, even though the economy is already in a technical recession. Investors have been forced to consider their positions accordingly.
There are the unfortunate costs of reducing inflation (higher interest rates, slower growth, and softer labor market conditions) that will bring some pain to households and businesses, but a failure to restore price stability would mean far greater economic pain. Markets have interpreted recent Fed comments as: “We are going to raise rates higher and keep them there longer than the market is anticipating. People now understand the seriousness of our commitment to getting inflation back down to 2%. If we have a hard landing and cause a recession, so be it.”
This year’s run up the coupon stack has led to the destruction of both purchase supply and refinance demand, which has drastically reduced prepayment activity. The Fed’s QE4 created a refinance bonanza in 2020 and 2021, but with the Fed leaving the MBS purchase space next week for the foreseeable future, that party is over. The MCT Review this week examines August prepayment speeds that were released yesterday and what to expect for the remainder of the year.
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.
This week’s commentary discusses market preparation and reaction to Fed Chairman Powell’s speech in Jackson Hole. As the Fed puts the brakes on the economy, the central bank is willing to let unemployment go up as a trade for getting inflation under control. Rate hikes are expected to continue as the Fed prioritizes driving down inflation rather than economic growth. Read the rest of this week’s market commentary for more information on the Fed and the MBS market.
Every week the mortgage industry has new headlines. This week saw talk of Wells Fargo scaling back its mortgage division (possibly greatly exaggerated), MBA mortgage applications dropping to a 22-year low, and U.S. retail sales resiliently remaining flat despite a drop in gasoline prices, though the biggest story was Ginnie Mae and FHFA releasing jointly updated seller/servicer requirements.
Last week’s U.S. employment figures pointed to a continued strengthening job market while this week saw a spate of softer-than-expected inflation data, but the 10-year Treasury yield closed each week at the same level. Mortgage rates, however, whipsawed around by 0.25-0.375 percent over the last several trading days, exemplifying the basis risk of hedging a pipeline with U.S. Treasuries.
The non-farm payrolls figure came in at 528k for July, well above the survey estimate of 250k. The market has sold off and a 75 BPS Fed hike in September is more likely than 50 BPS. The strong data likely signals the end of falling mortgage rates as the Fed will keep pressing with big hikes.