Fed policy cacophony confuses markets

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Mortgage issuers regularly ask this writer why the members of the Federal Open Market Committee feel the need to comment publicly on interest rates just about every day, on television and other media, and even on weekends. The answer, sadly, is that the FOMC thinks that confusing everyone completely is good for confidence, that intangible but entirely necessary ingredient for financial stability. 

Economist Komal Sri Kumar notes: "Just two weeks after telling an audience at Stanford University that inflation was on a 'bumpy' road toward the Federal Reserve's 2% target, Chairman Jerome Powell abruptly shifted." 

"If you were among the investors who had taken the Chairman at his word and thought we were entering a low-inflation environment, you are out of luck," Kumar added.

After seeing mortgage rates rally from last October through much of the first quarter of 2024, lenders now face rising mortgage rates and the prospect of lower volumes ahead. Yet with the Fed Funds target at 5.25 to 5.5%, rising loan coupons may lead to better profitability ahead, at least a positive spread between coupons and warehouse finance costs. 

The Basel III proposal will double the credit conversion factor on committed warehouse lines, which is absurd considering that it would have a significant impact on the unused portion of such commitments. Even as lenders begin to see positive spreads over funding costs for the few purchase loans available in the market today, federal bank regulators may slam the door shut on bank warehouse lines, reducing market liquidity.

Fact is that mortgage lenders are focusing on a world where purchase volumes are the predominant opportunity. These loans are very expensive, with a total cost to acquire the lead and close over $12,000 per loan, according to the Mortgage Bankers Association. But as mortgage loan coupons rise into the mid-7s, at least some lenders will be break even or positive on carry prior to the sale of the note. 

Through most of the first quarter, many lenders actually saw rising loan volumes and improved gain-on-sale margins as consumers who need housing are finding a way to make it work. Yet even with mortgage rates in the 7s today, lenders with large servicing portfolios are still finding ways to generate new volumes.

"One may think it is counter-intuitive to be discussing recapture at a time where primary mortgage rates are still hovering above 7%, but recapture is still playing a role in MSR pricing," opines Mike Carnes, managing director for mortgage servicing rights valuations at MIAC.  

The first action by the Fed is to slow the rate of runoff of the central bank's Treasury portfolio. Wall Street's happy progression toward a FF rate cut has been interrupted by 1) the approaching election and 2) bad inflation data. The slowdown in the rate of decline of the Fed's balance sheet is effectively a rate cut. More reserves means more bank deposits, which hopefully means more demand for loans and MBS by banks.

With the U.S. less than six months from a contentious general election and economic data that suggests inflation is again rising, it is a pretty good bet that the FOMC is not going to change the target for federal funds until December at the earliest. This means that market interest rates could move higher on the back of record debt issuance by the U.S. Treasury in the third quarter. 

Of note, Powell did not change the Fed's $35 billion monthly cap on runoff for MBS, probably because the actual rate of decline in the portfolio is more like $15 billion per month. Prepayment speeds for Ginnie Mae MBS are running a bit above 6% on average, but some pools are running far slower. 

With mortgage rates again rising toward the 8% peak seen last October, a number of observers are predicting lower home prices ahead. In the 2024 Buyer Insights report from Auction.com published last week, local community developers buying distressed properties at auction are increasingly bearish about home prices and rents for 2024.

Among those surveyed, 40 percent expect home price declines for the year, up from 32 percent in 2023 and up from 17 percent in 2022. Meanwhile, 29 percent of buyers surveyed expect rents to decline in 2024, up from 16 percent in 2023. While declining rents are welcomed by consumers, falling net operating income is bad for the valuations of residential and multifamily assets.

If you are long on residential homes in your investment portfolio, should you be worried about falling prices? Probably not in 2024. Valuations for multifamily properties are under downward pressure in some cities with progressive rent control laws, but overall the lack of new, affordable housing is keeping single-family prices firm. Inflation in costs for buying or operating a home is another factor that is limiting access to housing.

So will the Fed under Chairman Powell be able to tame inflation and thereby reduce inflation? Don't bet on it. The FOMC under Powell has been incapable of presenting a clear, unambiguous message when it comes to interest rate policy, leaving investors and lenders confused and increasingly angry with the central bank's lack of clarity. If we cannot trust the statements made by Fed officials to give us guidance on future interest rates, maybe the Fed should talk less? But that may not be helpful either. 

"The Committee has been surprisingly willing to leave the post-meeting statement unchanged despite the language becoming stale," notes Bill Nelson of Bank Policy Institute in a note last week. "But with inflation rising instead of falling, without adjustments, the Committee risks making the one communication tool it owns even more irrelevant."