By Serafino Tobia, Managing Director & Head of Agency CMBS Trading, Greystone
10-year Treasuries are now at 4.18%, a substantial move higher during the past two weeks. Macro factors are such that it’s likely that interest rates won’t go much higher – but rates are also unlikely to go back down below 3.75% until we see signs of a recession. Two key reasons -- inflation is likely to stay sticky above 3% and the Fed is likely to keep the Fed Fund rate “higher for longer.” Over the past six months, 10-year Treasury rates moved from a range around 3.50% to lower after the Silicon Valley Bank/Signature Bank insolvencies (March through May), to a range around 3.80% (June and July) and now, in August, a range around 4% and higher.
The past two weeks have been particularly volatile. 10-year rates moved higher every day in the first week of August, from about 3.95% on July 31st to 4.20% on Thursday (8/3) and then, after the employment report Friday morning (8/4) showing some moderation in job growth, rates gapped back lower, closing at 4.03%. And now this past week rates have moved back higher to 4.18%.
It appears as though the markets recalibrated to a 10-year rate at 4% plus, reflecting:
- A resilient US economy showing continued strength both in employment and productivity (taking the idea of a recession off the table for now), combined with
- A Federal Reserve that has a focus on getting inflation under control and therefore continuing to raise the Fed Funds rate higher. While we are near the terminal Fed Funds rate at around 5.25% - 5.50%, possibly 5.50% - 5.75% late this year, the Fed is likely to keep it there into 2024.
There are also supply and demand dynamics pushing Treasury yields higher. We’re seeing extra supply of bonds out of the US Treasury to fund deficit spending. The Treasury announced in early August that it will be auctioning $1.1 trillion Treasuries during the current quarter, which is up from $733 billion that was indicated back in May. Also, the Federal Reserve continues Quantitative Tightening (QT), or selling Treasuries and mortgage securities off its balance sheet at a pace of $90 billion a month. Since the SVB/Signature Bank insolvencies in early March, the Fed has sold some $527 billion in Treasuries and mortgage securities.
On the demand side, it was widely reported that Fitch rating agency downgraded US Treasuries (from AAA to AA+). Fitch highlighted as key reasons: the ballooning US debt (122.8% of US GDP) along with a federal government with little or no control over the budget. Most market pundits don’t think Fitch’s ratings matter much in and of itself. However, it certainly doesn’t help support demand for Treasury bonds. Also, the Bank of Japan is relaxing its yield curve control, allowing their yields to increase towards 1% (from 0.5%). So far, it hasn’t been too meaningful, but is this just a slight tweak from the Bank of Japan, or is it the first sign of a further trend? The bond market is concerned that this will negatively affect the demand for US Treasuries from Japanese investors. Japanese investors are the biggest foreign holders of US government debt ($1.58 trillion, 2022).
On a more positive note, last Thursday (8/10), the consumer price CPI report confirmed a moderating trend of core inflation (inflation without the more volatile food and energy prices). CPI Core was 0.2% for the month of July, the same as June. Recall, month-over-month CPI Core was running double that 0.4% for the previous four months (0.2% per month, which is 2.4% annualized). Top-line CPI (year-over-year) came in at 3.2%, slightly higher than June’s level at 3% (year-over-year).
Clearly, a disinflation trend is underway, it’s still too high, but moving towards the Fed’s 2% target. But at the same time, the overnight Fed Funds rate is at 5.25%-5.50% and is restrictive. Our market, commercial real estate, is bearing the brunt of the restrictive rates (i.e., floating rates are near 9% plus cap costs). The economy overall isn’t as dependent on rates – most homeowners refinanced and/or locked in a 2% or 3% mortgage a few years ago and most corporations have term debt in place as well. At this point, it seems likely that the Fed has done enough and will start reducing rates at some point soon.
Before the next FOMC meeting (not including the Fed’s symposium in Jackson Hole Wyoming, 8/24-26, where the Fed typically doesn’t take official actions), there will be another inflation read at the end of this month (PCE Index, 8/31) and consumer prices mid-September (CPI, 9/13).
The next FOMC rate announcement will be on Wednesday, September 20th. Assuming the inflation reads continue to support the notion of disinflation, the Fed is likely to leave the Fed Funds rate unchanged in September with the caveat that there are still some areas where inflation is still way too high (namely wage inflation) and the further caveat that their job isn’t done. The subsequent FOMC meeting is on November 1st.
Another ¼ point increase in the Fed Funds rate or not, the Fed will likely pause and keep rates high into 2024. The Fed would rather be on the side that they stayed too restrictive too long rather than declaring victory too early and then seeing inflation re-ignite. Further strong employment (with the unemployment rate at 3.5%, near-historic low) and GDP growth at 2% plus, the Fed has full cover to remain hawkish and to keep their focus on getting inflation down to their 2% target.
So, Where Do Interest Rates Go From Here?
To start to see rates drop, we will need further progress on core inflation (“credibly and sustainably” – Fed Chairman Powell) and, realistically, a weaker economy. Bad news is good news for the bond market and interest rates.
A restrictive Fed Funds rate is ultimately good for the long end of the bond market by keeping a lid on expected inflation (though it likely doesn’t feel that way since when the Fed increases the Fed Funds rates, 10-year rates move higher typically as well). But fundamentally, 10-year and longer rates are tied to inflation plus a risk spread. If your view is that inflation will settle back to 2% or below, 10-year rates could get back to 3.25% -3.50%. However, if your view is that that inflation will be sticky at around 3%, it is like that we will see a 4% 10-year rate.
Fannie Mae and FHA/GNMA Market Spreads
Fannie Mae DUS spreads have leveled off after improving by upwards of 30 basis points since March. Spreads are still about 10-15 basis points wider than they were before the SVB/Signature Bank insolvencies.
The improvement in FHA/GNMA spreads has also stalled. FHA spreads had improved some 25 basis points over the past three months but are still about 40 basis points wider than before SVB/Signature Bank. As a reminder, the GNMA REMIC accumulators dominate our market for individual GN/FHA loans and the regional banks were a large part of the end-user buyer based for the GN REMIC securities. The regional banks are still not engaging as investors like they were previously, and the inverted yield curve has severely reduced the value of the sequential pay GN REMIC structure.