When 2020 started, mortgage rates were on a downward trajectory. The COVID-19 pandemic accelerated that trend and we wound up with mortgage rates that are the lowest in a generation.
Mortgage spreads to 10 year US Treasuries are now well within historic normal levels. While Treasures dropped quickly, it took a while for mortgage rates to follow.
The low rates came about through a series of actions primarily through appropriate action by the Federal Reserve given the unprecedented job losses the country was incurring in April-June 2020. The Fed’s balance sheet holdings of debt instruments surged and are at record levels.
While spreads are normal, what has materially increased is inflation as measured by the CPI.
A review of the CPI reveals that a substantial portion of the inflation has incurred in very specific sectors of the economy and another portion has occurred in a non-recurring, very specific 3 month time period in a consequential sector.
For the Fed so much is about expectations and anticipation of the future. With the job market improvements, the Fed will have more latitude to deal with inflation by decreasing their balance sheet which will put upward pressure on interest rates.
The optics of the Federal Reserve in fighting inflation will be important and one way to do this is to increase the Fed Funds rates directly. By August 2022 the monthly non-recurring factors that are contributing to currently high CPI annual levels will have worked themselves through and as such, without additional inflation shocks, the annual CPI calc will decrease.
Analysis
On Jan 1, 2020, 30-year mortgage rates were 3.90% and were declining. As COVID spread to the US in Feb/March 2020 mortgage rates started to decrease as the depth of the pandemic caused huge job losses and fear gripped the economy. By Dec 31, 2020 rates were 2.84% and hit rock bottom in Jan 2021 at 2.75%.
By Dec 31, 2021, they are 3.26%--near multi-generational lows.
When COVID started to take hold in early 2020 the Fed took decisive action to lower rates. 10 Year Treasuries dropped immediately while Mortgage Rates were slower to react---as such the spread between the rates skyrocketed. Eventually, mortgage rates feathered down and the spread decreased to 177 which is only 9bp above the historical average of 168bp (green line).
The Fed was able to lower longer-term rates by becoming a buyer of longer-term maturities. Given the COVID crises resulting; in job losses in a free fall, it made sense for the Fed to take this monetary action. In doing so, the Fed’s balance sheet has materially increased. In Dec 2021 it has sent signals that it will decrease purchases---this will have upward pressure on interest rates.
The Fed has dual mandates regarding Employment and Inflation. Unfortunately, inflation over the past12 month period came in at 6.80% which is the largest since 1982 and is considerable above the 10 Year Treasury annual yield of 1.52%. The Dec CPI results are due out Jan 12 while the next Fed meeting is Jan 26. Be prepared for market volatility.
While inflation came in at 6.8%, excluding Energy and Food, CPI is 4.9%. It is this high due to the used car/truck price run-up that took place during 3 months. Exclude this and CPI is 4.1% and is within manageable distance of the Fed’s target range.
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