Increased market volatility continued this week as the main headline was the Fed mentioning in the Minutes from the March 15/16 FOMC meeting that it plans on a more aggressive approach to the shrinking of its $9 trillion balance sheet than has been done in previous wind-downs. The Fed will decrease its balance sheet starting next month as it stops purchasing MBS and instead lets its assets run off the balance sheet over time.
As the Fed begins to enact its plan to reduce the size of its MBS holdings, investors are curious to see how quickly the Fed plans to do so. There was agreement indicated in the Minutes of a maximum pace of $95 billion a month ($60 billion for Treasury securities and about $35 billion for Agency MBS) with the caps phased in over a three-month period, or slightly longer if needed. The balance sheet reduction will further tighten credit across the economy as the central bank raises interest rates to cool inflation.
There was also some agreement that “after balance sheet runoff was well under way, it will be appropriate to consider sales of Agency MBS to enable suitable progress toward a longer-run SOMA portfolio composed primarily of Treasury securities.” With the Fed focused on tamping down inflation, likely inflicting more losses, Treasuries continued their selloff and mortgage rates continued to rise this week.
The highest inflation readings in decades have raised the question of whether the Fed’s dual mandate of 2% inflation and full employment are compatible at the moment. The Fed’s fight to find its neutral state, which neither speeds nor slows growth, is a balancing act it has found challenging to figure out. The economy is generally strong, with low unemployment and decent growth. The Fed suggests it can cool off inflation without driving up unemployment or causing a recession, but such a “soft landing” sounds unlikely in what is expected to be the sharpest tightening in almost three decades.
Chair Powell believes it is possible, but indicated the Fed will prioritize reducing inflation and returning the economy to price stability, which is a major policy shift with unknown implications. Many critics have suggested the Fed has now waited so long to enact stricter monetary policy to respond to inflation that it will inevitably now send the U.S. economy tumbling towards a recession next year. “We do feel that the economy is very strong and well positioned to withstand tighter monetary policy,” said Powell. This recovery has been considerably stronger and faster than in the previous cycle.
He also believes that current global supply-chain problems, which have contributed greatly to the rise in inflation, should eventually recede. Inflation is expected to remain high through the middle of the year before starting to decline. Powell replied that the Fed’s goal was to “better align demand and supply” by nudging down interest-sensitive demand and giving workers more time to return to the labor force after covid. “The plan is to restore price stability while also sustaining a strong labor market,” he said.
During previous periods of high inflation, central banks have sometimes raised interest rates rapidly, and to such a degree that the demand for goods and services fell to the degree that firms were forced to lay off workers, sending the unemployment rate skyrocketing. With more people competing for each job, downward pressure was exerted on wages and other costs, and it was this brute force that eventually brought down the inflation rate. Since the start of the pandemic, Powell’s Fed has emphasized the need to give the economy time to recover fully.
Considering that MBS spreads have widened considerably, concerns persist that the Fed unwind may drain liquidity from the system and trigger higher borrowing costs and spikes in volatility. As a result of this increased volatility, investors have been tightening their rate sheets and policies. Many of the lower note rates have been completely removed depending on the aggregator or agency. Anything 3.25% and below on a 30-year that is still in the open pipeline should be either closed or canceled in the next few weeks. And even if an extension is being charged to the borrower, consider the liquidity of that production.
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