Navigating the Financial Storm: Unpacking the Fed's Impact on Mortgage Rates and Beyond

Navigating the Financial Storm: The Fed's Impact on Mortgage Rates 

Today I attended a seminar hosted by Barry Habib of MBS Highway, and I wanted to share some of the information with you. For a lot of people the current interest rates are stopping them from buying. So if the problem is mortgage rates, how do we get to lower rates?

Firstly, it's important to ensure that the Federal Reserve is content with the current inflation rates. Why does this matter? Well, mortgage rates have historically been tied to inflation. Think of a mortgage as a long-term bond you're holding. When you have a mortgage, you receive fixed monthly payments. If inflation is expected to rise, you'll want to consider the current inflation rate before committing to that mortgage. This is because inflation causes prices to increase. If inflation is on the rise, those fixed payments you receive each month will lose their buying power more quickly than when inflation is low. So, generally speaking, lower inflation leads to lower long-term rates like mortgage rates, while higher inflation causes them to increase. This has been the trend historically.

Now, let's turn our attention to the accompanying graph. The pink line represents inflation, and the blue line shows 30-year fixed-rate mortgages. As you can see, when inflation rises, mortgage rates follow suit. The same happens in reverse. However, during periods of Quantitative Easing (QE), this relationship gets a bit skewed. The Federal Reserve, in conjunction with government spending, drives up inflation, and mortgage rates respond by increasing. Then, as inflation decreases slightly, mortgage rates also dip. The expectation was that inflation would drop to 3% in June 2023, which it did. But contrary to popular belief, mortgage rates didn't follow the expected downward trend. They should have been around 5%. So what went wrong? Why didn't rates follow the historical pattern?

A few factors are at play here. First off, money started leaving traditional bank deposits. Why? The Federal Reserve had raised interest rates to such an extent that it gave people an alternative place to park their money. For instance, a regular bank deposit might offer you a measly 0.5% to 1% interest. But if you opt for a money market account today, you could be looking at returns over 5%. Banks usually invest your deposited money in various loans like car loans, personal loans, and business loans, earning a much higher rate of return than what they're giving you.

However, banks can't put all their eggs in one basket. If you decide to withdraw your money, they can't just go and demand immediate repayment from someone with a car loan. So they diversify by investing in mortgage-backed securities, which offer a higher return than what they pay you, the depositor. These securities are also highly liquid, meaning they can be easily sold. As people started pulling their money out of banks, these institutions had to sell off their mortgage-backed securities, which in turn drove mortgage rates up.

Adding fuel to the fire was the collapse of several banks like SVB, First Republic, and Signature Bank, all of which were taken over by the FDIC. Their assets, including mortgage-backed securities, were sold off, creating a negative impact on interest rates. The silver lining? Things seem to be stabilizing now.

Another contributing factor was the debt limit crisis. The Federal Reserve increased the debt ceiling by an unexpected $270 billion, leading to additional government spending. To cover this deficit, a large volume of treasuries had to be sold. To make these treasuries appealing to buyers, they were offered at a higher yield. As a result, when treasury rates climb, mortgage rates tend to follow suit.

On top of that, Fitch downgraded the U.S. credit rating from AAA to AA+. Just like for individuals, a lower credit rating for a country often leads to worse rates.

While these factors are concerning, the most troubling aspect is the Federal Reserve's approach to inflation. They initially fueled this inflation, and now they're aggressively trying to curb it. It's as if they started the fire and are now attempting to put it out, but in doing so, they're causing more harm than good. This is largely because they're misinterpreting economic data.

For instance, the July jobs report indicated a gain of 280,000 jobs. However, this figure was inflated due to seasonal adjustments; the actual number showed a loss of 871,000 jobs.

Moreover, the nature of the job market is changing. While it may appear that 200,000 jobs were gained last month, this number is deceptive. In reality, 900,000 part-time jobs were created, but 700,000 full-time jobs were lost. The net gain is 200,000 jobs, but the shift from full-time to part-time employment suggests that people are juggling multiple jobs to make ends meet.

When examining work hours, it's notable that they've been reduced by an average of 30 minutes per week. While this may seem insignificant, when extrapolated across the entire workforce of 160 million people, it equates to a loss of 2 million jobs. Observing the trend, in 2022, an average of 399,000 jobs were created each month, totaling 4.8 million for the year. However, in the last 12 months, that number has decreased to an average of 250,000 jobs per month, or 3.1 million annually. Even more concerning, the last six months have seen an average of only 195,000 jobs created per month, and in the last three months, it's been just 150,000. The numbers are clearly declining.

The Federal Reserve aims for a core inflation rate of 2%. In calculating core inflation, food and energy prices are excluded. A significant component of this calculation is shelter, which accounts for 43% of the Core Consumer Price Index (CPI) and 21% of the Core Personal Consumption Expenditures (PCE). Contrary to popular belief, home values were removed from this calculation in 1976, and it now solely includes rents. The current blended rate for new and renewed rents stands at 3.1%.

When considering the CPI and PCE, there's a noticeable lag. This is because these metrics consider the average rate over the last 12 months. Currently, the average CPI is at 7.3%, which is what the Federal Reserve focuses on, while the actual rate is 3.1%. This discrepancy of 4.2% becomes even more significant when multiplied by the 43.7% weighting of shelter. The Federal Reserve claims that inflation is too high at 4.3%, but a closer look reveals a lag effect of 1.8%. In reality, we're at 2.5%, much closer to the Federal Reserve's target of 2%, and the trend suggests it will continue to decrease.

Imagine you're speeding down the highway and you spot a brick wall up ahead. Common sense says you'd hit the brakes well before you reach that wall, right? Well, the Federal Reserve doesn't seem to operate on that logic. In 2021, Janet Yellen was advocating for aggressive quantitative easing, and Jerome Powell was saying they weren't even considering rate hikes. Why? Because they thought inflation was too low. They were looking at the average rent and shelter costs, which showed a modest 2.5% increase. But that's misleading because it's an average over the past 12 months.

If they'd paid attention to the current data, they'd see rents were already soaring at an 8% rate. Had they looked ahead and considered the trajectory, they could've started adjusting rates in 2021 and avoided the inflation and high rates we're dealing with now. Not to mention the banking crisis and other financial turmoil. All of this could've been avoided if the Fed had just acted sensibly.

Now, this mismanagement has led to some interesting trends. Take a look at the graph. The pink line at the top represents 30-year fixed-rate mortgages, while the blue line at the bottom is the 10-year Treasury yield. Historically, these two have moved in tandem for the past 35 years, with mortgage rates typically about 2% higher than the 10-year Treasury yield.

So, here's the deal: instead of being 2% above the 10-year Treasury, 30-year fixed-rate mortgages are now 3% above. Why? Because the Fed has jacked up the fed funds rate so much that it's even surpassed the 10-year Treasury. This is a rare event, folks. It's only happened five times in the last four decades.

Now, what usually follows this kind of move? A recession. Yep, the Fed realizes they've overstepped and have to backtrack. For example, they once had to drop the fed funds rate from 10% down to 3%.

Let's bring mortgage rates into the picture. The first time this happened, mortgage rates dropped from 11% to 7.5%. The second time, from 8.5% to 5.5%. And so on. So where are we headed now? I've got a feeling we're in for some good news. Even though the Fed's saying they won't cut rates anytime soon, I bet it's going to happen quicker than we think.

In conclusion, In a nutshell, the financial landscape has been a rollercoaster, to say the least. From the Fed's questionable decisions on inflation and interest rates to the impact on mortgage rates, it's been a wild ride. Banks have had their share of drama too, with money flying out of deposits and into higher-yielding alternatives. Add in the debt limit crisis, credit rating downgrades, and job market fluctuations, and you've got a full plate of economic twists and turns.

But here's the silver lining: history shows that when the Fed overshoots, a course correction usually follows. So, while we've seen some turbulence, there's reason to believe smoother skies are ahead. Mortgage rates are likely to adjust, and hopefully, the Fed will get its act together.

 So, what's the takeaway for you? Keep an eye on the trends, but don't panic. The market has a way of self-correcting, and there's good reason to be optimistic about what's coming next

Post a Comment