Interest Rate Market Commentary: Spreads Inch Wider

April 19, 2023

Interest rates will be ultimately driven by inflation. March CPI numbers showed that consumer prices rose just 0.1% in March, month-over-month.

By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone

Treasuries Take Note

The Treasury bond market has sustained most of the improvement in interest rates since the Silicon Valley Bank (SVB) and Signature Bank insolvencies in early March. The firming of 10-year Treasury rates at around 3.50% +/- 10 basis points is tied to the thinking that a recession is just on the horizon (later this year or early next). There is also an expectation of tighter credit conditions post-SVB and Signature Bank (tighter lending standards and loan availability), the thinking that the Fed will stay diligent in fighting inflation with another quarter-point increase in the Fed Funds rate in early May and possibly again in June. Still, there have been several measures of inflation that continue to improve.

Treasury yields moved higher last week after comments from Chris Waller, one of the Fed Governors. Waller noted that monetary policy needs to be tightened further – and the market took its cue from there (2-year Treasuries initially went from 3.95% to 4.12%, and now are even higher at 4.18%. Recall, back on March 8th, before the bank crisis, 2-year Treasuries were at 5.07%).

Before Waller’s comments Friday morning, the 10-year Treasury was at 3.44% -- the 10-year benchmark is currently at 3.57%. Back in early March, pre-banking crisis, the 10-year Treasury rate was as high as 4.06%. We are still 47 basis points lower over the past month and a half but certainly still off the sub-3.40% lows from the previous couple of weeks.

Inflation Measures

Interest rates will be ultimately driven by inflation. March CPI numbers showed that consumer prices rose just 0.1% in March, month-over-month. February’s CPI monthly increase was 0.4%. Year-over-year, CPI came in at 5% in March (vs. last month’s reading, February, of 6%). This shows good improvement.
Last Thursday, PPI, producer prices surprised to the downside as well. Producer prices, month-over-month, were actually negative by -0.5%. PPI year-over-year came in at 2.7%, vs 4.6% in February. The PCE Price Index for March (announced March 31st) came in at a 5% increase year-over-year (vs. 5.4% in February) and 0.3% increase for the month (vs. 0.4% increase in February).

Again, most all the price indices point lower on inflation.

Fed Funds Rate Likely to Move Higher by 0.25% in Early May

The Federal Reserve’s FOMC committee meets the first week of May. The consensus is that the Fed will increase the Fed Funds rate by 0.25%, pushing the target range to 5% - 5.25%. The committee likely indicates that they continue to be data-dependent for further Fed Funds rate increases. The markets are thinking that the Fed will likely pause further rate increases either after the May FOMC meeting or possibly after another 0.25% in June.

Some economists argue that the Fed should stop further rate increases after the bank crisis in March. However, the consensus view is that the conditions for a pause have not yet been met. We still have inflation at 5% and very strong employment. The non-farm payrolls posted an increase of +236,000 new jobs in March, the unemployment rate moved lower to 3.5%, vs. 3.6% in February.

Treasury Rate Outlook

Barring a hard landing recession (or a geo-political event or some other black swan), it’s likely that 10-year Treasury rates will stay in the current range (3.25% - 3.75%). For interest rates to come down further, we need to see continued improvement on the inflation front. Certainly, the inflation trend is in the right direction, but we are still too far away from the Fed’s 2% inflation target.

Despite top-line CPI and PCE Price index being at 5% in March (much lower than the 8%-9% last July and August 2022), the concern remains that the next further 2-3% incremental reduction in inflation will be harder and take longer to achieve.

On the short end of the curve, we should expect the Fed to pause the Fed Funds rate increases after another 0.25% increase in early May (or pause after a second 0.25% increase after the June meeting depending on data over the next month). There isn’t much logic for the Fed to move the Fed Funds rate lower over the next several months (and the Fed governors’ dot plots indicate that they won’t). They will want to retain the restrictive Fed Funds level for a number of months to allow the policy to work in slowing economic activity and bringing inflation lower. Unless something else breaks, like further banking stress or some other event, the Fed would lose credibility if it started to reduce rates without inflation moving significantly closer to 2%.

There is a caveat viewpoint - that the so-called banking crisis moves firmly into the rearview mirror, tighter credit conditions from the SVB/Signature failure don’t substantially materialize, employment stays below 4%, and inflation stays sticky. The Fed could decide to move rates even further and we could see Treasury rates back to the pre-March 8th levels – over 5% on the 2-year and over 4% on the 10-year. Such an increase is not expected at this point because a 5%-5.25% Fed Funds rate is already restrictive and the Fed will want to pause and give the economy some time to adjust to the higher rates.

FHA and Agency Multifamily Market Spreads

In the second half of March, market spreads for Fannie Mae DUS and FHA/GNMA Securities had widened upwards of 0.40%+, after the bank crisis began. The spread widening was due in part due to simple negative correlation with the drop in Treasury rates. Mortgage investors just don’t reduce their required yields as quickly as investors in Treasuries. Further, our markets compete for investors’ attention with all the other spread-fixed income investment alternatives in the market like Agency residential CMOs, private label CMOs, CMBS, SBA securities, ABS and corporate bonds.

Spreads were further impacted by the pull-back of investment by the regional banks and the federal home loan banks. The banks stepped out of the market and in some cases became sellers on the secondary market to raise liquidity. Regional banks have been a mainstay investor base for Agency securities and GNMA REMIC securities.

In mid-March, Fannie Mae DUS 10/9.5 spreads had moved wider as 40+ basis points versus pre-banking crisis. We’ve improved a good amount from there, and some of the federal home loan banks are back in the market and there is interest from money managers, hedge funds and insurance companies. FHA/GNMA Spreads moved wider by just over 40 basis points and remain in this range.

With mortgage spreads, it feels like two steps forward, one step back. With Fannie Mae DUS, we are getting stronger bids by as much as 10 basis points for good size ($10+ million), plain vanilla structures (10/9.5 and 7/6.5 and 5/4.5s with full term IO) and better credit, LTV/DSC – Tier 3 and 4. However, the FDIC retained Blackrock to conduct the sale of the SVB and Signature Bank securities portfolios, approximately $114 billion in aggregate. Certainly, the extra supply in the secondary market will weigh on spreads generally.

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