By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone
A very good CPI report came out this morning -- 0.2% CPI Core month-over-month vs 0.4% (or higher) for the past 4 months. 2-year Treasuries are at 4.77%, lower by 0.10%, 10-year Treasuries at 3.92%, lower by 0.05%. That said, this CPI report probably doesn’t dissuade the Fed from moving the Fed Funds rate by a ¼ point after the next FOMC meeting (July 26th) but will be part of the data evidence for the Fed to stop there and not raise rates again later this year.
Rates Settle Around 4%
10-year Treasuries are at 3.98%; 10-year interest rates were at 4.06% on July 7, a recent high mark, but rates have inched lower this week. The bond market has recalibrated when we may see a recession and how quickly inflation moves down to the Fed’s 2% target. The long-end interest rates aren’t likely to go much higher -- we are probably going to be in the 4% to 4.25% range for now unless we see progress on core inflation to allow the Fed to stop moving short-term rates higher.
Looking back, we had quite a run-up in interest rates during the past few months. It’s worth noting that we registered a low mark on the 10-year Treasury back on April 6th (3.31%) and then again May 11th (3.39%). The high-end of the range was back on March 2nd, just before the Silicon Valley Bank/Signature Bank insolvencies (4.06%). Essentially, we have come full circle.
We’ve had a similar retracement of rates with 2-year Treasuries. On March 8th just before the regional bank crisis, the 2-year marked a high of 5.07% and then moved down to 3.77% two weeks later (March 24th), and here we are again at back to 4.90%.
Over the past few months, the bond market has been anticipating a recession that still hasn’t materialized. The market continues to weigh both mixed economic data (with a number of upside surprises) and the response by the Fed with hawkish monetary policy.
- Inflation indexes (CPI, PPI, PCE) – these have shown a steady improvement in inflation since the summer 2022, a year ago (4% top-line CPI in May 2023 vs. 9.1% back in June 2022). However, core inflation, without the more volatile food and energy prices, has been sticky near 5%. The last Core CPI report in May (over April) was 0.4% (4.8% annualized).
- The markets had been concerned about the bank system and a contraction of credit availability. While there has been a drain on low-rate demand deposits out of the regional banks and into the larger money center banks and higher yielding money market funds, the bank system concerns have subsided.
- There is no sign of any significant downturn in the economy – GDP (Gross Domestic Product) is at a 2% increase as measured by the May reading of Q1. This past Friday, the unemployment rate came in at 3.6% for June, lower by 0.1% versus May, and it’s generally accepted that level is essentially beyond full employment. New jobs grew by 209,000 in June – that’s lower than it has been (May’s growth was 306,000 jobs, as revised). But 209,000 is still significantly positive job growth and won’t derail the Fed from raising the Fed Funds Rate another quarter point later this month. The question now: Is this jobs slowdown a trend to a weaker labor market that might allow the Fed to hold off on any more rate increases?
The Fed has moved the overnight fed funds rate higher at each of their FOMC meetings since March 2022, and then paused hikes at the last FOMC meeting on June 14th (along with a dot plot indicating that the Fed governors are expecting two more quarter-point fed funds rate increases before year end). The bond market was anticipating a pause in June, but not necessarily the notion of another ½ point increase before year-end.
So, Where Do Interest Rates Go From Here?
On the short end, we should expect the overnight SOFR, monthly SOFR (and out to two years) to continue to track the overnight fed funds rate expectations. The 5%-5.25% current fed funds rate will likely move up a ¼ point after the next Fed FOMC meeting on July 26th and then again, another ¼ point after the November FOMC meeting (assuming the Fed moves to an “every other meeting approach” and skips raising rates at the September meeting).
10-year rates are fundamentally tied to the expected inflation rate (except when the Federal Reserve steps in and distorts market levels as the Fed did during the pandemic; at one point, early August 2020, we had a 10-year rate at one half percent. But here we are with a 4.8% core inflation rate (based on May’s Core CPI month over month at 0.4%, annualized) and yet the 10-year Treasury is at 3.98%, arguing that lower inflation is already built into the yield curve.
Therefore, unless we see a substantive improvement in core inflation, expect the 10-year to inch higher with increases in the fed funds rate; probably as high as 4.25% assuming the Fed continues to keep monetary policy hawkish. The bond market (and the Fed) will be focused on the upcoming inflation numbers – CPI and PPI this week, and the PCE Price Index later this month (Friday, July 28th). The focus will be on the month-over-month change in the core inflation rate – without the more volatile food and energy prices. Let’s hope inflation continues to slow.
Two weeks ago, Bill Dudley, the former head of the NY Fed, wrote an opinion essay for Bloomberg (June 29, 2023), in which he asserts that 10-year Treasuries should be at 4.50%. Simple math – inflation at 2.5% (on average) plus a 1% risk premium for overnight Fed Funds rates plus another 1% premium for 10-year debt. One could argue that the expected 2.5% average inflation is too high given the Fed’s 2% inflation target and that the 1% risk premium for overnight fed funds and the 1% add-on for 10-year debt are both on the high side, but certainly a reasonable and rational opinion.
Fannie Mae and FHA/GNMA Market Spreads
Fannie Mae DUS spreads have improved considerably over the past few months, but have leveled off recently. After the banking system stress in March, Fannie Mae DUS spreads widened by about 40 basis points for 10-year loans. Fannie Mae spreads improved in May and June, but spreads are still about 12 basis points wide to pre-SBV Bank/Signature Bank insolvencies.
FHA/GNMA spreads were wider by 60 basis points from pre-SBV Bank /Signature Bank levels in early March. FHA/GNMA spreads have improved by over 20 basis points but continue to stay wide due to illiquidity with the investor base (the regional banks were major investors in GN REMIC securities) and also due to the inverted yield curve which directly impacts the benefit of the sequential pay GN REMIC structure.
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