Let’s take a minute to look at some silver linings in the mortgage market. The last couple of months have been a volatile (read: unpleasant) time for the industry, with market sentiment torn between pushing yields higher due to Fed rate hikes and falling yields caused by recessionary fears. Originators have seen volumes drop and margins contract, leading to downsizing. We are nearing the cusp of “bad news is good news,” where economic weakness is interpreted as good news for medium-term economic growth because it means the Fed may ease up on the brakes.
The FOMC minutes from the June 14/15 meeting showed that the Fed is worried most about inflationary expectations becoming entrenched in the economy and the central bank indicated a willingness to cause a recession to defeat inflation. The 2s-10s spread inverted this week, historically an early warning sign of a recession. The biggest mistake, in the Fed’s opinion, would be to fail to restore price stability. The problem for the Fed is that interest rates are still highly negative on an inflation-adjusted basis. So, even though the Fed is being aggressive in hiking rates, overall monetary policy remains highly accommodative.
A primary concern for the MBS market in the second half this year will be the additional net supply thrown onto the market by the Federal Reserve’s change in monetary policy. Expectations are for between $150 and $180 billion in total runoff from the Fed’s balance sheet to hit the market by year’s end, combined with the conspicuous absence of the Desk’s daily MBS purchase operations. Current expectations are for another 75 BPS at the July FOMC meeting, 50 BPS in September, then 25 BPS in November and December. That is still a lot of tightening to go, and since the Fed Funds rate tends to impact the economy with a roughly nine-month lag, we haven’t even begun to feel the impact of the rate hikes we have already seen.
Forgetting the Fed Funds rate for a moment and looking at MBS, the absence of quantitative easing does not necessarily connote “quantitative tightening,” at least until the Fed begins to actively sell MBS. Yes, there is balance sheet runoff from early payoffs, but some of that is being reinvested in MBS and the minutes from the June 14/15 FOMC meeting made no mention of MBS sales. As has been broadly discussed, the Fed is attempting turn down the heat on demand (and the broader consumer economy) without causing undue hardship for firms that rely on mortgage finance.
The drop of mortgage refinancing activity due to higher rates and receding from the en fuego purchase market from the last two years will help ease the flooding of MBS supply. The type of bonds created via refinancing (the 10-year, 15-year and 20-year variety) have predictably dropped a larger percentage than aggregate gross issuance for agency mortgage bonds. Agency mortgage bonds have the advantage over investment-grade corporate bonds of having no credit risk, which in an uncertain economic environment grants it a significant advantage.
Given where rates have headed, many lenders have been exploring new product offerings, including ARMs. We have seen some questions surrounding pricing. Fortunately, issuance is picking up and July is shaping up to be a solid month based upon forward sales. For any secondary marketing concerns or questions you may have, feel free to contact us or reach out to your MCT trader.