It doesn’t take a psychic to predict Treasury and mortgage-backed security (MBS) yields moving higher as quantitative easing winds down. What we are seeing with widening spreads is a natural recourse after the previous two years the mortgage industry enjoyed. Trillions of dollars were pumped into securities markets, driving yields lower and spreads tighter. Estimates are that Fed purchases of MBS pulled rates down by about 50 bps or so on average. So, when the Fed moves to drain that massive stimulus from the market, the opposite will naturally occur. Those that have been in the mortgage industry long enough have been witness to these market cycles before, so there is little reason to panic.
But at what point does a sell-off go too far? The rate on a 30-year mortgage has shot up over 200 bps since the beginning of the year due to expectations of aggressive Fed tightening on its balance sheet and an expected peak to fed funds rate of around 3.00% to 3.25%. With mortgage rates increasing to the highest level since 2009 or 2010 (depending on what index you are viewing), mortgage applications continue to decline. Refinances as a percentage of all applications have dropped to the lowest level over the past five years, and on the home buying front, the sudden large gains in mortgage rates have reduced the pool of eligible homebuyers. In the secondary market, we are seeing securities at 94 trading with more liquidity than those at 104.
Over the past 20 years or so, the spread between the 10-year U.S. Treasury and the 30-year mortgage rate has stayed in a roughly 150 bps to 200 bps range. But during recessions, the spread has moved outside this range. The spread shot up to roughly 300 bps during parts of the 2008 financial crisis, and jumped over 200 bps again in March 2020 before falling significantly in the following months. Spread compression since that point has coincided with massive purchases of agency MBS by the Fed. In 2022, the mortgage spread has trended up and is now a bit higher than 200 bps. Put another way, the rate on the 30-year mortgage has risen by significantly more than the yield on the 10-year Treasury security since the beginning of the year, and that Treasury yield has increased markedly.
The Federal Reserve will soon allow some MBS to roll off its balance sheet and stop reinvesting the principal payments received from its holdings of Treasury securities and MBS, just as the central bank did between late 2017 and mid-2019. Will this planned balance sheet shrinkage cause mortgage rates to shoot even higher? Maybe, maybe not. There is a significant amount of monetary policy tightening that is already priced into financial markets. In theory, yields on longer-dated Treasury securities, and by extension, mortgage rates, should not rise much further if the Federal Reserve raises rates in line with current market expectations.
Central bank purchases of MBS since 2009 have pulled down the benchmark 30-year MBS yield by a larger amount than they have the rate on the 30-year mortgage, so it is reasonable to expect that MBS yields may face more upward pressure than actual mortgage rates as the Fed allows some MBS holdings to roll off its balance sheet in the coming months. The last time the Federal Reserve allowed securities to roll off its balance sheet (during the aforementioned 2017-2019 period), MBS yields notably rose a bit more than rates on a 30-year mortgage. Markets are forward-looking, and the effects of balance sheet runoff may already be priced into MBS yields, at least to some extent. That said, even if mortgage spreads only widened a bit further, the actual level of mortgage rates could keep rising if longer-term Treasury yields continue their upward ascent, a distinct possibility in this environment of heightened economic uncertainty.
Talk of stagflation is setting in, with the U.S. Q1 GDP declining into negative territory and inflation still at a four-decade high. Expectations are that inflation will moderate gradually over the next year or two, such that the FOMC does not need to take the federal funds rate materially above 3%. There are risks where rates need to go even higher to re-establish price stability. As has been understood for some time, it is a tough balancing act for the Fed. Swap traders are pricing in about 140 bps of hikes over the Fed’s next three meetings. The last time it carried out back-to-back increases of 50 bps or more was in August 1984. Fortunately, the 30-year mortgage rate likely will not rise as much as the yield on the 30-year MBS as the Fed’s MBS holdings decline.
All that being said, the economic outlook is highly uncertain, and mortgage rates could move higher than current expectations. With a lot of sharp moves in the market, it helps to have actionable recommendations to protect your business and pipeline. Check out our most recent webinar Taper Tantrum Two? Comparing 2013 to 2022 & What Lenders Can Do. In this webinar, Phil Rasori, Justin Grant, and Andrew Rhodes compared 2013 to 2022 in terms of the deteriorating market, market liquidity in specific coupons, loan sale execution liquidity, and investor pricing performance.
