Insights

The Fed's Interest Rate Increases & Impact on Loans

September 27, 2022

By Serafino Tobia, Head of Capital Markets Trading, Greystone

What Happened at the Last Fed Meeting?

The Federal Open Market Committee met in late September and increased the Fed Funds rate by 0.75%. The target range for the overnight Fed Funds rate is now 3% to 3.25%. The Fed’s “Dot Plots” – the projected outlook for the Fed Funds rate from the Fed governors - imply another 1.25% Fed Funds rate increase before the end of 2022 (a 0.75% increase in November and 0.50% increase in December). The Dot Plots also suggest another 0.25% increase at the February 2023 meeting and that the Fed Funds rate will top out at 4.625%.

The Fed has no reason to slow down on raising interest rates to combat inflation - the economy is still quite strong, and consumers, banks, and corporations all have healthy balance sheets. With the very low interest rates over the past few years, most homeowners refinanced into 2% or 3% handle mortgages, so they are practically immune to these interest rate increases.

At the same time, Fed Chairman Powell commented after the FOMC meeting that the Fed will do what it takes to get the inflation rate down to 2% -- that’s quite a tall order given that, as of the last CPI inflation reading, inflation is running at 8.3% top-line year-over-year. 

The surprise with the August CPI numbers was the 0.6% increase in the Core CPI, month-over-month. Economists were expecting an 0.3% increase (the same as July). Core CPI is the inflation gauge without food and energy included. For reference, 0.6% month-over-month is 7.2% annualized (0.6% x 12). Markets interpreted the Core CPI reading as further evidence that inflation isn’t coming down so quickly.

10-year Treasury Rate Movement

The 10-year Treasury now stands at 3.97% (at the beginning of September, it was at 3.25%, and on August 1st it was at 2.57%). If you believe the Fed Dot Plots, and that the Fed Funds rate is moving to over 4.50% by year-end, we may see the 10-year move to 4.25%. 

What’s going to get the 10-year Treasury to stabilize or move back lower is a sense that the rate increases have been overdone, that inflation starts to come down and/or that the economy is slowing down and moving towards a recession. As always, the markets and the Fed will be watching the latest economic data, such as home sales, GDP revisions, and consumer sentiment – all of these have the ability to move rates.

Implications for Interest Rates on Loans

With the unemployment rate at 3.7% and higher-than-expected CPI numbers, the Fed has a clear path to stay hawkish and higher for longer.

So what does the overnight Fed Funds rate mean for the rest of the Treasury curve? The 2-year Treasury is at 4.30%; at the beginning of September it was at 3.50% (that is an 80 bps increase just in September). This is impacting the interest rate cap costs for floating rate loans. Six months ago, when the Fed started moving the Fed Funds rate from the 0% target, it was possible to buy 2 and 3-year, 3% strike rate interest rate caps for borrowers at less than a quarter of a point. Essentially, it was considered “disaster insurance” by many borrowers -- something they didn’t ever expect to have to use. Borrowers are now recognizing that a good part of the upfront cap cost is now “pre-paid interest” -- unless the strike rate is 5%-6% certainly.  

Mortgage Spreads Widening

Spreads for multifamily mortgage rates over Treasury rates are higher for both Fannie Mae DUS® and FHA (Ginnie Mae). Since the beginning of September, Fannie Mae mortgage spreads are wider by about 15bps, and FHA (Ginnie Mae) spreads are wider by 5bps. It seems as though spreads are widening every which way (when Treasuries dropped in July, spreads widened, and now with rates moving higher, spreads are widening again). Ultimately, interest rates will need to stabilize for mortgage spreads to come back in.

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