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December 27, 2023 | Christmas came early to the owners and managers of federally insured depositories. After a year of near death experience c/o trillions of dollars of unrealized losses on COVID-era securities and loans (aka “toxic waste”), US banks were handed a very nice zero risk trade from Uncle Jay Powell and the Equity Market Chorus. As bond yields fell, one-year swap rates also declined, handing banks a risk-free arbitrage opportunity at the Fed, as shown in the chart below.
1-Year Overnight Index Swaps
Source: Bloomberg
The Fed's Bank Term Funding Program (BTFP) prices off of one-year Overnight Index Swaps (OIS). The interest rate for term advances under the BTFP is the one-year OIS rate plus 10 basis points. As of December 22, 2023, the BTFP rate was 4.85%. This morning, banks are buying funding from the BTFP below 4.85% and selling Fed funds at 5.5%. Back in September, the BTFP was trading near 5.5%, but today the trade is worth more than three quarters of a point risk free. The chart below shows total outstandings at the BTFP.
FRED reports that the BTFP was over $120 last week and is likely to grow in January 2024. The little present to the banksters from Uncle Jay and the other members of the FOMC was unexpected and, indeed, is being done in size by a growing number of institutions. Yet the growing popularity of the program means that the Fed will likely discontinue the BTFP in March as currently planned. Of note, Fannie Mae 3s for January 2024 are 88-04 bid this AM on the Bloomberg.
Not only did the Fed's messy public capitulation on inflation move swap rates 80bp, but it also shook public confidence that the US central bank is actually concerned about long-term price stability. Perhaps it is time for Chairman Powell to end the discordant cacophony of FOMC members in the media. How is it helpful for members of the FOMC to parade around in the media mosh pit? We believe that members of the Committee should express the consensus of the FOMC or resign in protest.
Over the holiday weekend, Komal Sri Kumar wrote in “Confusing Messaging Continues”:
“Federal Reserve Chairman Jerome Powell put risk assets into overdrive with his press conference December 13 strongly hinting that the next move by the Federal Open Market Committee would be to lower interest rates. Since then, a long line of Fed officials have made public statements alternating between agreeing with, and contradicting, the Chairman. Both the Treasury and equity markets have decided for now that it is Powell’s view that matters.”
We are pleased that the FOMC tamed most aspects of inflation, at least as the Committee defines the rate of change in prices. Housing, however, stands as a striking rebuke to the FOMC when it comes to long-term inflation. The powerful subsidy provided to millions of homeowners because of the $6 trillion in new mortgages underwritten in 2020-2021 (roughly half of all residential mortgages) is exerting positive pressure on consumer liquidity and downward pressure on home sales.
Mortgage lenders and allied media are cheering for a return to the good old days of mortgage refinance transactions. There is a growing population of borrowers with WACs of 6.875% and higher “that will be seeing their first-ever and best-ever opportunity to refinance their loans should rates fall to 6.50% or below,” writes Brean Capital’s MBS strategist Scott Buchta. We are a structural seller of the refinance opportunity, sad to say.
Simon White wrote in Bloomberg before Christmas: “The surfeit of lower-rate loans means that the effective rate remains considerably lower than the rate for new mortgages, and is rising only slowly.” White notes that the teaser rate so loved by the media is in the 7s, but the effective mortgage rate is still in the 3s thanks to quantitative easing. Remember, we use Fannie Mae 3s as our mark-to-market benchmark.
Home sale volumes are at decades lows, but home prices continue to rise. Zillow and Redfin think that home prices and mortgage rates will decrease slightly in 2024, while inventory rises. Really? Again, we are a seller of falling home prices outside of the legacy urban centers. If the FOMC drops interest rates, housing prices in the suburbs will soar, starting an inflationary process that will likely end in a significant correction when the FOMC is forced to again respond to inflation.
In fact, some of the smart money in residential mortgage finance is preparing for precisely this outcome, a pop in home lending volumes for a couple of years, followed by a sharp deflation. Meanwhile, “the Fed’s 3Q flow-of-funds report shows private wealth, mutual funds, insurance companies, overseas buyers and broker-dealers increased their market shares in MBS while Fed and bank runoff continued,” writes Erica Adelberg of Bloomberg. That is, banks remain sellers of MBS.
Source: FDIC * Nine months 2023
Since the FOMC lacks the courage (and the political capital) to actually force home prices down, the Powell “pivot” portends another cycle of asset price inflation and, eventually, price deflation like that visible in commercial real estate. The residential home market will be the next example of the Fed's commitment to long-term price stability, followed by a maxi reset in home prices back down to ~ 2020 levels that may not even wait for 2028.
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