By this time next week, we will have heard the Fed announce the next rate hike on September 21. It will be big too. How big is a matter of debate. 0.75% is a safe starting point, but 1.00% will also be on the table. The first would correspond to the July increase, the largest since 1994. A 1.00% increase has not been observed since 1982.
Desperate times call for desperate measures, and the Fed is desperate to fight the highest inflation in decades.
The Consumer Price Index (CPI) is the oldest and most widely followed measure of headline inflation in the United States. The Fed is targeting an inflation rate of 2.0% at the base level (orange line above). This mission was going as well as it ever had for most of the last 2 decades until Covid. For a variety of reasons, the Fed dragged its feet a bit in responding to the threat of post-covid inflation and has been trying to catch up ever since.
This “jostling” is evident in the financial markets. The typical reaction for stocks and bonds is to SELL SELL SELL when the Fed sends hostile messages. When traders sell bonds, rates rise. Stocks obviously fall when sellers are in control. The net effect looks like this:
What precisely are the “hostile messages” and the “change in Fed policy outlook”? In January, the big wake-up call was the Fed’s clear communication that its rate hike schedule would unfold much faster than it did during the 2013-2018 tightening cycle. As Fed speakers made this increasingly clear through speeches and official policy communications, stocks and bonds continued to panic.
Once the market feels like it understands the Fed’s mindset, it doesn’t expect such rhetoric. If traders know the data the Fed is interested in, traders will react to the data itself. In the current case, things are quite straightforward as inflation has no other contender for the Fed’s attention. When this week’s CPI data came out hotter than expected, traders knew what to do.
Luckily for consumers, the data didn’t actually show much of an increase in overall monthly obligations – something best measured by the overall CPI as seen here:
The title number includes all prices collected in the IPC report. It did not rise at all in July and rose only 0.1% in August. That’s the good news. The bad news is threefold. First, it was only as weak as it was due to lower fuel prices. Second, the Fed is focusing on the “core” CPI, which excludes food and energy.
We find the third piece of bad news in the data itself where core CPI largely defied forecasts, climbing 0.6% from expectations to hold steady at 0.3%.
If you noticed that the percentages of the last 2 graphs are much smaller than the first graph, it is because they are monthly figures. The first graph is expressed in annual terms, and it is in these annual terms that the Fed would like to see core inflation around 2.0%. Obviously, if each month increased by 0.6%, that would leave us at 5.0% in annual terms! Hence the sense of urgency in the financial markets and the mounting expectations for a rate hike next week.
This is a good time to answer the main question “what really matters?” While it’s true that the market could see a lot of volatility next week if the Fed hikes 1.0% instead of 0.75%, traders have made much bigger changes to the Fed’s rate hike outlook. Fed for subsequent meetings.
How can traders alter the Fed’s rate hike outlook? They don’t, really. They simply make bets on where the fed funds rate will be after a given month’s Fed meeting. The following chart shows how those expectations have evolved over time for next week’s meeting as well as next December and June (there’s a lot going on in this chart and we’ll break it down in more detail below) .
Let’s break it down into steps:
1. Note that expectations for next week’s meeting haven’t really changed overall. A 0.75% rise was expected at 100% before the CPI data. There is now a 20-30% chance of a 1.00% upside.
2. Note that most of the big spikes in 2022 followed inflation reports. The beginning of August was an exception, mainly for the longer-term outlook, and there were good reasons for that (surprisingly strong economic data, which said less about short-term inflation and more about existing inflation resistance)
3. Note that traders have already seen the Fed climb to 4.0% at the end of the year before the CPI data and are now seeing at least 4.25% without relief by June 2023 Compare that to late July when the green line was below the orange line (i.e. traders saw the Fed Funds rate fall between December 2022 and June 2023).
Simply put, the market hoped for a favorable rate scenario at the end of July and has been forced into a sharp 180° turn since then, both on economic data and inflation reports. This week was just the latest example. This turned out to have had an outsized impact as it is a very uncertain time for inflation. Economists look for signs (and see them in some places) that inflation has turned a corner.
They were also worried about the possibility that these positive signs were just by-products of falling oil prices. This week’s basic CPI data indicates that the concern is valid. It doesn’t help that Fed speakers are in their blackout period (12 days without Fed speeches leading to an official policy statement) and almost all have said they will let the data determine the extent of the next increase.
But to reiterate, it’s still not the size of next week’s hike that matters most. What matters most (or at least more) in no particular order will be the Fed’s own rate hike outlook. This is conveyed as a dot chart in the Fed’s “Summary of Economic Projections” or SEP. The SEP is published at 2 p.m. with the announcement of the rate hike. This frequently moves the markets far more than anything in the announcement itself, and therefore frequently leads to the erroneous conclusion that the market is reacting to the Fed’s rate hike.
In the case of the current meeting, the rate hike actually has more driving force in the market than average due to uncertainty over the magnitude of the hike.
Mortgage rates and housing markets
Let’s connect the dots, briefly, to how this has impacted the mortgage market. Again, it is not the fed funds rate itself or the short-term outlook that matters as much as the longer-term outlook. The Fed also completely abandoned its bond-buying programs on September 15. Although this dagger in the heart has been planned for months, daggers still hurt. The Fed’s bond purchases had been a major source of downward pressure on rates until they began reducing their purchase amounts at the end of 2021.
A few notes for anyone involved in the mortgage process these days:
First, note that rates first topped 6% in June and moved back above that line for most of September. Extensive media coverage of Freddie Mac’s weekly rate survey (which just rose above 6%) gave the mistaken impression that it was a new development. Even then, the high rates might not be as frustrating for some borrowers right now as the lack of “prime.”
Investors who buy mortgages pay historically prime (think of it as paying $310,000 on a $300,000 loan) and then expect to recoup that premium with interest over time. When rates have risen a lot and there’s even an ounce of hope that they might stabilize enough to trigger refinancing activity in the next few years, investors REALLY DON’T LIKE THE IDEA of paying that prime. This is one of the altruistic reasons for the now infamous “prepayment penalty” that existed before the regulations put in place after the financial crisis. In this environment, what would have been the prepayment penalty is now simply paid by borrowers up front in the form of higher closing costs.
All that to say that it is very difficult if not impossible to cover all the necessary upfront costs on some loan scenarios simply by raising the rate. In the past, increasing the rate got you more premium from the lender/investor. These days, that bounty doesn’t really exist, or it’s just too small to make sense. This will change over time, but rates will need to be lower and much less volatile.
Speaking of volatility, congratulations! You are living in a time that has not been seen in more than a generation with regard to the persistence of exceptionally high volatility (it was briefly a little higher for small periods of time in the past, such as March 2020, but it hasn’t been this high in over 40 years).
Last but not least, as a word on conforming loan limits. This is the maximum amount of a loan that can be granted to Fannie Mae or Freddie Mac, the two agencies that guarantee the majority of mortgage loans in the United States. Conforming loans are generally more desirable than others due to lower rates and streamlined, standardized underwriting processes. The amount is determined by Fannie and Freddie’s regulator, the FHFA (not to be confused with the FHA).
Conforming Lending Limits (CLL) increase every time house prices increase from Q3 to Q3. FHFA releases relevant third quarter data at the end of November, and loan limits go into effect for loans “delivered” to Fannie and Freddie beginning Jan. 1 (“delivery” may be weeks or even months after release). grant of a loan). For this reason, lenders have increasingly anticipated the expected changes in CLL. There is only one problem.
We do not yet have ANY third quarter 2022 home price data from the FHFA. Lenders are guessing price changes by then during a very volatile time. Several lenders have already pressed that trigger this year, much earlier than last year. The magic number seems to be 715k. If these lenders are willing to honor foreclosure commitments even if the official lending limit is lower, that is their business and should have no implication for borrowers or originators. The only point of this update is to clarify that the CLL HAS NOT BEEN MODIFIED YET. There are a few lenders struggling to guess what the change will be, but it won’t be officially announced until Tuesday, November 29.