By Serafino Tobia, Head of Capital Markets Trading, Greystone
The big takeaway from the price action after the Fed’s latest press conference is that the markets are poised to front-run any change in Fed policy. That was evident with the big rate moves between when the FOMC statement initially came out versus how the markets reacted after Powell cleared suspicions of any easing expectations during the press conference. Easing of financial conditions is the last thing that the Fed wants to see right now; it works against the Fed’s intention to slow the economy in order to bring down inflation.
Additional takeaways by the markets were:
- The Fed Funds rate increased by 0.75% (the 4th 0.75% increase in a row - June, July, September and November. Now the target Fed Funds rate is 3.75% - 4%.)
- The Fed is not pausing – expect further increases in the Fed Funds rate.
- The Fed is more concerned about under-tightening and allowing for inflation to stay high than over-tightening and causing a recession.
- No commitment to the size of the Fed Funds rate increase at the next FOMC meeting on December 14th – the increase will be data dependent (expect 0.50% or 0.75% increase).
- While the Fed will likely pause rate increases in the 2nd quarter of next year, a pivot to a lower Fed Funds rate in 2023 is highly unlikely.
The Fed stated that while their focus is on a restrictive monetary policy consistent with bringing inflation back down to 2% (from 8.2%), future Fed Funds rate increases will take into account:
- Economic Data – inflation and economic and financial developments
- The cumulative effect of the tightening monetary policy
- The lags with which monetary policy affects economic activity and inflation
Data dependency is nothing new. But \ The Fed is now acknowledging that the economy acts with a lag to Fed monetary policy. Therefore, at some point even if inflation hasn’t come down materially, the Fed may pause to allow for the higher rates to work through the economy and inflation. Also, by acknowledging that there is a “cumulative effect” of the rate hikes during the past 9-months, the Fed may look to slow the pace of future rate increases – possibly 50 bps in December and then 25 bps increments in 2023 to allow for the economy to catch up to the rate increases.
Where do Interest Rates go from here?
We are expecting another 0.50% - 0.75% Fed Funds rate increase in mid-December, and then another two to three more 0.25% rate increases in early 2023 with a “terminal” Fed Funds at about 5% - 5.25%. At that point, expect that the Fed will pause to look for the economy to slow and inflation to move lower over the course of 2023. If the Fed raises the Fed Funds rate by another 1% (to 5%), the 10-year Treasury probably moves higher by another 0.50%.
If the Fed moves the overnight Fed Funds rate to 4.50-4.75% at the mid-December FOMC meeting, the 2-year Treasury likely moves to 5% and the 10-year Treasury moves up to 4.375% +/-. Assuming the Fed stays the course with a focus on bringing down inflation, the 10-year could top out below 4.50% and start to come down mid-2023 (when and if we get progress on inflation) and ultimately back down to 3% (when inflation moves back to the 2% Fed target). A less optimistic case would be if inflation doesn’t come down and stagflation sets in (entrenched inflation along with a recession); this would result in higher rates for longer.
Fannie Mae and FHA/GNMA Mortgage Spreads
Agency and Ginnie Mae Mortgage spreads are approaching the high end of historical levels – only higher four other times since the financial crisis (2009). The mortgage spread is the extra yield over Treasuries and swap rates required by mortgage securities investors.
Spreads have moved higher with all structured asset securities – residential MBS, CMBS, and corporate bonds. Higher spreads ultimately reflect supply and demand – and it’s not extra supply, it’s the investors backing away. We are now depending on money managers and insurance companies as the marginal buyer of Agency securities.
Demand from bank investors for longer-term Agency securities has almost disappeared. The banks have always been an important investor base for Agency securities, particularly during the pandemic. With the extra liquidity from the Fed (bringing the Fed Funds to 0% and $4.5 trillion of quantitative easing QT), recall spreads for 10-year Fannie Mae DUS were lower than 10 basis points. With where rates are today, any long-term securities purchased during 2001 may potentially be worth 85-90 cents on the dollar.
Spreads are widening in large part because of the inverted yield curve in the Treasury and swap markets. Investors are basically saying that given how high short-term rates are, they need more yield to invest long-term (i.e., higher spreads to compensate).
Navigating through this Interest Rate Environment
Higher rates and higher mortgage spreads are hard to accept (but understandable given inflation now at 8.2%, as measured by the CPI). There is a strong argument to simply meet the debt market as you find it and move forward with long-term debt financing with standard prepayment terms. Not ideal but anything short of the basic fixed long-term debt structures comes with extra interest cost and/or interest rate risk. Some of our borrower clients are opting to fix their debt with a shorter term and/or less pre-pay penalties (recognizing that fixed debt with easier prepay terms comes with a higher interest rate and a “ding” to loan proceeds for debt service-constrained loans). Another approach is to finance with floating rate debt; Fannie Mae Structured ARMs (SARMs), Freddie Mac floating rate loans and new or extended bridge loan debt. Both fixed-rate financing with easier pre-pay terms and floating-rate debt allow for borrowers to refinance in a few years if, in fact, interest rates come back down.