This week was all about a sell-off in the bond market. Let’s look at why that is occurring, how the Fed can take action from here, and ways for those in the mortgage space to mitigate risk.
Last week closed with a global bond sell-off that continued to open this week as Fed chair Jerome Powell’s remarks have become increasingly hawkish, along with other Federal Open Market Committee members. The last three weeks have delivered an increase in the 10-year Treasury yield of almost 70-basis points, the largest such move since the end of the initial pandemic-induced volatility of Spring 2020.
Many people believe that the Fed has waited too long to tighten monetary policy and as a result has been unable to prudently manage the U.S. macroeconomic situation in the face of unexpectedly high inflation and strong real economic performance. Short-term real interest rates have been pushed unwittingly lower due to the fed funds rate remaining low while inflation has risen sharply. The fed funds rate is a nominal interest rate that does not account for inflation. Real interest rates, or inflation adjusted rates, are said by economists to be what really drive behavior.
If the fed funds rate is stuck at zero, but inflation increases, real interest rates are falling, and that is stimulating the economy more. The opposite can be true, where low rates in a deflationary environment have the effect of tightening an already stagnant economy. That means even if the Fed doesn’t do anything with interest rates, changes in inflationary expectations are moving real interest rates.
The Committee now seems to recognize the need to move quickly to address this situation or risk losing credibility on its inflation target. St. Louis Fed President James Bullard, a noted hawk, said he would like to see the fed funds rate raised to 3% this year. He says inflation is “way over” where it ought to be and policy makers need to think bigger and act faster. Minneapolis Fed President Neel Kashkari, a prominent dove on the Fed, said that he sees seven quarter point hikes this year. That would put the ending fed funds rate at 1.75%, though his forecast is below other committee members.
The fed funds futures continue to move into a more hawkish direction. Just one week ago, the central tendency was for the December fed funds rate to be something like 1.75% to 2.25%. Today, it is looking more like 2.25% to 2.5% (more or less where rates were in 2019 before the pandemic), a massive change in sentiment. Goldman is out with a call saying that the Fed will raise the fed funds rate by 50-basis points at both the May and June meetings. Given that the markets are predicting such a huge increase in the fed funds rate, investors have to be concerned that the Fed might tip the economy into a recession, potentially next year.
A recession is a valid fear and sometimes a necessary evil to beat inflation. While the economy grew at a healthy clip last year, much of that was the rebound from COVID and also stimulus money. Inflation is currently much higher and rates much lower than when the Fed managed to raise rates without triggering recessions in 1994 and 1984. While stock bull markets generally last a few years, and bear markets last under a year, bond market cycles are much longer. Fortunately, the biggest driver of recessions is inventory build, and today’s inflation is being driven by a lack of inventory. If we are headed into a recession, we should see both an inversion of the yield curve (when long-term rates are lower than short-term rates) and rising credit spreads, the incremental return investors demand for taking credit risk.
With mortgage rates now at 4.5%, compared to at or below 3% not that long ago, and expected to continue to trend higher through the course of 2022 as a much faster pace of rate hikes and fewer MBS purchases from the Federal Reserve are priced in, increased uncertainty has been introduced into the market. The market has transitioned to the 4 coupon, making the need to stay on top of production and roll out of non-production traded coupons in order to reduce basis risk exposure paramount. Be careful of abnormally wide bid-offer spreads in these newly traded coupons, especially for GNMA securities.
Some other ways MCT recommends mitigating risk include discontinuing and avoiding free extensions, limiting or discontinuing locks outside of market hours, including overnight and weekends, considering adding temporary margin to offset the risk of market volatility, and keeping communication with your trading team a top priority prior to the close of market and close of business to ensure you are appropriately covered to minimize interest rate exposure.
Even though strong liquidity in low coupons (priced at a discount) and strong execution by aggregators means there is stability in the market, sell-offs without new significant news may signify more persistent market uncertainty. We are monitoring the market situation closely and will keep you informed of potential impacts to your business and pipeline.