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The Institutional Risk Analyst

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Will the Fed Pivot or Pause?

October 10, 2022 | For the past several months, the asset gathers in the world of finance have been trying to turn the economic narrative of fighting inflation to the concept of a “pivot,” meaning a return to artificially low interest rates and perhaps even new bond purchases for the Fed’s system open market account (SOMA). This is a narrative that has appeal to residents of Washington, where the Biden Administration is largely dead in the water when it comes to the economy.

Two-thirds of likely voters say that inflation is their top issue as the November election approaches. The big issue in the minds of equity investors seems to lie with the assumption that the world of quantitative easing between 2009 and 2021 is a normal time to which we can return.

Or in other words, the increase in interest rates towards 5% for federal funds may turn out to be permanent for several years, especially if inflation in wages, necessities and housing remain in mid-to-high single digits or more. Mohamed A. El-Erian summarized the anxiety of the asset gatherers nicely in his Bloomberg column:

“On the surface, investors would appear to have only themselves to blame for this whipsaw, given the sharp contrast between their romancing, yet again, the idea of a Federal Reserve “pivot” and what, for once, has been consistent messaging from central bank officials that no such policy change is in the offing. Below the surface, however, the situation gets more complicated.”

One big complication is that the Fed is trying to regain credibility without actually addressing the central bank’s failure. "The Fed could do more on the communication side,” notes former Fed of New York President William Dudley. “Specifically, officials would do well to be more forthcoming about what went wrong, and why they now must raise short-term rates by more than 400 basis points in just 9 months."

While the Buy Side community continues to fret about rising interest rates, most observers still do not appreciate the impact of current short-term market rates on sectors such as housing. For example, if the premium Fannie Mae MBS for November delivery is now a 7%, how high does the loan coupon need to be to generate a positive gain-on-sale for the lender? Try 8.5%.

Today the on-the-run TBA contract is a 6.5% MBS soon to be a 7%. Think of what an 8.5% loan coupon will do to home prices in 2023 and beyond.

As we noted in out latest column in National Mortgage News, volatility is the enemy for markets not inflation. The sharp rise in interest rates has imposed huge losses on holders of loans and securities created during QE. We wrote:

“In the wake of QE, volatility in loan prices has exploded. Billions in low coupon delinquent government loans bought out of pools (a.k.a. EBOs) are now trading in the low 80s, choking both investors and lenders alike. Many of these EBOs were purchased above par, say 103, when the TBA was a 2% MBS trading at 106. But no more.”

The Fed has swung from indifference toward inflation a year ago to an almost maniacal focus on killing inflation. Equity markets assume an immediate pivot when inflation statistics fall. Obviously taming both the reality and the psychology of inflation will take more time, thus our view that the pivot is going to evolve into a pause in rate increases once we get to 5% on federal funds.

The difficulty for the equity markets is that we could be looking at higher rates for longer for at least the next year or two. Even when visible inflation starts to respond to tightening by global central banks, the US may not see a 2% yield on MBS for many years to come. This suggests a long-term valuation reset for many high-beta stocks and other asset classes that thrived during the Fed’s massive asset purchases. It also suggests billions in eventual mark-to-market losses on loans and securities created during QE.

When it comes to higher interest rates, get used to it.


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