Last week, the Federal Reserve's decision to pause interest rates was met with applause from the markets. Over the past 15 months, the Fed has raised interest rates in 10 consecutive meetings, resulting in a cumulative increase of five percentage points, bringing the Fed funds target rate to 5 to 5.25%.
Now, the question on everyone's mind is whether this marks the end of the rate-hiking cycle and what lies ahead.
As mentioned earlier, the Federal Reserve had been aggressively raising the federal funds rate to combat inflation. Inflation peaked last summer, reaching a growth rate of over 9%. The Fed's goal is to bring it back down to around 2%. However, the Fed's initial belief that inflation was temporary turned out to be incorrect. In turn, the rate hikes, which began in March 2022, proved to be the most aggressive in over four decades.
To understand why the Fed changed its stance, we need to grasp the concept of demand-pull inflation. It occurs when there is an excess of money chasing too few goods, resulting from an increase in the money supply. In the United States, historically, money supply has grown at an average rate of 7% per year. However, due to quantitative easing measures implemented over the past decade, the money supply has grown at double that rate, reaching 14% per year. Quantitative easing involves the central bank injecting more money into the system by purchasing securities such as bonds and mortgage-backed securities from banks. This infusion of capital allows banks to lend out more money, thereby increasing the money supply.
In addition to quantitative easing, the government's injection of COVID-19 relief funds further increased the growth of the money supply, growing at an astonishing 27%. With an excess of money in the economy, inflation began to rise. Initially, the Fed believed it was due to supply constraints, but they underestimated the real inflationary pressures. It wasn't until March 2022, coinciding with the first rate hike, that they finally ceased quantitative easing.
To combat inflation, the Federal Reserve has two primary tools at its disposal. The first is raising short-term interest rates by directly increasing the federal funds rate, which affects borrowing costs between banks. The second tool is quantitative tightening, the opposite of quantitative easing. Instead of injecting funds into the market, the Fed stopped purchasing bonds and mortgage-backed securities and halted the reinvestment of payoffs, reducing the inflow of funds into the economy.
Now that the Federal Reserve has hit the pause button, does it mean we can relax and expect no further interest rate hikes in the near future? Unfortunately, we must temper our enthusiasm. Upon reviewing the statements made by the Federal Reserve members, the majority of policymakers still foresee one to two quarter-point rate hikes later this year.
According to the Fed Fund futures, there is currently a 50% probability of a quarter-point hike in either the next meeting in July or the following one, and possibly both. Previously, the futures market had been anticipating rate cuts later this year, but that expectation has dropped to near zero. Now rate cuts are not expected until next year, with a 96% probability of cuts by the middle of next year. However, in the short term, there remains the potential for one to two more rate hikes.
The pause in rate hikes is primarily due to the Fed's desire to monitor incoming data over the next month. The Consumer Price Index (CPI), a broad measure of inflation, has shown some decrease in the growth rate of inflation, but still remains above the Fed's target. Currently, it stands at about 4%, but the Fed is more concerned about the Core CPI, which excludes energy and food, and it sits at around 5.3%. This core measure of inflation appears to be more "sticky".
The reason the Fed is still considering rate hikes is that they want to see these numbers come down. What the Fed has not discussed is the fact that 1/3 of the Core CPI is made up of shelter (ie. rents). Rents are a lagging indicator and have not passed through to the core CPI figures. We expect to see rents decreasing on a year-over-year basis in the upcoming CPI reports, which should help lower the Core CPI.
Nevertheless, it's important to remember that the Federal Reserve tends to swing the pendulum too far in either direction. They do not want of a repeat of the 1970s, which is why they have a high potential for overcorrecting or continuing to raise rates. What they don't want is to cut rates too soon. They are fearful that doing so would cause history to repeat itself.
Their aversion to the 1970s is rooted in the experience of runaway inflation during that time, primarily driven by soaring energy prices, exemplified by the long lines at gas stations. Under then Fed Chairman Arthur Burns, rates were aggressively raised between 1972 and 1974, only to be quickly followed by rate cuts. However, this led to a resurgence of inflation. The subsequent Fed chairman, Paul Volcker, had to aggressively raise rates to combat inflation, resulting in back-to-back recessions and an unemployment rate that exceeded 10%.
The current Federal Reserve is genuinely concerned about reliving the 1970s and is determined not to repeat those mistakes. They are cautious about not cutting rates prematurely, and thus, there is a significant likelihood of them overcorrecting or maintaining a high rate of increases.
Although most people argue that our current economy is vastly different from the 1970s, it doesn't matter to the current Fed officials who experienced that era firsthand. They vividly remember the challenges and are determined to prevent a similar situation from occurring on their watch. Therefore, I anticipate at least one more rate hike, potentially two, depending on how quickly the CPI numbers and other inflation indicators decrease, especially the Core CPI.
Now, let's turn our attention to the banking system. While much has been said about the collapses of Silicon Valley Bank, First Republic, and Signature Bank, these significant bank failures seem to have been forgotten quickly. Yet, they are among the largest bank failures in US history, all occurring within this year. Although I won't delve into the details of these specific bank runs, it is worth noting that there are other indicators of cracks in the banking system, partially attributed to the aggressive rate hikes and unrealized losses in their portfolios due to bonds held with values below par value. The Fed is closely monitoring these indicators as they aim to prevent any cracks in the banking system. Additionally, the commercial mortgage and commercial loan scenario should also be kept in mind, as it presents its own set of concerns.
So, what does all of this mean for you? How does it affect mortgage rates and the potential impending recession that has been the topic of discussion for over a year? In terms of mortgage rates and interest rates, it is important to continue monitoring the 10-year Treasury, as the 30-year fixed-rate mortgage follows its trends rather than the Fed funds rate. Throughout this year, the 10-year Treasury has traded within a range, approximately between 3.25% on the low end and 4.25% percent on the high end. It has tested the lower end of the range multiple times but hasn't been able to break it due to various factors. Therefore, it's crucial to keep an eye on any breakouts to either the upside or downside, as it will have significant implications for the 30-year mortgage rates.
In the meantime, 30-year mortgage rates are expected to continue trading within the range of high 5% to low 6%, up to the low 7% range. This is influenced by the 10-year Treasury and the wider spreads between the 10-year Treasury and the 30-year mortgage, which are currently higher than normal, around 3% (historic spread between the two averages 1.72% over the last 50 years). The market's volatility, the absence of the Fed's mortgage-backed securities purchases, and other factors (like banking crisis) contribute to these increased spreads.
Regarding the potential recession, many people wonder if it will occur this year, next year, or if we can avoid it and have a soft landing as often discussed by the Fed. From my perspective, yes, we will experience a recession, most likely sometime next year. This belief is supported by several factors. Firstly, the inverted yield curve, whether it's the two-year 10-year, three-month 10-year, or the three-month versus the 18-month forward, has been inverted for over a year. This inversion historically indicates a recession. Furthermore, since the 1960s, every recession has been preceded by an inverted yield curve, typically occurring 12 to 24 months before the recession manifests. Therefore, the chances of a recession are relatively high. Typically, when we are entering a recession, the yield curve tends to flip (back from its inversion), usually at the beginning or right before the recession.
Numerous other indicators and red flags, such as manufacturing indexes, also point to a potential recession. But right now, all the flags are up except employment. And the funny thing about employment is that everyone is using it to argue for a soft landing because the job market is strong. However, if we examine this chart we can observe that unemployment reaches a low point almost every time before a recession.
Therefore, the current low unemployment rate is not a new phenomenon; it is typical in previous recessions. It's important to keep an eye on any signs of it starting to rise.
Regarding the Fed's future actions, I believe they will continue to raise rates at least one or two more times. They seem determined to impact the labor market, aiming for a five to 5.5% unemployment rate to ensure inflation remains in check and prevent a repeat of the inflationary issues experienced in the 1970s.
As for the possibility of a recession, I still think it is likely. My bigger concern is the banking industry, and I hope we don't face another crisis there (which I fear could be caused by commercial defaults). Let's stay tuned to the data, and I'll make sure to keep you informed.
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