The MCT Review: Market Commentary Week of January 10

What to Watch in 2022

As traders return to action and open 2022, it is to a market dominated by increasing (milder?) COVID infections under the shade of inflation and tightening by the Fed. The last two years have shown that changes in COVID infections shift the economy, though each successive wave of infections has led to milder economic slowdowns. The U.S. finished 2021 with three-decade high inflation and the topic is certainly top of mind for homebuyers, lenders, investors, and our clients. Some say inflation will cool down this year if the global supply chain is able to return to something approximating business as usual. The Fed’s most recent Minutes noted that some of the factors that worked against inflation in the past (e.g., globalization, technology, and productivity growth) may be diminishing. Even with supply chain issues optimistically projected to calm, rising prices of homes are also a worry. 

 

The high demand for housing coupled with low rates over the last two years has seen originators thrive. However, the housing market is shifting into a new era heavily influenced by inflation and lack of supply. Rising prices may delay buying for some if they worry that now is not the right time to make a huge purchase. Others may move faster to find a house because they’re worried home prices and rent prices will increase even more, and they want to lock in a fixed payment. What does it mean for the industry? Demand is strong, but rising mortgage rates would ultimately help quell surging home prices. Housing supply is expected to remain tight due to the wave of millennial first-time buyers, work-from-home individuals looking to buy, and millions of refinance candidates still out there. It would take a considerable decrease in home buyer demand and/or an increase in housing inventory to return things toward a balanced real estate market. The amount of newly listed homes is down 6.6% year-over-year, putting inventory down to 22 days in November 2021 versus 50 days in 2019.  

 

For the mortgage industry, a large focus will be on taking share in a shrinking market. As we see rate and term refinance volume continue to fade (though cash-out refinances remain a good source of business), purchases have the spotlight. Thinner margins and volumes will mean that servicing sales will be very important for many lenders as converting those assets to cash helps to maintain a healthy balance sheet. There is always the looming specter of policy changes, like FHFA announcing targeted increases to Fannie Mae and Freddie Mac’s upfront fees for certain high balance loans and second home loans, that impact front-end pricing. By most accounts, volume will be down this year, and companies will continue to force employees to increase their efficiency and become more efficient themselves. Managers have already cut overtime, increased training and productivity, and stopped replacing employees who are leaving, leaving layoffs as a last resort. There is, of course, optimism on the horizon for 2022. Many indicators depict a healthy economy as we enter the new year, especially if supply chain issues clean themselves up. The labor market is tight with unemployment below 4%, wages are rising, and many households have excess savings accrued over the last two years that will help to cushion the blow against rising prices.

 

Federal Reserve’s Hawkish Pivot

The Fed is expected to raise interest rates approximately three times in 2022, bringing the Federal Funds Rate to just under 1%, and remove stimulus, which will put upward pressure on mortgage rates. After the Minutes to the December FOMC meeting were some of the most hawkish in recent memory, the stage is set for the Fed to fight inflation this year. The Committee has recognized that emergency-level policies are no longer necessary and discussed earlier and faster rate hikes, faster tapering, and balance sheet normalization sooner than previously anticipated. Almost all FOMC members stated that they had revised up their forecasts of inflation for 2022 notably, and many did so for 2023 as well.

 

Fed Chairman Jerome Powell’s appetite for a faster tapering of stimulus is casting him in a role financial markets haven’t seen since he started his tenure in 2018: hawk. Powell’s term has redefined the way the central bank looks at both its employment and inflation mandates, letting inflation accelerate past prior targets in the interest of getting more of the population back to work and at higher-paying jobs. The Treasury bull run over the last couple of years is evidence that markets have enjoyed his dovishness. December 2018 was when Powell’s last big pivot happened, and the dismantling of interest rate hikes made the fourth quarter of that year one of the worst for equities ever. It’s been virtually nothing but encouraging words from the Fed since then against what is now an increasingly bleak picture of inflation.

 

With the inflation target being met and exceeded, the Fed is suggesting a continuing job recovery would mean it’s ready to usher in higher interest rates. Higher rates haven’t always snuffed out bull markets; the pace of tightening makes a big difference, and the Fed must balance tightening before the economy has reached employment goals. The economy is already receiving trillions of dollars worth of fiscal stimulus and negative inflation-adjusted interest rates. More stimulus could be like pushing on a string which would serve to stoke inflation higher. Persistent inflation could place the Fed in the unwanted position of having to react aggressively by raising rates higher than planned and potentially disrupting asset markets.

 

The hope is that the Fed does not have to initiate any real hawkish policies and sees inflation slowing down on its own. High inflation data should keep the Fed focused on gearing its monetary policy toward battling inflation as opposed to battling the impact of the Omicron variant. The Fed has also discussed balance sheet normalization, which would begin after rate liftoff and could be another way to combat inflation. The Fed would like to wind down its balance sheet “sooner” than it did after liftoff during the last policy normalization, which lasted two years. The Fed has indicated its preference is to get rid of MBS from its portfolio first, which will take some time as maturing proceeds are reinvested to maintain the level of holdings before letting them run off. Runoff “caps” are still likely to be appropriate. It does lead to a tightrope act for the Fed: balance annual cost-of-living increases from becoming a permanent part of the labor landscape against the economy returning to the slow growth and low inflation state from the past 20 years.