With the Federal Reserve expected to raise the Fed funds rate another two to four percent this year, it bodes ill for the economy that we are already talking about a technical recession: two straight quarters of negative GDP prints. That said, the government has changed the definition of a recession from two consecutive quarters of negative GDP growth to the more subjective: “A marked slippage in economic activity.” The designation of a recession is the province of a committee of experts at the National Bureau of Economic Research, a private non-profit research organization that focuses on understanding the U.S. economy.
What this means is that even if we get a negative GDP print in the second quarter, the government and the business press will have the discretion to insist we are not in a recession (at least until it is over), citing the strong labor market and low unemployment rate. Regardless, the yield curve (e.g., the difference between short-term rates and long-term rates) and its slope, a reliable indicator of an impending recession, is giving clues that we are headed towards one. The Fed is trying to avoid hiking the Fed funds rate into the mid-teens as it did during the 1981-1982 recession to defeat inflation.
With inflation at a four-decade high, the Fed has made it clear it is willing to take the steps necessary to avoid inflationary expectations becoming baked into the economy, even if it necessitates a recession. Inflationary expectations have reinforcing effects: people tend to accelerate purchases, buying before prices rise, thus exacerbating shortages. Workers expect annual cost-of-living increases and negotiate raises into, further increasing the prices of finished goods. Vendors begin to build expected price increases into contracts, and both consumers and businesses begin to hoard materials in anticipation of future price increases.
The Fed has a couple of vehicles to measure inflationary expectations, such as consumer sentiment surveys like the University of Michigan and the differential between Treasury Inflation Protected Securities (TIPS) and Treasuries. The University of Michigan report along with the tight labor market gives the Fed considerable runway to act aggressively in its fight. The self-reinforcing aspect of inflationary expectations means that the growing cost of bringing down inflation now is much lower than it will be when these expectations become entrenched. The “soft landing” we have been hearing of is undoubtedly tricky, and remember, there is normally a nine- to 12-month lag for the economic effects of rate hikes to matter.
When it comes to the mortgage market, purchase demand is down from what we have seen over the past two years (check out the June MCTlive! Rate Lock Indices), but home prices remain elevated. That’s good for homeowners, but bad news for the Fed. With housing, a key driver of inflation, trying to balance the housing market by choking off demand via higher mortgage rates hurts both consumers and the economy. Balancing the market through increased supply, which also helps the broader economy, is healthier, but also harder. The government would love to see increased new home construction. However, the constraints are on the supply side: materials and especially labor.
Housing construction is the answer to soaring home prices and has historically led the economy out of a recession. Chatter out there is that the recovery from the current (or imminent) recession will be a wave of new home construction. Single-family home starts collapsed to a 682k annual rate during the 2010-2019 decade, just 63 percent of the average pace seen over the preceding four decades due to the overhang of foreclosures. That annual rate is still yet to recover this decade, but the under-supplied housing market is the main reason an imminent housing price collapse, as seen from 2007 to 2012, is unlikely. It wasn’t unusual to see housing starts spike above a 2 million annualized pace coming out of recessions in the past, par for the course in the 1970s and 1980s.
Until increased supply begins to hit the market, originators are being forced to compete over a smaller pie and against banks that have a cost of funds between 25 BPS and 50 BPS. The best way to boost revenue per loan is to do more Government loans. You already knew that, and in addition to doing everything possible to do more FHA, VA, and USDA loans, a lot of our clients have shifted the focus onto non-QM and ARMs. For more tips or any questions you may have, reach out to your trader or contact us. And if you aren’t subscribed to this newsletter yet, you can subscribe over at the MCT Newsroom.
