Labor Market Still on Solid Footing
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.” While the immediate aftermath of the Fed statement saw stocks and bonds rally as there were indications that the Fed was open to the possibility of a pause in rate hikes, the press conference poured cold water on that as Powell said it is “very premature” to be thinking about pausing and that “we have a ways to go on rates.”
Bond Markets Back in Selling Mood
Investors, in particular, focused on a piece saying that, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” That is a change of pace rather than pause or a pivot. Further, Chair Powell began his opening remarks during the press conference by stating, “we still have some ways to go” with rate hikes and that any talk of a pause in rate increases is premature. He emphasized that no decision has been made and it was likely that at the next meeting the FOMC would have a discussion about it.
So, back to selling went the bond markets, as the prevailing sentiment is now that the Fed is far from the point where it can lift its foot off the economic brake and declare victory over inflation. One positive was that Chair Powell did signal that further rate hikes might be smaller. The December Fed Funds futures have a toss-up between 50 BPS and 75 BPS with another 25 BPS to 50 BPS of tightening priced in for the entirety of 2023. If the Fed’s next dot plot in December indicates that the tightening cycle is largely done, we should see a large rally in MBS and corresponding drop in mortgage rates.
The volatility seen in mortgage rates this year should subside once 1) the peak rate for this hiking cycle comes into view, and 2) inflation begins to slow.
Mortgage rates are based on what MBS investors are willing to pay for these securities. When spreads are large, as they are now, MBS are “cheap” relative to Treasuries. When spreads are narrow, as they were to begin last year, you could say that MBS are “rich.” MBS spreads are wider than the depths of the financial crisis. Bond fund managers constantly swap in and out of different fixed income asset classes to find the best returns, and at some point bond investors will flood into MBS to take advantage of a government-guaranteed rate of return far in excess of Treasuries, which should put some downward pressure on mortgage rates.
Volatility and Associated Problems
The volatility seen in mortgage rates this year as we have progressed up the coupon stack should also subside once 1) the peak rate for this hiking cycle comes into view, and 2) inflation begins to slow. Once inflation is contained, not only should volatility subside, but mortgage rates will start to drift lower. Unfortunately, it may be another year or two until that happens, and the Fed seems firmly in the camp of those who see the job market as too hot. Today’s payrolls report did not help matters.
Keep in mind that the biggest problem facing the economy right now is that prices are rising far too quickly from the lingering effects of the pandemic, which continue to disrupt international supply chains, and the war in Ukraine, which has pushed up the price of food and energy. Inflation is also at least partly the result of excessive demand. Between now and December, we receive additional readings of the consumer price index and the PCE price index. Which path policymakers choose moving forward depends not solely on inflation, but in part on how Fed Chair Powell and his colleagues view the labor market.
If U.S. companies keep adding jobs and raising pay, inflation will remain stubbornly high and the Fed is likely to remain aggressive. If there are indications of job growth stalling and unemployment rising, the Fed would likely pause sooner to avoid causing a recession. Unfortunately, it would seem we are in what could already be called a “housing recession.” Elevated mortgage rates, combined with steep home-price growth from the past couple of years, have greatly reduced affordability. Home sales have slowed to a crawl and the rise in interest rates over the course of 2022 has hurt the willingness and ability of potential home buyers to enter the market. It’s also hurt potential home sellers who are locked in to low rates and not willing to reduce sales prices materially enough to motivate buyers. Until we have some clarity on how quickly this housing recession spreads to the rest of the economy, MBS spreads and mortgage rates should remain elevated.