By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone
Fed Funds Rate Higher by 0.25%, Peak Rate in Sight
This week, the Federal Reserve raised the fed funds rate by 0.25%, despite the turbulence in the markets and concerns over the banking system. That puts the target range for the rate at 4.75% to 5.00%. The increase was in line with the expectations of most bond market participants.
Chairman Powell stated that the FOMC is still concerned about inflation and the Fed is prepared to go higher if necessary to bring inflation down. Powell acknowledged that the stress on the banking system may well have an impact on credit tightening and allow for a substitute of further rate hikes, but at this point, the Fed really doesn’t know the impact of the banking stress on credit conditions, the economy and inflation. In other words, it’s too early to say.
Also released were the “dot plots” from the Fed governors that show the members’ views of the future path of the fed funds rate. For the end of 2023, the dot plot average is 5.10% (vs. the current target range of 4.75% - 5.00%), suggesting just one more ¼ point increase. The dot plots show a consensus around a 1% decrease in the fed funds rate in 2024 and another 1% drop in 2025.
Also this week, Treasury Secretary Yellen told a Senate committee that the Treasury Department is “not” considering a broad increase in FDIC insurance. The markets had been anticipating that the Treasury Department was looking to apply FDIC insurance to all deposits (not just those of $250,000 or less) in order to stem the illiquidity problems with the small and mid-sized banks.
Taken together (the Fed Funds ¼ point increase and Secretary Yellen’s comments), the markets turned “risk off,” with a strong bid in Treasuries with rates down some 15 bps across the yield curve and the stock market trading lower (S&P 500 down 1.65% on the day).
Recent Developments in the Markets
To recap the past two weeks: The FDIC took over Silicon Valley Bank and Signature Bank and, together with the Federal Reserve, stepped in to stem a wider banking crisis by providing FDIC insurance for all depositors at these two banks and providing a new lending facility at the Fed. This past week, UBS acquired Credit Suisse, and $17 billion of Credit Suisse’s AT1 bonds got wiped out as part of the negotiated acquisition. Ongoing - the exodus of deposits at First Republic Bank, and JP Morgan and other banks working to bring some stability to First Republic and regional banking overall.
We are in the middle of a major concern over the stability of our banking system, while at the same time, inflation remains persistently high and the central banks continue to raise short-term rates. It could be the beginning of a recession (and likely lower rates across the yield curve). This may well be the right time to be hedging against lower rates and acquiring real estate assets in anticipation of refinancing into lower-rate perm loans over the next year or two.
Regulators and markets are still in the middle of evaluating the bank insolvencies, understanding how the Fed’s 10+ years of easy money (followed by a rapid increase in short rates this past year) helped create these bank problems, and determining what needs to be done to restore confidence in our banks.
Impact of the Banking Concerns on Mortgage Spreads
The commercial real estate mortgage markets are being directly impacted by the concerns over the regional banks. Aside from the rescue package for Silicon Valley Bank and Signature Bank, FDIC deposit insurance currently only covers up to $250,000 for each depositor. Small and mid-sized businesses (and other larger depositors) are moving their uninsured demand deposits out of regional banks, creating a liquidity crunch. The regional banks have been major buyers of mortgage-backed securities and they are now on hold (or selling) in order to raise liquidity. Over the past two weeks, mortgage spreads are wider by some 35 basis points for both Fannie Mae DUS securities and FHA/Ginnie Mae securities.
There are also underlying issues that bank risk managers are re-evaluating – the fact that accounting rules allow banks to avoid mark-to-market of assets by designating assets as “hold to maturity” and also reserve no capital against government securities and Ginnie Mae MBS, based on a zero-risk weighting and very little capital against Agency securities. Clearly, some banks have mismatched asset/liability duration on their balance sheets. To the extent that gets fixed by regulation (or simply better bank risk management), it’s likely that mortgage spreads in our markets remain wider.
US Treasury Market Over the Past Month
10-year Treasuries are currently at 3.43% as of March 22. At the beginning of March, before SVB, 10-year Treasuries made a recent high of 4.06%, so the 10-year has moved lower 63 basis points in the past few weeks. Recall a month ago, the markets were focused on the slowdown in the progress that we had seen in inflation over the past 5-6 months. 10-year bonds were below 3.50% two months ago, then back up over 4% last month and here we are again at 3.43%.
The 2-year Treasury has had even more dramatic moves. The 2-year is currently at 3.94%. Just 2 weeks ago, the 2-year topped out at 5.07%, that’s 113 basis points lower since SBV and the banking concerns came into focus.
The Economic Data
The economic data has taken a backseat to some extent to the recent concerns over the stability of the banks, but it’s ultimately what will dictate Fed policy and the level of interest rates.
We had 311,000 new jobs created in February, after an outsized 517,000 new jobs increase in January. The unemployment rate ticked up to 3.6% (from 3.4% in January), due in large part to folks coming back into the labor market.
Last week, CPI came in at 6% year-over-year and 0.4% for the month of February. 6% year-over-year is an improvement over January at 6.4%, but the 0.4% monthly figure annualized equals 5%, which is still too high. Producer prices slowed some, -0.1% month-over-month and retail sales were also - 0.4% after a blockbuster +3% increase the previous month.
We are watching for how new economic data expected before the next FOMC meeting on May 3 may impact sentiment, including New Home Sales; GDP, the University of Michigan Sentiment Index, and the PCE Price Index; Jobs report; and March CPI and PPI inflation figures and retail sales reports.
Where Do the Economy, Treasuries and Mortgage Rates Go from Here?
Fed Chairman Powell’s comments and the FOMC statement downplayed concerns over the recent bank failures and the possible economic fallout. Raising the fed funds rate by 0.25% probably helps calm concerns about a further banking crisis unfolding. It is ultimately good for the long end of the Treasury curve (10 and 30-year) for the Federal Reserve to stay diligent with raising short-term rates to stall inflation. Secretary Yellen’s testimony to the Senate took away the possible backstop that the markets had been anticipating; hence the risk-off trade in both bonds and equities late in the afternoon.
A 10-year Treasury rate below 3.50% (3.43% currently) is reflective of ongoing concern about the banking system, a likely pull-back in lending, and more restrictive economic conditions. We need inflation to come down below 3% in order to get Treasuries to look attractive.
It’s worth noting that we are seeing mortgage spreads start to stabilize with some incremental improvement over the past day or two. Hedge funds and money managers are buying mortgage securities to take advantage of the wider spreads. Keep in mind, we are still dealing with a dearth of end-user investors with the regional banks and the federal home loan banks on hold (or net sellers). There’s an argument that even when the regional banks return to buying commercial mortgage securities again, that they will be more selective and less aggressive. Therefore, higher spreads could easily drag on for weeks or months.
The information provided on this website, including, without limitation, any opinions, predictions, forecasts, commentaries or suggestions, is for informational purposes only and should not be construed to be professional or personal investment, financial, legal, tax or other advice.