Powell’s Dovish Remarks
We had three different types of news this week that tangibly impacted bond prices. Federal 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% from October.
In Powell’s remarks from Wednesday, he stated that the biggest component of core inflation, services excluding-housing (the other two largest components are goods and housing services), is driven by wage inflation. Stubbornly high core inflation is the result of an extraordinarily tight labor market, which we saw today still has plenty of steam. The Fed would like to see more balanced supply and demand in the labor market, either through a reduction in demand for workers after the economy has been cooled with rate hikes, or more supply if workers who left during COVID return. The latter is a much more natural solution, but one the Fed has no influence over.
Rate Hike Moderation Incoming?
The Fed’s most aggressive actions since the 1980’s this year have lifted the target range of their benchmark rate from nearly zero in March to a current 3.75% to 4%. Following four straight 75 BPS moves and despite the hawkish jobs report, expectations are now heavily leaning toward a 50 BPS hike after the Fed’s December 13-14 meeting rather than 75 BPS. The only other major report between then and now is CPI on the morning the Fed begins their meeting. There are rising odds of a rate cut by next November, but before we get ahead of ourselves, remember that rates are set to rise further and stay at restrictive levels for some time. Terminal Fed funds estimates remain around a 5.0% range.
While the central bank is still preoccupied with trying to land the plane without cratering the runway, investors have become optimistic that they are starting to see some light at the end of the tunnel when it comes to rate hikes. This optimism has shown up across a range of assets, and Treasury yields were down 30 BPS in November. Mortgage rates in the U.S. fell for a third straight week this week, and now sit at the lowest level in more than two months, offering some slight relief to would-be homebuyers.
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.
There is so much uncertainty in the forecast though. Powell stressed that the timing of that moderation is far less significant than the questions of how much further rates will need to rise to control inflation and the length of time it will be necessary to hold policy at a restrictive level. Tighter policy and slower growth over the past year have not caused enough strong evidence to make a convincing case that inflation will soon decelerate. The path ahead for inflation remains highly uncertain. When it comes to the (inverted) yield curve, further declines in long term rates will be more difficult to come by and more fleeting, as the 2-year has been driven primarily by the Fed Funds projection while the 10-year has been driven by market sentiment.
Uncertainty or Scarcity
Uncertainty isn’t so much the word in the origination space rather than scarcity. November gross issuance of all agency mortgage bonds was down nearly 15% from the prior month and 65% YOY, registering at just $82 billion, the eighth consecutive monthly decline and lowest monthly total since March 2019. Overall agency mortgage bond gross issuance year-to-date stands at $1.6 trillion, and is forecasted to end the year between $1.7 or $1.8 trillion. While this would still be above the $1.3 trillion annual average seen during the 2000 through 2019 period, it would also be far below the $3.3 trillion average seen in 2020 and 2021. Forecasts are for around $1.2 trillion gross issuance for 2023.
We’ve seen 4.5% and 5% coupon issuance fall off, while 5.5% through 6.5% are increasing. It’s tough times out there, but keep in mind that the December through February period is historically the kindest period for mortgage excess return performance. Until then, we recommend reviewing your strategy when trading higher less-liquid coupons as wider rolls will start to come in with liquidity. Finally, profitable mortgage companies are earning all or nearly all of their profits from servicing income or servicing portfolio valuation adjustments instead of from originations. Reach out to our MSR team for help on that side of things.