The last few days of March offered hope 2022’s massive rise in interest rates may become slower. The first few days of April shattered those hopes, and things have only gotten worse as the new week begins. After breaking above 5% at the end of last week, Monday morning brought the average 30-year fixed rate up to 5.25%, a level not seen since 2009.
To understand why, we need to revisit the general motivation for the rate hike. Before we do, let’s put “massive“in context. This is not an exaggeration given that this is the largest, fastest jump in mortgage rates since at least 1994.
regarding “Why,” it’s actually pretty straightforward. The Federal Reserve (aka “Fed”) is best known for setting the Fed Funds rate, which dictates the cost of the shortest funding. It raises and lowers this rate to try to persuade inflation and employment to remain in certain areas. In cases where interest rates are lowered to zero and the Fed believes more needs to be done, they buy bonds (specifically US government bonds and mortgage bonds). Buying bonds creates surplus demand in the bond market, which in turn pushes longer interest rates down. It is basically a way for the Fed to influence both short and long term interest rates.
At the beginning of the pandemic, the financial markets were in chaos and the Fed agreed to lower interest rates to 0% and buy bonds at a faster pace than ever before. Instead of repulsing these bond purchases as markets began to settle, the Fed concluded that it should continue to provide as much monetary stimulus as possible in light of covid’s impact on the labor market. They justified this with assumption that covid-driven inflation would decline as the pandemic subsided.
As we know now, covid-related inflation did not do decrease. After the Fed’s own admission, it drastically miscalculated the persistence of inflation and even the health of the labor market. As 2022 approached, we suddenly saw ourselves staring down the barrel with the largest inflation figures and the tightest labor market in decades. Meanwhile, the Fed still had its Fed Funds interest rate at 0% and still bought more than $ 100 billion in bonds each month.
Changes were slow to come in the beginning. In September 2021, the Fed began settling new bond purchases – a process it had to complete before raising interest rates. A few months later, as inflation continued to rise and the labor market tightened, the Fed began accelerates its exit from easy monetary policies, but much like one battleship in a river.
In early 2022, the Fed’s communications spoke to a certain level of panic not seen since the 1980s. The Fed does does not likes to make big course corrections when it starts to turn the legendary battleship, but 2022 has seen that kind of unexpected accelerations in a row. This rapid reconsideration and rapid removal of bond buying demand by the Fed is the key ingredient in the rate hike seen so far in 2022. Last week brought just the latest iteration.
Quite concretely, in a prepared speech Tuesday morning, Fed Vice President Lael Brainard (usually one of the most pro-Fed speakers) joined a chorus of more outspoken Fed members who have talked about the possibility of extremely large reductions in Fed bond purchases ( referred to as “normalization”). This was not a completely new concept, as the Fed is already registered, saying that 2022’s normalization will certainly be greater and faster than 2017 – the only relevant precedent. That said, the market was surprised to hear it from Brainard – at least in such emphatic terms.
One of the reasons for the surprise was that the following day the minutes of the most recent Fed meeting would be released (3 weeks before). Fed protocols often contain additional clues about impending policy changes. Traders correctly assumed that there could be a bomb in the current version. It was a long way to go to soften the blow when the minutes actually came out.
So what was all the fuss about?
In a nutshell, the protocol set out an explicit roadmap for normalization. While the Fed rolled out the 2017 normalization process with a hit of 4 billion. $ per month for MBS (mortgage-backed securities) purchases, the 2022 plan requires phase one to start with a staggering $ 35 billion. $ a month! The discrepancy is the same when it comes to the Fed’s Treasury purchase. Again we knew it would get bigger and faster, but not quite as big / fast.
Because Fed bond purchases are targeting longer-term interest rates, that was where we saw the pain after the release of the minutes. In other wordsthings like 10-year government interest rates continued to move higher, while 2-year government interest rates managed to recover.
Mortgage rates worry about 10-year interest rates because 10-year interest rates talk about trends in “long-term interest rates” in general. Alternatively forget all that and simply observe the context in the following diagram:
While longer term also correlates with shorter interest rates, as you can see in the following charts, it is not quite the same. Short-term interest rates rise and fall faster and less frequently. Interestingly, when short-term interest rates peak, relief is typically not far behind long-term interest rates. Unfortunately, we have yet to confirm that highlight.
So many things are so different about this economic / monetary cycle that previous precedent may not be as useful as usual. The only thing we really know at the moment is that we are waiting for more important developments. The most important of these would be that inflation data show signs of shift. However, it may take months and the bond market may have priced an abundance of caution at the time.
Before then, we’ll wait to see what triggers the Fed is actually pulling at its upcoming meeting in May. They will definitely hike, probably by 0.50%. They are also likely to adopt the normalization plan set out in last week’s minutes. If that’s the extent of the damage, then the market does finally be on the same page with the Fed (with the exception of further accelerations in the coming weeks). Paradoxically, this means that the rate hike and the large reduction in bond purchases can actually be a good thing for longer interest rates.
That would not be the first time we have seen such a paradox. Longer interest rates always do their best to cater for future opportunities. If they know the Fed is likely to raise short-term interest rates or normalize bond buying at a certain pace, they are free to move on to their next trend. In several previous occasions, we have actually seen mortgage rates fall while Fed policy was tight or tight.
Then again only questions are: how well have the long interest rates priced in the future this time? It has only been the unexpected changes in the outlook that have caused so much extra upward momentum in interest rates. When these prospects stabilize, interest rates are likely to fall again already. Unfortunately, there is no telling whether it is the kind of thing that will happen in a few weeks, a few months or in seizures and starts during the year.