By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone
US Treasury Rates
The 10-year Treasury is at 3.51% (as of 1/17), down from 3.66% four weeks ago, so there has been some improvement, albeit in the same trading range. The high-water mark over the past few months was on 10/24 when the 10-year stood at 4.24%, before the CPI report for October. Since then, with a string of good inflation reports and a reversal in market sentiment, the 10-year has come down some 75 basis points in just 2 ½ months.
We appear to be in a trading range (3.50% +/- a quarter of a point), and do not expect 10-year Treasuries to move substantially lower over the next few months. It will really depend on the incoming data – inflation, the economy, employment, GDP, any recession, and how The Fed responds.
The 2-year Treasury, at 4.19% currently, is down close to 50 basis points since early November, but still a lot higher than the current 10-year and 30-year treasuries because of the restrictive monetary policy of The Federal Reserve and The Fed’s intent on keeping short term rates high to fight inflation.
Consumer Price Index
What’s driving interest rates lower on the long end of the market has been the good news with inflation. The Consumer Price Index (CPI) rose just 6.5% year over year in December. (Recall, top line inflation was at 7.1% for the year ending in November, 7.7% in October, and 8.2% in September.) Core inflation, which excludes food and energy, came in at 5.7% year over year. Annualized, the core inflation rate is at 3.6%.
While there still is a good amount of inflation in the economy, the bond market is interpreting that the recent CPI figures put the Fed on track to downshift to smaller Fed Funds rate increases and to move to reduce rates later this year.
Federal Reserve Monetary Policy
As we’ve discussed before, Fed Policy is focused on bringing inflation back down to 2%.
While inflation improves, The Fed moved to increase the Fed Funds rate by 50 basis points in December, and 75 basis points four times in a row at each of the previous four Fed meetings. The markets are now expecting the FOMC committee to increase the overnight Fed Funds rate by just 0.25% on February 1st and again in March. With another ½ point added to Fed Funds over the next two months, that would put the Fed’s target range for Fed Funds at 4.75% to 5%. The Fed will likely pause at that point with the hope that a 5% Fed Funds rate, along with selling securities from their portfolio, Quantitative Tightening, will be sufficiently restrictive. There is still a long way to go to get inflation down from 6.5% to 2%.
Beyond Full Employment
The Fed is still particularly concerned about wage inflation and it seems to be subsiding as well, but only modestly. The December employment report showed the average hourly earnings slowed in December to 4.6% on a year-over-year basis, an improvement from November’s 4.8% (as revised). The month-to-month average hourly wages increased 0.3% in December, again smaller than November’s number (0.4%).
However, the December employment report was also a reminder that the discussion of an impending recession and significantly lower wage inflation is way premature. We added 223,000 non-farm jobs and the unemployment rate moved back down to 3.50%. That’s nine months in a row with 200,000 plus job growth. Arguably, we are still at or beyond what would be considered full employment.
Where Do Interest Rates Go from Here?
10-year rates have already come down a good amount and will likely be in the 3.50% range until there is evidence of a recession and/or inflation moving towards 2% in earnest. A sub-3% 10-year Treasury will require the Fed to be on its way to bring down the Fed Funds – which is unlikely to happen anytime soon. That said, a 3.50% 10-year Treasury is a bargain over the near term and a good time to rate lock.
Fannie Mae and FHA/GNMA Mortgage Spreads
With regard to market spreads for Agency and FHA loan/Ginnie Mae Mortgage securities, spreads continue to move lower. Fannie Mae 10/9.5 spreads are lower by about 10 basis points since mid-December. Since November 1st, Fannie Mae 10/9.5 spreads improved by 40 basis points.
FHA loan/GNMA spreads are also lower – a 15 basis point improvement in the past month.
Weighing Prepayment Today
We continue to get inquiries from borrowers for loans with less prepay protection. If you think interest rates are going to come back down, having more flexible prepay protection gives you the option to refinance or sell. Just a reminder, there’s a trade-off between (1) the ability to prepay earlier with less penalties versus (2) the add-on cost to the mortgage rate and possible reduction in proceeds with debt service constrained loans.