By Serafino Tobia, Head of Capital Markets Trading, Greystone
There was a reversal in market sentiment in the middle of November 2022, just after the October Consumer Price Index (CPI) data was released. Since then, we are still on the path of lower rates due in large part to a better-than-expected November CPI inflation report in mid-December 2022.
CPI came in at 7.1% year-over-year, and 0.1% (seasonally adjusted) month-over-month from October to November. CPI was at 7.7% in October which was an improvement from the September 8.2% level. Back in June, top-line CPI was 9.1%. We are clearly moving in the right direction and the bond and mortgage markets are reflecting this.
The 2-year Treasury dropped 45 basis points (bps) between mid-November and mid-December, and the 10-year Treasury dropped even more than that.
Federal Reserve Fed Funds Rate Increase
In mid-December, there was an expected 50 bps increase in the Fed Funds rate, a downshift from the 75 bps increase at each of the past four Fed meetings, putting the Fed Funds target rate at 4.25- 4.50%.
Chairman Powell was particularly hawkish about staying the course with an even more restrictive monetary policy – continuing to raise the Fed Funds rate, maintaining asset sales and quantitative tightening (QT). In other words, the Fed is not ready to “call it quits” on fighting inflation – they remain laser focused on their goal to bring inflation back down to 2%.
The dot plots from the Fed Governors suggest that the Fed is going to move the Fed Funds rate up another 50 to 75 bps during the first quarter of 2023 with the Fed Funds rate topping out at 5.125% and holding there through the balance of 2023.
Back to the US Inflation Rate
Some economists aren’t expecting inflation to roll over and come down so quickly. Mohamed El-Erian, President of Queens' College, Cambridge, and chief economic adviser at Allianz, the corporate parent of PIMCO where he was CEO and co-chief investment officer, is expecting inflation to stick around 3-4% and expects the Fed to ultimately move their target higher from 2%.
This view is primarily because we are still at or beyond full employment and we still have a shortage of workers. Also, when looking behind the “headline” inflation rate there is still high wage and services inflation. However, the bond market is saying that we’ve seen the worst of inflation and is expecting it to continue to move lower.
From our point of view, the markets are reading the inflation outlook and future risks correctly. With the month-over-month increase in the CPI just 0.1% from October to November, on an annualized basis, inflation would be below 2%.
Next year, we will be measuring inflation off 2022 numbers as the basis, when inflation was driven higher by supply disruptions and higher goods and services demand coming out of the pandemic. In the first quarter of 2022, we also had rates near zero, and Fed quantitative easing was still ongoing. On top of that, we experienced inflation price shocks to food and energy from the Russian invasion of Ukraine beginning in late February.
As we look out to next year, we would expect that inflation will continue to move lower – in part because year-over-year inflation is calculated relative to 2022.
The Fed’s current hawkish thinking is also helpful in bringing inflation down. While it hurts the short end of the yield curve, a tight monetary policy -- at this point in the cycle – is helpful for the longer end of the bond and mortgage markets.
Long-term rates have already come down a good amount. The bond and mortgage market are front-running inflation coming down and interest rates won’t move lower unless there is data showing inflation moving towards 2% in earnest and/or we have evidence of a weakening economy and signs of a recession such as a higher unemployment rate or negative GDP prints. In the meantime, expect 10-year rates to stay in this current range between 3.50% to 4%.
Fannie Mae and FHA/GNMA Mortgage Spreads
With regard to spreads, we continue to see improvement in market spreads for Agency and Ginnie Mae Mortgage securities. Before the CPI numbers in November, spreads were approaching the high end of historical levels. Back in early November, Fannie Mae 10/9.5 spreads over 10-year LIBOR swaps were at 100 bps, and in mid-December, we are quoting 71 bps – that’s 29 bps tighter.
GNMA spreads are also lower; about 13 bps since early November. FHA/GNMA spreads will stay stubbornly high until we start to see the yield curve normalize. Buyers for most all GNMA multifamily securities are Wall Street REMIC dealers that pool and package the individual GNMAs into REMIC sequential-pay classes – Class A, Class B, Class C and IO Class. With the inverted yield curve, this sequential-pay structure is less valuable and therefore it’s impacting mortgage spreads.