Fed Goes Hawkish & Urges “Risk-On Mode” for Investors
Have you heard the good word(s) of Jerome Powell? U.S. banks will now charge an overnight rate between 3.00% and 3.25% when loaning deposits to another bank, 75 BPS more than over the past six weeks. I’m pretty certain you’ve also heard the phrase “Don’t fight the Fed.” The phrase was first published in the 70s (a lovely time period for inflation lovers) in a book called Winning on Wall Street. For most of the last few decades, the phrase meant that the Fed has the market’s back and keeping one’s portfolio in a risk-on mode will keep it on the right side of history.
Fighting the Fed cuts both ways, but investors have historically been rewarded for keeping their foot on the gas pedal as the Fed injects liquidity, dampens volatility, and drives outsized returns. Easy financial conditions like we saw in the wake of the liquidity shock at the start of the COVID-19 pandemic have been largely responsible for creating long and strong bull markets. Most Federal Reserve officials since the Great Recession have displayed a willingness to ease monetary conditions with little hesitation while displaying extreme caution to tighten.
Despite inflation above 8% and Fed officials intent on taming prices, bond yields, equities, and credit spreads all rallied this summer. But that has changed over the last two weeks with a self-purported hawkish Fed. The dovish past contrasts with the hawkish present: it’s unusual for the Fed to tighten so aggressively at a time when the economy is already in a technical recession. Investors have been forced to consider their positions accordingly.
Fed’s Monetary Restriction Strategy Causes More Volatility
The Fed’s commitment to restricting monetary conditions comes at a time of divergent data for the U.S. economy, which has caused further volatility. Retail sales were up 0.3% month-over-month in August, but the prior month was negative.
Without significantly boosting real interest rates, which are adjusted for some gauge of inflation, we are still short of neutral policy. The Fed Funds rate is a nominal interest rate which doesn’t take into account inflation. By any measurement, with core inflation running around 5% and the Fed Funds rate at 3%, real interest rates are still negative.
The most recent industrial production declined, but first-time unemployment claims at historically low levels remind us that the labor market remains strong. Additionally, supply chains continue improving. The economy does seem well positioned to handle tighter monetary policy, but the Fed and other central banks did a poor job of predicting the surge in inflation last year. So, what reason is there to expect that they have it figured out now?
We are still at the start of this tightening cycle. While the Fed will likely be very cautious in continuing to remove monetary accommodation, officials have made it clear that the punch bowl will not be spiked again anytime soon. Fed Chair Powell has committed to a “bad cop” routine, though investors are pricing the fed funds rate to top out near 4.50% and the first rate cut to be enacted by May of next year. He has pivoted to the belated-but-commendable stance of “price stability is the responsibility of the Fed and serves as the bedrock of an economy that will not function without it.” The front-end of the yield curve has been pressing toward terminal Fed Funds targets, which should continue for the foreseeable future.
In the meantime, Fed purchases are at an end and private investors must now take down that supply and will only do so at a reasonable price. The question of active Fed MBS sales continues to come up, but Fed Chair Powell said MBS sales are not something he expects in the near term. He added that runoff would first need to be well underway and we are ” not close” to that point yet. Nothing from the Fed events this week changes the view that MBS sales will be, at the earliest, a 2023 event. So it is likely they will continue to be slow in applying the brakes and they will “monitor the situation,” as they love to say.
Higher Interest Rates Contribute to Large MSR Spreads
Roll off from the Fed’s holdings over the last few months is just shy of $19 billion monthly, which is far below the stated cap of $35 billion per month. With prepayment speeds falling and so much of the mortgage universe out-of-the-money, it is hard to see roll off coming anywhere near the cap. The economic situation makes mortgages, in my opinion, a far less risky asset class than corporate bonds.
The rise in interest rates this year has caused MBS spreads, the difference between the mortgage rate and a Treasury of similar maturity, to widen considerably compared to what has been seen over the past half-decade. Wide spreads means that mortgage rates are high relative to underlying interest rates. Until the Fed gets toward a terminal overnight rate, we are going to see increased volatility. With headwinds in the market, it helps to have actionable recommendations to protect your business and pipeline. Did you attend our webinar: Improve Profitability to Counter Market Headwinds? Phil Rasori, Justin Grant, and Andrew Rhodes explained how MCT is helping clients Bring BPS Back and improve profitability to counter market headwinds. Additionally, view our hedge advisory calculator to learn how MCT is helping client profitability with unique software and services.