The last few days of March offered some hope for that The massive rate hike of 2022 might slow down. The first few days of April dashed those hopes and things have only gotten worse as the new week begins. After rising over 5% late last week, Monday morning brought the average 30-year fixed rate to 5.25%, a level not seen since 2009.
To understand why, we need to revisit the overall motivation for the rise in interest rates. Before we do that, we say “Celebrationin context. It’s no exaggeration considering this is the largest and fastest rise in mortgage rates since at least 1994.
As for that “why,” it’s actually pretty easy. The Federal Reserve (aka “the Fed”) is best known for setting the Fed Funds Rate, which dictates the cost of short-term funding. It raises and lowers this rate to try to persuade inflation and employment to stay in certain areas. In cases where the interest rate is cut to zero and the Fed believes more needs to be done, it buys bonds (particularly US Treasuries and mortgage-backed securities). Buying bonds creates excess demand in the bond market, which in turn pushes longer-term interest rates down. It’s basically a way for the Fed to affect both short-term and long-term interest rates.
At the beginning of the pandemic, the financial markets were in chaos and the Fed stepped in, cutting rates to 0% and buying bonds faster than ever. Instead of scaling back these bond purchases as markets began to calm down, the Fed concluded that it should continue to provide as much monetary stimulus as possible given the impact of Covid on the job market. They justified this with the adoption that Covid-induced inflation would ease as the pandemic subsided.
As we now know, Covid related inflation not ease up. By its own admission, the Fed has grossly misjudged the persistence of inflation and even the health of the labor market. As 2022 approached, we suddenly found ourselves staring at the barrel of the highest inflation numbers and the tightest labor market in decades. Meanwhile, the Fed still had its fed funds rate at 0% and was still buying more than $100 billion worth of bonds every month.
Change came slowly at first. In September 2021, the Fed began phasing out new bond purchases — a process it had to complete before raising rates. A few months later, as inflation continued to rise and the job market tightened, the Fed began acceleration his exit from easy money politics, but similar to a battleship in a river.
In early 2022, Fed communications spoke of a level of panic not seen since the 1980s. The Fed does not I like to make big course corrections once it starts turning the proverbial battleship, but 2022 has seen those kinds of unexpected accelerations come and go. This rapid shift in thinking and removal of demand for asset purchases by the Fed is the key factor behind the rise in interest rates seen so far in 2022. Last week only brought the most recent iteration.
Special, in a prepared speech Tuesday morning, Fed Vice Chairman Lael Brainard (usually one of the Fed’s most interest-friendly speakers) joined a chorus of more hawkish Fed members who raised the possibility of extremely large cuts in Fed asset purchases (as “normalization” designated). This wasn’t an entirely new concept, as the Fed already on record says normalization in 2022 will definitely be bigger and faster than 2017 – the only relevant precedent. Still, the market was surprised to hear this from Brainard – at least in such emphatic terms.
One of the reasons for the surprise was the fact that the minutes of the last Fed meeting (3 weeks earlier) would be released the following day. Fed minutes often contain additional clues about upcoming policy changes. dealer correctly accepted that there could be a bomb in the current version. That went a long way to softening the blow when the Minutes actually came out.
So what was all the fuss about?
In short, the protocol presented an explicit roadmap for normalization. While the Fed kicked off the normalization process in 2017 with a monthly loss of $4 billion on MBS (mortgage-backed securities) purchases, the plan for 2022 is for phase one to start at a staggering $35 billion a month! The discrepancy in the Fed’s Treasury purchases is similar. Again, we knew it was going to be bigger and faster, but not quite as big/fast.
Since the Fed’s asset purchases target longer-term interest rates, that’s where we saw the pain after the minutes were released. In other wordsThings like 10-year Treasury yields continued to rise while 2-year Treasury yields were able to recover.
Mortgage rates are interested in 10-year yields because 10-year yields generally indicate trends in “longer-term interest rates.” Alternative, forget all that and just observe the correlation in the table below:
While longer-term interest rates also correlate with shorter-term interest rates, as you can see in the charts below, it’s not quite the same. Short-term interest rates rise and fall faster and less frequently. Interestingly, however, relief in longer-term rates is usually not long in coming when short-term rates peak. Unfortunately, we have yet to confirm this peak.
So many things are completely different over this economic/currency cycle, this past precedent may not be as useful as normal. All we really know at the moment is that we are awaiting several important developments. Most importantly, the inflation data shows signs of a shift. That could take months, however, and the bond market may have priced in excessive caution by then.
Before that, let’s wait and see what the Fed actually triggers at its upcoming May meeting. Certainly they will hike, probably by 0.50%. They will also likely enact the normalization plan outlined in last week’s minutes. If that’s the extent of the damage, then the market will finally be on the same page as the Fed (subject to additional acceleration in the coming weeks). Paradoxically, this means that the rate hike and sharp reduction in asset purchases could actually be a good thing for longer-term interest rates.
It it would not be the first time We have seen such a paradox. Longer term interest rates always do their best to accommodate future possibilities. If they know that the Fed is likely to hike short-term rates or normalize asset purchases at a certain pace, they’re free to move on to their next trend. On several occasions in the past, we have actually seen mortgage rates fall while Fed policy has been hawkish or tightening.
So again the only question is: How well are long-term interest rates priced into the future this time? It was just the unexpected changes in the outlook that provided so much additional upward momentum for rates. As soon as this outlook stabilizes, interest rates are likely to start falling again. Unfortunately, there’s no telling if something like this will happen in a few weeks, a few months, or in spurts throughout the year.