Updated: May 5, 2022
"Without price stability, the economy really doesn't work for anybody."
May 4, 2022 | Premium Service | In this issue of The Institutional Risk Analyst, we return to the topic of interest rates, credit and mortgage assets. For the past several years going back to April of 2020, the housing market has been turbo-charged by quantitative easing or QE, pushing interest rates and loss-given default (LGD) down to negative levels. BTW, we just updated our latest paper on Ginnie Mae mortgage servicing assets.
With the increase in interest rates now set in motion by the FOMC, which moved by unanimous vote this month, our assumption is that credit default expenses for banks and bond holders will begin to revert to the mean. This repricing of risk will take time, perhaps several years. But if we assume that the FOMC means to wring the inflation out of the system, then the outlook for short-term rates – and credit over the medium term -- is decidedly bearish.
When LGD on a mortgage loan or secured bond is negative, that means that after a default, the proceeds generated upon liquidation exceed the original amount of indebtedness. In 2009, LGD on the average 1-4 family mortgage was 80-90% vs the 40-year average of 65%. Twenty three years and 5 QEs later, LGD on prime bank owned 1-4s is essentially zero and inflation is in double digits. As the FOMC raises interest rates significantly for the first time since 2008, we see major inflection points coming in credit as well as interest rates.
The chart above from Bloomberg illustrates how strongly the FOMC has been holding down the short end of the curve. This chart also symbolizes the degree of inflation in asset prices that the Fed has facilitated, an important relationship that is now about to change. Since default rates were muted during the entire decade of the 2010s, the mean reversion could be far larger than expected.
As the FOMC raises the target rate, the short-end of the curve will adjust accordingly. But everything from 2-year Treasury notes on out is above 3%. Obviously, the FOMC is behind the curve both figuratively and actually. This is perhaps one reason why St Louis Fed President James Bullard and others on the Committee are calling for faster action by the FOMC. Consistent with his strategy, Chairman Jerome Powell continues to move deliberately.
We interpret Powell’s caution as a recognition that the US market cannot tolerate a very significant upward move in short-term interest rates. This caution is reflected, we believe, in the average structure of the infamous dot plots, which show Fed Funds rising to less than 3.5% through 2024.
Listening to the press conference, it seems pretty clear that the "transitory" view of inflation is alive and well. Powell is slow walking inflation fight to avoid a market meltdown. Even the modest pace of change, however, suggests much higher long-term interest rates and a recession ahead. Even as Powell signals willingness to take interest rate targets higher, he has put off a decision on the Fed's balance sheet until June. That is perhaps one of the most important take-aways from this Fed meeting.
Mortgage Servicing Rights