The Fed’s Continued Fight Against Inflation
Last week was full of significant economic data releases, and though that was not the case this week, that gave markets plenty of time to digest the latest employment and inflation figures ahead of the Fed’s meeting (and subsequent rate hike decision) next week. Fed Chairman Powell hinted in speech last Wednesday that it might be time to reduce the magnitude of rate rates from 75 BPS to 50 BPS as inflationary data, despite being very elevated, hasn’t been getting worse.
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. Recall that personal income increased significantly more than analysts had expected in October, rising 0.7 percent. Spending met expectations, but came at the expense of saving with the personal savings rate falling to one of the lowest levels dating back to the 1950s. Meanwhile, employment continues to outperform with 263,000 jobs added in November.
Monetary Tightening on the Labor Market
It would seem that recent monetary tightening has, to this point, had minimal impact on labor markets, which show continued demand for workers. Over the last three months, job gains have averaged 272k. During the prior recovery, following the great recession, job gains averaged 190k per month. Current figures suggest that the economy is resilient and can handle more rate hikes and restrictive policy for longer, which has contributed toward recent poor risk sentiment. Job openings have been moderating since earlier in the year, but there are still 1.71 jobs available for each job seeker. Wage growth remains below the pace of inflation (+5.1% YOY), meaning that households will have an increasingly difficult time managing higher costs.
This week’s calendar included updates on non-manufacturing PMIs, PPI (+7.4% YOY), and consumer sentiment, but those are secondary data points to the Fed and did little to sway expectations either toward a 50 BPS or a 75 BPS hike. Bets are on the FOMC delivering a 50 BPS rate hike next week and targeting overnight rates around 4.9% by the end of 2023, with the first cut coming in 2024. Keep in mind that historically speaking, the series of 75 BPS rate hikes that have been enacted this year are a drastic shock to the economic and monetary systems.
Volatility will remain a characteristic of the mortgage sector until the Federal Reserve reaches its terminal rate (estimated) at the end of the first quarter.
Volatility will remain a characteristic of the mortgage sector until the Federal Reserve reaches its terminal rate (estimated) at the end of the first quarter. Until then is anybody’s guess. There is chatter out there that the recent rally, due to poor risk sentiment, has gone too far, too fast. 10-year U.S. Treasury yields are now 30 BPS lower than Thanksgiving and 60 BPS better than Halloween. That move has been difficult on option models and duration calculations.
Fixed Income Buying and Selling
Bond funds have seen outflows, and when fund managers need to fund redemptions, they raise capital by generally selling the most liquid part(s) of the portfolio because they can raise the most money with minimal impact on the security price. If fund managers attempted to raise funds by selling less liquid non-QM loans or junk bonds, that would depress that market, which would lower the net asset value of funds’ portfolios. As a result, capital is raised first and adjustments are made for the best returns later.
When we see a sell-off in fixed income as an asset class, as has been the case recently, MBS are the first to get whacked. Note that the Fed is now paying more in interest than it receives in income from its Treasury and MBS portfolio. The Fed pays all of its profits to the Treasury, but it is currently accumulating losses. These are in the form of an I.O.U. The Fed also does not mark its portfolio to market, which is good news because it is probably a few hundred billion dollars underwater on its MBS portfolio. When the Fed begins earning profits again, those profits will pay off the I.O.U. I’m sure there are some mortgage companies out there that wish they could pay off their losses when origination volumes pick up again in the hopefully not-so-distant future.
