As the first quarter of 2022 ended, volatility persisted in the bond market. Let’s take a look at what a flattening yield curve means and how the Fed plans to engineer a “soft landing.”
Estimates have the Federal Reserve’s nearly $3 trillion of MBS purchases since the onset of the pandemic lowering mortgage rates by 40-basis points, meaning the worst global bond rout of the modern era continued as we enter April with markets pricing in tighter monetary policy by the Fed. The first quarter of 2022 has officially ended, though we have already recorded the worst year for bonds since 1973.
The yield curve has been flattening (or, in some cases, inverting) as investors bet the Fed will tighten policy rapidly enough to risk a sustained slowdown in growth. Five-year Treasury yields rose above those on 30-year bonds this week to invert for the first time since 2006 (the spread between five-year and 10-year Treasuries inverted late last month) as shorter maturities have been selling off faster than their longer-dated peers.
As investors re-calibrate expectations for further rate hikes this year, with fed funds futures now predicting a fed funds rate between 2.5% and 2.75% by the end of the year, chatter is that the Fed may inevitably cause a recession if it gets serious about taming inflation. Data is mixed on tightenings and recessions, but the yield curve inverting is a strong recessionary indicator. Not all yield curve inversions are fatal, but rather a sign that the recent distortions are unsustainable.
The question is not whether the Fed is about to embark on a tremendous amount of tightening, but whether or not the economy is strong enough to take it. A strong labor market (Non-farm Payrolls in March were +431k while the unemployment rate came in at 3.6%) means both that the economy is at or near full employment and also that wage-based inflation pressures might dictate the Fed can take an even more aggressive approach in removing its policy accommodation. Rising wages create shortages and that causes prices to rise. While the Fed hopes supply chain issues work itself out, there seems little to cause the tight labor market to reverse course.
A flat yield curve means a few things for mortgages, the first being that shorter duration mortgages should underperform relative to longer duration mortgages. Yet to really materialize, but something to keep an eye on: a compression on new ARM offerings relative to 15-year and 30-year fixed mortgage rates. That said, largely driven by the bank backing of these products, ARMs have been slower to move relative to the recent uptick in rates.
As bonds sell off, mortgage rates have moved inexorably higher. MBS spreads widened into the end of the quarter, meaning that mortgage rates are rising faster than Treasury rates. Much of this is based on fears that the Fed will start selling its portfolio of MBS. We aren’t quite there yet, but the market does its best to price in future expectations.
For those wondering why the Fed is still purchasing MBS despite announcing it was done, the recent Fed purchases of MBS are a reinvestment by the Fed of principal repayments and are not part of the quantitative easing, which has wound down. There should continue to be some reinvestment purchases of MBS as the Fed manages its balance sheet and makes sure that the market transitions smoothly to the Fed being much less of a market participant.
At the most recent Federal Open Market Committee meeting (the FOMC is the Fed’s main policy making body), the Fed indicated it will begin reducing its balance sheet through traditional means. This is separate from the tapering of purchasing treasuries and MBS, which ended last month. The plan will ultimately be shared at the next FOMC meeting in four weeks, but the expectation is that the Fed will not actively sell mortgages as some had feared based on previous remarks.
We are monitoring the market situation closely and will keep you informed of potential impacts to your business and pipeline.