Lack of Clarity in High Coupon MBS Pricing
The lack of clarity in the high coupon MBS pricing makes it a difficult time out there for those trying to set rate sheets. A lot of loan scenarios are pricing below par as it has taken time for higher interest rates to be established in this market. The rapid rise in interest rates and transition to this high interest rate environment have been so swift that there aren’t any higher interest rates to offer. Mortgage prices are indeed a function of natural supply and demand, so one can’t order investors to pay a higher price.
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.
Rates on the Rise
The futures market is now pricing in a terminal fed funds rate of just above 4.75% which would be 450 BPS of tightening over a year-long period, an aggressive cycle historically. For some historical context, in 1994, the Fed took up the target rate 275 BPS over the course of a year, which “blew up” the MBS market, taking out a bunch of mortgage arbitrage hedge funds in the process. From 2003 through 2006, the Fed took up the fed funds rate by 400 BPS and “blew up” the residential real estate bubble. This time around, the Fed will need to rely on continued strength in the labor market to soften the blow to the economy.
This week offered a fresh look at inflation and CPI which came in above expectations at a whopping 8.2% year-over-year in the headline figure. The average 30-year mortgage rate is nearly 7% as of this writing, about 100 BPS higher compared to the same time last month. The universe of American homeowners are almost guaranteed to remain without any incentive to refinance at least over the near term.
This week offered a fresh look at inflation and CPI which came in above expectations at a whopping 8.2% year-over-year in the headline figure. The average 30-year mortgage rate is nearly 7% as of this writing, about 100 BPS higher compared to the same time last month.
The Fed (hopefully) understands the overall higher mortgage rate environment that they have created in an attempt to raise prices and slow demand across the economic spectrum to bring inflation back down to its 2% goal. The Federal Reserve works under a Congressional mandate that requires it to pursue three policy outcomes: maximum employment, stable prices, and moderate long-term interest rates. While we often only hear of the dual mandate of 2% inflation and maximum employment, the current priority essentially boils down to just one policy outcome: stable prices.
The Fed has repeated that price stability is essential if we are going to have another sustained period of strong labor market conditions, but has exhibited little success in achieving it this year. After having consigned the word “transitory” to the realm of macroeconomic punch lines, the Fed has spent much of 2022 coming down hard on inflation. The Fed assumes that by stabilizing prices, long-term interest rates and employment will fall into place.
America’s Strong Job Market
It’s America’s seemingly invincible job market that has pushed benchmark Treasury yields to their longest weekly up streak since 1984. The U.S. economy lost a mind-boggling 22 million jobs in the first two months of the pandemic, but has since gained them all back, plus half a million more. After the previous recession, it took more than five years to achieve that feat. American unemployment is still at a half-century low, though last Friday’s jobs report does show indications of moderating demand, including a decline in job openings and an uptick in firings in some sectors. Almost no one thought that furious hiring pace was sustainable long-term and the labor market was always bound to cool off eventually, though it remains strong.
The Federal Reserve continues to wind down its balance sheet each month, putting upward pressure on rates. Over the past week and a half alone, we’ve seen close to 350 BPS in price movement. The heavy competition among mortgage lenders for eligible borrowers that remain can be seen in both the primary-secondary spread (the 30-day moving average of that spread is 102 BPS, close to its trailing five-year average of 107) and the elevated level of conventional 30-year lending rates over that of 30-year jumbo rates (+33 BPS, far above the trailing five average of 7 BPS).
Another 75 to 100 BPS rate hike is anticipated at the Fed’s next policy meeting on November 1-2. The Fed’s hope is to loosen up the job market and slow wage growth and we have seen signs that the cool-down is clearly underway. Hiring is slowing. Job openings are falling. Fewer people are jumping ship to other employers. While a recession remains a real possibility, there’s little sign of it yet in the data. Wage growth is still well above what the Fed considers consistent with its goal of 2 percent inflation and if policymakers want to get it down further, as they have indicated, they will have to get even more aggressive at the risk of putting more people out of work.