Money Market and Fed Disconnect
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 inflation has clearly slowed from its pace in the middle of 2022, it is doubtful that the FOMC is ready to declare “mission accomplished.” Fortunately, the latest CPI report does send a clear signal that the Federal Reserve’s tightening campaign is working, and set off a sharp rally in both bonds and equities. That rally comes on the heels of last week’s utopian payrolls report, where the U.S. economy added more jobs than expected while wage increases, a driver of inflation, eased.
Hawkish or Dovish Fed?
Both the payrolls data and the inflation data have led to a renewed sense that the Fed may not have to raise the fed funds rate range by as much as previously feared. Optimistically, this puts the Fed on track to downshift to smaller interest-rate increases and raises hopes for the economy avoiding a recession. Keep in mind that while the Fed has not notably misstepped yet in the tightening cycle, this tightening cycle was preempted by the mistake that was the Fed’s fourth round of quantitative easing. And before we are able to declare mission accomplished, the Fed has repeatedly warned investors that it is by no means finished tightening and the central bank will need to continue raising interest rates to combat inflation.
Both the payrolls data and the inflation data have led to a renewed sense that the Fed may not have to raise the fed funds rate range by as much as previously feared.
Several Fed speakers remarked on the subject with San Francisco Fed President Daly saying she expects the central bank to raise rates to somewhere over 5% while Atlanta Fed President Bostic said that the Fed is willing to overshoot when it comes to tightening and “there is still much work to do.” St. Louis Fed President Bullard noted that interest rates are moving closer to a “sufficiently restrictive” level, although they are not there yet. Kansas City Fed President George said that she believes the federal funds rate will be above 5% into 2024. Minneapolis Fed President Kashkari pointed out that rising prices should force both supply and demand to adjust (up and down, respectively), but supply hasn’t increased.
Reasons for Optimism
While Fed members continue to pound the hawkish message that rates are heading above 5% and will stay there all year, traders have speculated that the slowdown in wage growth will keep the Fed from having to enact further hawkish rate hikes. Money markets are pricing a peak fed funds rate around 4.9%, followed by nearly half a percentage point of rate cuts by the end of this year.
Obviously, inflation data is heavily influencing the plans for lenders and originators in 2023. It is hoped that the reduction in inflation we have seen over the past couple of months will nudge the Fed to turn “dovish.” Once the Fed wraps up its tightening cycle, MBS spreads will revert to the mean, downward pressure will be put on rates, and originators will see mortgage demand to start to rise again.