The Federal Reserve triggered a modest interest rate hike on Wednesday, while hinting that it may soon ease its fight against inflation, even before it barely dented its pile of mortgage bonds. .
“We have no incentive and no intention to over-tighten,” Fed Chairman Jerome Powell said at his press conference after the decision to raise its benchmark rate by 25 basis points, which was following a series of larger increases in 2022.
Although Powell admitted the process of disinflation had begun, he also said the Fed’s overall battle to keep inflation below a 40-year high was not yet won. “We have to finish the job.”
The problem is that a spike in housing costs in a pandemic is still a big part of the Fed’s inflationary puzzle.
Home prices in the United States have risen by around 40% during the pandemic, having only recently begun to decline nationally after the Fed raised its key rate significantly since March. This pushed longer-term bond yields higher
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and 30-year mortgage rates.
“It just took a sledgehammer to be affordable,” said Mike Cudzil, portfolio manager at fixed income giant Pimco, which oversees about $1.7 trillion in assets.
Refinance activity has also slowed as many existing homeowners have already refinanced at fixed rates below 3.5%, Cudzil said, a trend he said is unlikely to reverse soon, given the Fed promise to keep rates high for a while.
See: ‘The recession is underway’: Homebuilders expect single-family housing starts to fall further before recovering in the second half of this year
At the Fed, the housing market cooling has complicated its plans to passively reduce its holdings of mortgage bonds at a faster pace. Mortgage bond investors said a faster exit was unlikely without the central bank taking more drastic action, such as selling its mortgage bonds outright.
In recent months, the Fed’s Powell has been throwing cold water on selling as a possibility for a while.
Federal caps not reached
Along with interest rate hikes, the US central bank wants to tighten the screws on financial markets by reducing its holdings.
Its balance sheet hit a pandemic peak of nearly $9 trillion after the Fed bought trillions worth of Treasuries and agency mortgage-backed securities each month starting in 2020 to avoid a downward spiral on credit markets. In doing so, it has helped drive up asset prices and drive yields back to historic lows.
Now, it’s taking longer than expected to reduce its holdings of mortgage bonds.
Powell said on Wednesday that the U.S. economy was in the “early stages” of easing inflation. The Fed has now raised its benchmark rate to a range of 4.5% to 4.75%, its highest since 2007, from near zero.
Tighter financial conditions did not prevent the central bank from hitting its $60 billion monthly cap to reduce its Treasury holdings, which totaled about $5.4 trillion at the end of January (see red line). But trimming its $2.6 trillion stack of agency mortgage bonds (blue line) was trickier.
For starters, the Fed began in June letting up to $17.5 billion of its agency mortgage bond holdings off its balance sheet as the bonds matured. In September, the central bank raised its monthly runoff cap to $35 billion.
But by then the housing market was already collapsing. Refinancing activity and new mortgage issuance froze as the 30-year fixed rate briefly hit a 20-year high of 7% in October, before falling recently to around 6%.
In recent months, monthly runoff from Fed mortgage bonds has reached about $20 billion, according to BofA Global rates strategist Mark Cabana.
“They’re partly to blame for missing their own targets,” Greg Handler, head of mortgage and consumer credit at Western Asset Management Company, said of the Fed’s rapid rate hikes. “But clearly real estate activity is down as well.”
Avoid what the Fed holds
Like Cudzil at Pimco, Handler said agency mortgage bonds look attractive in 2023 given expectations of lower volatility as the Fed nears its terminating key interest rate, as well as the years of underbuilding that led to the housing supply crisis in the United States.
The huge reserves of equity that most households have built up should also provide a cushion for families and the market against foreclosures, even if house prices fall 10% to 15% and a mild U.S. recession hits, have they stated.
Meanwhile, yields have improved for mortgage bond investors to kick off 2023. The ICE BofA US Mortgage Backed Securities Index rose 4.2% on the year to Thursday, according to FactSet, while the Bloomberg US Aggregate Government – Agency index return was nearly 1.8%.
The iShares MBS ETF
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with its focus on agency mortgages rose 4.1% for the same period, while the Dow Jones Industrial Average
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was 2.6% higher and the S&P 500 Index
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was up 8.9%.
It should be noted that much of the Fed’s mortgage holdings are tied to the pandemic boom it helped create. Handler said the central bank’s portfolio was focused on mortgages with rates averaging around 4%.
“They won’t come close to their $35 billion cap,” Cudzil said.
The Fed has helped provide homeowners with low mortgage rates. Removing them now makes it harder to get out of mortgage debt.
